Financial crises come in all shapes and sizes. In a recent post, I summarized a new NBER working paper by Michael Bordo, which broke financial crises into a few broad categories by type and time period. Bordo’s broad, historical takeaway is that financial crises are extremely diverse. For example, the credit boom and bust we focus on in a post 2007-2008 world was completely absent for decades before that.
Given such diverse crises, what can we learn about proper monetary policy?
In this kaleidoscope of crises and ever-changing monetary policy regimes around the world, it may appear that any policy suggestions cannot possibly generalize. The next crisis is most certainly not going to be another 2007-2008. The retrospective advice “don’t overheat a housing market” may be irrelevant next time. To further complicate matters, major crises like 2007-2008 end up changing the whole monetary policy regime itself. At first glance, any general principles must be hard to come by.
Bordo isn’t so pessimistic. He suggests we might draw substantial lessons from past episodes. Specifically, he stresses four principles for a stable monetary policy regime.
First, and most obvious, is that monetary policy regime stability requires price stability. If the price level rises or drops drastically, the whole system becomes vulnerable and changes, as when the Bretton-Woods system collapsed.
Second, we need real macro stability. Recessions undermine monetary stability as much as drastic inflation, such as during the Great Recession, when prices were relatively stable but output contracted drastically.
Third, the regime must have a credible, rules-based lender of last resort. Bordo argues that crises in the recent decades stemmed from the failure of central banks to follow Bagehot’s rule and, instead, starting a “too big to fail” policy.
Finally, the financial system must include sound financial supervision and regulation. Bordo sees 2007-2008 partially as a failure of sound financial supervision.
There is plenty of room for discussion about how to best implement these goals. For example, some would argue that NGDP targeting is an effective way to achieve real macro stability. But Bordo’s broad point still stands: whenever policymakers have deviated from these lessons, the regime has changed drastically. Therefore, we need to create incentives for policymakers to follow Bordo’s principles.
Bordo shows policy improvement isn’t hopeless. He points to Canada as the shining example of a country that has broadly followed the four principles for stability (that is, if one ignores the price instability of the 1970s). Unlike the United States, Canada was able to avoid the worst problems of the Great Depression and Great Recession. We might hope that, based on the work of Bordo and others, more countries will be so effective in the future.