Central Banking during the Great Recession

Abstract

Monetary policy before the Great Recession rested on three unacknowledged assumptions: first, the central bank could effectively control a short-term rate; second, this short-term rate had a stable relationship with longer/riskier rates; third, the central bank could move the short-term rate up or down as needed. In one or the other phase of the Great Recession one or more of these assumptions no longer held. The Fed and the ECB reacted to these difficulties, adding balance sheet management to their weaponry. After the failure of Lehman Brothers, measures of financial stress exploded and the banking sector was affected by an acute lack of liquidity, large losses, a disproportion between diminished capital and a riskier balance sheet, low profitability, enhanced competition of shadow banks, deleveraging, and difficulties in raising new capital. The Fed and the ECB could address some, but not all, of these problems.

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“…Truman (2013) is particularly in favour of a more robust global financial safety net centred on central banks 'because that is where the money is'. 11 Central banks are seen by some as ideally suited to handle in particular fast-developing crises with practically unlimited potential short-term liquidity needs (Truman, 2013;Papadia, 2013).…”

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“…If the FRBNY were auctioning off 28-day loans, the ECB would be happy to offer Fed-provided dollars for the same term against euro collateral in European time. As the then head of ECB market operations later put it, the ECB would serve as the 13th Federal Reserve Bank (Papadia 2013).…”