A Peek Into Crisis-Policymaking.

The Great Recession of 2008 and the following sovereign debt crisis in Europe have radically altered the response that government agencies adopt against financial crises.

The primary responsibility to combat a financial crisis lies with the central bank. A central bank monitors the general economic health of a nation and is usually mandated to maintain stable prices and employment level. They also undertake the surveillance of—most of—the financial sector.

It is important to know that there are only a finite number of tools by which a central bank may fulfil its above mentioned duties. And, in the pre-crisis era those tools were commonly two: Policy rates (Basically, interest rates that a central bank sets) and word of mouth. Central banks would lower policy rates when the economy fell into a recession, thereby dropping all market rates of interest, boosting lending and thus the economic activity. They would also announce to all the players in the financial arena the thinking behind lowering policy rates and the goals the policy move seeks to achieve, thus guiding the economy towards that goal.

When crisis struck in 2008, central banks—mainly the Federal Reserve, the European Central Bank and the Bank of England—very naturally started lowering their policy rates. Over time, they continued to lower rates to near zero levels—while reassuring the markets via their press offices that the rates will remain at ultra-low levels for an extended period—to keep the economic activity afloat. This policy was dubbed ZIRP: Zero Interest Rate Policy.

But with the passage of time, ZIRP proved to be ineffective: Unfortunately, interest rates could not be lowered below zero [1] and all the reassurances by central banks failed to inspire confidence in the economy. This meant that the conventional tools at the disposal of central banks were exhausted—with no apparent improvement in the health of the economy.

With the situation deteriorating, central banks adopted bold policies that were never before considered, and some of them were even taboo amongst central bankers. The flagship of these policies was dubbed ‘Quantitative Easing’ or ‘QE’. Under QE, central banks directly intervened in the markets to purchase securities—which were primarily government bonds—by creating new money to fund these purchases. This move appeared similar to ‘monetizing of government debt’ which had resulted in hyperinflation in the Weimar Republic and Zimbabwe [2]. Under various QE programmes, central banks infused an unprecedented amount of liquidity into the system which lead their assets to soar—to levels north of USD 20 trillion!

Unlike other heads of government and government agencies, central bankers share a close bond (some of them address each other on a first-name basis!). They make contact with each other numerable times a year which helps them furnish a cordial rapport. This espirit de corps granted central bankers with yet another tool to combat the economic downturn: If the major central banks of the world took policy decisions toward the same direction in tandem, there would be a much severe impact on the world markets [3]. And, it did!

Not only were central bankers co-ordinating their policy moves, they also conjured up a mechanism to boost the requisite kind liquidity called ‘Central Bank Liquidity Swaps’ or merely ‘swap lines’. Through swap lines, central banks in need of a particular currency could swap it for their own currency. For example, at the peak of the crisis, the European Central Bank was in desperate need of dollars to keep their banks afloat. The ECB could exchange their Euros for Dollars with the Federal Reserve via the swap lines, and meet with the liquidity requirement in Europe [4].

In addition to fulfilling its ‘lender of the last resort’ operations, central banks also engineered bailouts of a few firms, most famous of them being the American International Group and Bear Stearns. Central Banks and the Federal Reserve in particular took a lot of flak for this move [5]. It hit the moral wall of dichotomy of using tax-payer money to fund the seven figure bonuses of executives of firms that brought the economy crashing down into a recession.

Though some of these policies may seem unfair, it is because of the nerve that central bankers exhibited at the hour of need—via their bold policymaking—that the worst economic depression in history remains the one in the 1930’s. They have shown great character to make unpopular decisions (some decisions against their own long cherished principles and tradition) even in the face of mounting adversity to preserve the economic system.

In this article, I made an attempt to broach the seemingly ‘reckless’ policies made to combat the crisis beginning in 2008 without going into much of the complexities that have evolved to become a part and soul of the financial system. While I have tried not to take a position with regard to these policies through the course of this article, I would like to conclude on a note of commendation. And, even though problems remain in Europe and Japan, and some rise in China, the new breed of policymakers—who are willing to do whatever it takes to protect the economy—should inspire confidence of its successful conclusion.





1. Nominal interest rates below zero would mean you would have to pay the borrower for lending out money. Now that doesn’t make sense, does it?

2. Monetizing government debt means intervening in the primary market (the market where securities are first issued) to buy government bonds. Under, QE the central bank intervened in the secondary market to purchase bonds. There is one other technicality, as told by former Fed-chairman Ben Bernanke, cash is not printed immediately, but an electronic transfer is made to the banks, and cash is printed only when withdrawals are made at the banks.

3. The first of these co-ordinated moves came on October 8th, 2008.

4. The swap lines were opened for the first time (with respect to the crisis) on December 12th 2007: The Fed, The Bank of England, The European Central Bank, The Swiss National Bank and Canadian Central Bank provided for it up to $24 billion. This was extended on 18th of September 2008 by $180 billion and the Bank of Japan was included. Another expansion by $330 billion came on the 29th of September. And, on the 29th of October, the central banks of South Korea, Mexico, Brazil and Singapore were included in this group.

5. The Federal Reserve took a lot of heat for bailing out big financial firms and to certain extent buying up government debt. It was a popular opinion that it was time that the Fed’s wings be clipped. A lot of stuff went down, but in the end the Fed soared higher than before.


Abhishek Anirudhan
An article by:
Abhishek Anirudhan

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