Age of Turbulence, the book written by the U.S. Federal Reserve (Fed)'s former governor Alan Greenspan, hints that the Fed was also responsible for the global financial crisis. The Fed's expansionary policy approach to overcome the shock after 9/11 ended up with a huge mortgage market in the U.S. But this growth was not limited only to the mortgage credits in the domestic market; the derivatives like subprime mortgage loans also became a major financial instrument. These expansions in the financial markets were non-problematic when the interest rates were low due to the Fed's policy approach. But after 2006, the rate hikes by the Fed influenced the mortgage market directly and all markets related to these mortgage credits indirectly. The result was a subprime mortgage crisis started in 2007 and deepened in 2008 September with the crash of one of the too-big-to-fail: "Lehman Brothers." This was the Fed's role until that moment but after the crisis widened globally, nearly all central banks took measures that harmed national economies and the crisis resulted in negative growth and unemployment turmoil.
The Fed's main response by ex-governor Ben Bernanke, who had studied 1929's Great Depression, was quantitative easing policy and this policy approach helped the U.S. economy to overcome the problems earlier than expected compared to other developed economies, mainly in Europe. This was one positive result of the policy, but there was also a bad side, which has come up with the financial opportunities created by expansionary measures. The unrealistic overvaluation in the bonds and stocks market helped the financial institutions to recover their losses after the financial crisis.
This new scene started to turn out being the same as the pre-crisis period, which was criticized after the crisis, as the financial intermediaries were taking risks without enough accountability and with insufficient regulatory structure in the markets.
Without fiscal policy, money policy is disabled
The last financial crisis and the results of the monetary policy measures reminded us that monetary policy and fiscal policy should be used together in a synchronized approach to achieve a permanent recovery. Unfortunately, we have not seen such a coordinated monetary policy and fiscal policy in the EU and the U.S. despite the last financial crisis. Before the crisis fiscal policy was not effectively used and the whole solution was expected from the monetary policy measures. But expecting the Fed and the European Central Bank (ECB) to be the "superheroes" of the globe was too much for these institutions, which went without the support of fiscal measures, including taxation and public expenditures stimulated economic growth.
Thus, the Fed's Vice Chairman Stanley Fischer, in his speech at the 40th Annual Central Banking Seminar, New York, said when the economy falls into the liquidity trap, traditional monetary policy loses its effectiveness and fiscal policy has to be used for countercyclical stabilization; confirming what I have mentioned above. Also, in the last eight years, the effort to solve economic problems with just fiscal policy became like walking with one leg and made it harder for the U.S. and EU economics during the process of exiting the financial crises.
In 2014 and 2015, the general atmosphere in the financial markets was "bad news is good news." Why was bad news good news? Because it was easy to see that bad news would lead monetary policy authorities to continue their expansionary approach and market actors would continue their high-risk operations. In the meantime, since 2013, the Fed named these high-risk activities by financial intermediaries as the new potential trigger of the financial crisis and until the end of 2015, tried to manage the process with public diplomacy.
The rate hike decision at the end of 2015 changed the game from bad news is good news to bad news is really bad news. Even though the expectation was a three-time rate hike in 2016, from last December to today, only once has the Fed increased the policy rates. While we are going through presidential elections in the U.S., a new rate hike for 2016 is still on the table and this is the main agenda for financial markets.
Signals by Fed and ECB took markets down
In the last week, international media has been talking about the unofficial consensus in the ECB to end the monetary expansion and Fed's high probability of a rate hike in the last quarter. These expectations had a negative impact on the markets. The differences between the messages given by leading central banks and the measures they took has led to the international financial actors questioning the credibility of these central banks. The negative effect in the markets is one aspect but questioning of credibility is also putting the monetary policy's effectiveness under risk.
These inconsistencies and the decreasing credibility of the decisions by the central banks are harming the global financial system, which is also under threat due to the economic and political tensions across the globe. One piece of bad news that could be considered worse is the commercial banking industry's future. As the main intermediary for increasing international economic transactions, commercial banking industry is also under more pressure due to these uncertainties. Next week, I will continue to discuss these risks that we face off.
About the author
Kerem Alkin is an economist, professor at Istanbul Medipol University. He currently serves as the Turkish Permanent Representative to the Organisation for Economic Co-operation and Development (OECD).