Monetary Policy, The Eurozone, And the Crisis

A common theme among those who de-emphasize the role of monetary policy in the creating the housing boom and ultimate bust is that the story doesn’t apply outside the United States. In other words, how do we explain housing booms in other countries? The policy European Central Bank, for example, is not perceived by some observers to be as loose as that of the Federal Reserve.

On this point, however, I wondered whether this was correct. For example, policy rates for the Eurozone may have different effects on different members. Specifically, regarding Ireland, I wrote:

I have found the Irish experience of the worldwide recession to be one of the most intriguing. From 1990 up until the beginning of the recession, the Irish economy grew over four-fold. However, since the recession began the economy has contracted by almost 20%. Part of my interest in Ireland is due to the fact that with the economy growing as rapidly as it did during its “Celtic Tiger” phase, rising productivity should have put downward pressure on prices. However, Ireland uses the Euro as its currency. As a result, it is possible (likely?) that monetary policy was comparatively loose in Ireland compared to other European Union members. Thus, if monetary policy became tight following a negative aggregate demand shock, this could potentially explain — at least in part — why the contraction was so severe in Ireland as one would expect to see a number of projects financed as a result of loose monetary policy fail.

Thus, the question is whether monetary policy played any role in the downturn.

A tangentially related new working paper by Angela Maddaloni and José-Luis Peydró might provide an answer as to the mechanism through which monetary policy could produce differing effects across countries. The paper focuses on deviations of monetary policy from the Taylor rule across countries in the Euro Area. Here is the abstract:

We analyze the root causes of the current crisis by studying the determinants of bank lending standards in the Euro Area using the answers from the confidential Bank Lending Survey, where national central banks request quarterly information on the lending standards banks apply to customers. We find that low short-term interest rates soften lending standards for both businesses and households and, by exploiting cross- country variation of Taylor-rule implied rates, that rates too low for too long soften standards even further. The softening is over and above the improvement of borrowers’ creditworthiness and all the relevant lending standards are softened, thus implying that banks’ appetite for (loan) risk increases. In addition, high securitization activity and weak banking supervision standards amplify the positive impact of low short-term interest rates on bank risk-taking, even when we instrument securitization. Moreover, short-term rates – directly and in conjunction with securitization activity and supervision standards – have a stronger impact on bank risk-taking than long-term interest rates. These results help shed light on the origins of the current crisis and have important policy implications.

I believe David Beckworth would refer to this as the risk-taking channel of monetary policy.

About the author: Josh Hendrickson

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