A Decade After the Crisis: Assessing Monetary Policy and Financial Supervision

Adecade ago, the US subprime mortgage crisis erupted and ultimately evolved into a full- fledged global panic with the collapse   of the investment bank Lehman Brothers. What have we learned in these 10 years? Were there any positive things that emerged from that painful experience and what were the biggest negatives? Are there hidden risks of another crisis? It is clear there is a need for further reflection on the causes of the crisis and continued vigilance in order to prevent a recurrence.

In most countries the response to the crisis focused on the following aspects. There was a need to determine the causes of the crisis, a need for stepped up financial governance and a need to address the problems with appropriate strategies, including the use of countercyclical macroeconomic policies. After the outbreak of the crisis, with the global economic recession and financial markets in turmoil, countries needed to launch large-scale rescue measures that made use of fiscal and monetary tools to maintain economic and financial stability. 

The crisis, which inflicted substantial damage in terms of lost economic growth, increased unemployment and battered public finances, was a result of global imbalances, the instability of the international monetary system, loopholes in global financial regulations and national policy flaws. It pointed to a need for greater international policy coordination and reform of the global governance system, which was clearly ill-suited to new economic and financial demands. There was also a pressing need to deepen structural reform. 

Many deep structural problems remain unresolved and threats to financial stability continue to accumulate. More reflection is needed on a range of issues -- from the macro level and the international monetary system to micro level financial products, and from global economic imbalances to the moral hazard of credit rating agencies. Combined with the current situation facing the world economy, there is a need for a broad review of the experience gained over the last decade. Monetary policy and financial supervision are among the areas that demand our attention.

Monetary Policy
Monetary policy was an important contributor to the subprime mortgage crisis. Policy makers and influential academics generally believed that from the 1990s to 2007, the developed economies led by the US were safely in a period of "great stability." Gross domestic product, the consumer price index, industrial production, unemployment and other real economic indicators saw less severe swings, contributing to a feeling of optimism among policy makers. Spurred on by the tech stock crisis and the terror attacks on September 11, 2001, the US implemented long-term low interest rate policies. From 2000 to 2003, the US Federal Reserve's benchmark interest rate declined from 6.5% to 1.0%, setting the stage for a consumer and real estate bubble. The Federal Reserve did not pay sufficient attention to the relevant risks, mistakenly believing that the free market would automatically make all necessary adjustments.

In the following three years, with inflationary pressures gradually accumulating, the Federal  Reserve continued to raise interest rates, and this eventually led to the bursting of the real estate bubble. The defaults on subprime mortgage products, dramatic increases in property inventories and bank auctions added to downward pressure on property prices. Problems linked to asset securitization, credit default swaps and other derivatives inflicted huge losses on major financial institutions. Some ultimately collapsed. Market confidence suffered unprecedented shocks with a sudden tightening of liquidity across the globe.

The US subprime crisis demonstrates that there are risks associated with the easing or tightening of monetary policy. Policy makers are trying to grapple with this issue at this very moment as they assess the best way to withdraw from the super loose monetary policies adopted after the crisis.

In response to this extraordinary financial crisis, the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan quickly reduced their benchmark interest rates to near-zero levels and made use of fiscal stimulus and other tools. These measures played an important role in restoring market liquidity and prevented the global economy from sliding into another “Great Depression." But the world noted that zero interest rate policies and even negative interest rates are still incapable of promoting real economic recovery without creating liquidity traps. Major central banks later implemented a variety of monetary measures that generally fell under the broad category of quantitative easing. Although there were differences in the types of quantitative easing policies as to specific asset purchases, the timing of these moves and the manner in which they were made, they all were aimed at reducing long-term interest rates in order to stimulate the real economy. After learning the lessons of the subprime crisis, most countries adopted a combination of quantitative easing -- an easier monetary policy -- coupled with tighter financial supervision to minimize excessive speculation and prevent asset bubbles from too much liquidity.

At present, developed economies are facing new challenges as they continue their recovery, but with some degree of higher inflation and potential asset price bubbles. The question now is how do global decision makers avoid distorting the effects of long-term low interest rates on financial resource allocation and prices?  How can they ensure that emerging economies can adapt to the demands of this return to policy normalization?

Many countries learned from the Federal Reserve's excessive policy tightening between 2004 and 2007. The current round of normalization of monetary policy highlights three major risks. There is a need for close monitoring of economic conditions and development prospects to guard against a hasty withdrawal that could disrupt an already weak economic recovery. There is also a requirement of greater market communication and greater attention to the selection of exit tools to ensure that the level of interest rates, asset prices and the like are not adjusted drastically.

As the global economic recovery is relatively weak and uneven, the withdrawal from these super loose policies will be a challenging task. Each step on this path may contain significant risks. The US economic recovery began before recoveries got under way in Europe and Japan. As a result, the Federal Reserve is at the forefront of monetary policy normalization. Since 2014 the Fed began to develop its principles and plans of monetary policy normalization, but the implementation process has been full of twists and turns. From the beginning of the discussion of monetary policy referring to when to begin raising interest rates to announcing the withdrawal from quantitative easing, each step has had an effect on global markets, ranging from exchange rate fluctuations to capital flows and at times market tur