Lessons for Monetary Policy from the Global Financial Crisis: An Emerging Market Perspective
By Deepak Mohanty∗
The global financial crisis has challenged the conventional views on the role of monetary policy. Post-crisis, the weight of arguments tilts towards acceptance of financial stability as an objective of central bank or monetary policy. However, the key challenge is to evolve a consistent framework for implementation. While interest rate can continue as the dominant instrument for implementing monetary policy, supplementing it with other quantity or macro-prudential instruments even in normal times will not only enhance the flexibility of monetary policy to attain multiple objectives but could also obviate the risk of hitting the zero lower bound.
I. Introduction
I thank the Bank of Israel for this opportunity to present my views before this distinguished gathering. The past three years have been unprecedented in the history of the world economy. The crisis though not unique in terms of its nature has certainly been more global and intense in terms of its impact. The expanse of the crisis has tested all the limits of conventional and unconventional policy options available to policymakers around the world. In fact, the speed and intensity with which the US subprime crisis turned into a global financial crisis and then into a global economic crisis has led to a whole new debate on the dominant tenets in macroeconomics.
The crisis has certainly questioned the efficacy of the existing institutional framework and available policy instruments at the national as well as international levels in ensuring global financial stability. It has raised skepticism about the functioning of financial markets ∗ Paper presented by Shri Deepak Mohanty, Executive Director, Reserve Bank of India in the Central Banks Conference of the Bank of Israel, Jerusalem on April 1, 2011. The assistance by Jaya Mohanty, Rajeev Jain and Binod B. Bhoi is acknowledged. 2 and institutions, in particular their capacity to price, allocate and manage risk efficiently. It exposed weaknesses in both private sector risk management and inadequacies in the public sector’s oversight of the financial system. The lessons, though are still being distilled, are relevant not only to advanced economies but also to emerging market economies (EMEs).
Against this backdrop, I will reflect on the following set of questions. How was the recent crisis different from the past crises in terms of its cause and impact? What were the differences in the nature of policy response in the advanced economies and EMEs? How was India impacted and what were its policy responses? I will conclude by highlighting six key lessons from the crisis which have implications for the conduct of monetary policy.
II. Genesis of the Crisis
It has now become clear that the crisis was not an outcome of any single cause rather the result of the complex interaction between a host of macroeconomic and microeconomic factors. From a macroeconomic perspective, the crisis has been viewed as being caused by the persistence of global imbalances, excessively accommodative monetary policy pursued in major advanced economies and lack of recognition of asset prices in policy formulation. The microeconomic causes highlighted in the literature are the excessive credit growth and associated leverages, the lowering of credit standards, rapid financial innovations without adequate regulation, inadequate corporate governance, inappropriate incentive structure in the financial sector and overall lax oversight of the financial system.
Global Imbalances
It is argued that while the subprime problem was the trigger, the root cause of the crisis lies in the persistence of the global imbalances (BIS, 2009). Large current account deficits in the advanced countries, especially the US, mirrored by large current account surpluses in EMEs, especially China, implied that excess saving flowed uphill from developing countries to developed countries (Chart 1). This ‘saving glut’ (Bernanke, 2005) was considered as one of the factors leading to the crisis. The causation, however, is not very clear: whether it is excess saving in China or excess consumption in the US that contributed to the crisis (Mohanty, 2010).
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