Lessons for Monetary Policy from the Euro-Area Crisis

The earlier 2007/2008 financial crisis generated the main lessons for monetary policy, notably that price stability does not necessarily guarantee financial stability. Nevertheless, the on-going Eurozone crisis has pointed to further lessons, notably that a single currency covering diverse states does need a Banking Union; and to problems of zero risk-weighting for sovereign debts. Without such a Banking Union, economic divergences between the Eurozone states have continued and look likely to persist. 2013 Elsevier Inc. All rights reserved. 1. The 2007/2008 crisis The crisis with the most lessons for monetary policy was the original 2007/2008 crisis, not the subsequent Eurozone crisis. This initial 2007/2008 crisis, however, originated in the US housing market, and was not specifically European. Nevertheless the resulting financial debacle entailed numerous important lessons for monetary policy. Amongst these were: (i) Price stability does not necessarily guarantee financial stability. As HymanMinsky demonstrated, price stability may even conflict with financial stability, rather than complement it. This is because a reduction in macro-economic volatility may seem to reduce risk, and therefore make financial institutions raise their leverage, and reach for yield. Hence there is a need for counter-cyclical macro-prudential instruments. The use of these would be relatively new, and remains unproven. In particular, macro-prudential counter-cyclical measures would have to be imposed against the momentum and grain of the market. If an asset price boom was perceived to be unsustainable, it would immediately subside under its own weight. Accordingly, the majority of those involved must be believing that further price increases in the relevant asset market(s) may well continue. Politicians may believe that the asset markets have risen because of their own successful policies. Consequently, macro-prudential counter-cyclical policies would have to be introduced at a time when they are likely to be opposed by many politicians, most borrowers and lenders, and many, probably most, commentators in the Press. 0164-0704/$ see front matter 2013 Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.jmacro.2013.08.014 ⇑ Tel.: +44 (0)20 7955 7555. E-mail address: [email protected] Journal of Macroeconomics 39 (2014) 378–382