Friday, September 03, 2010

Monetary Policy and economic expectations: Lesson from 2008

It is going to take years before the main economic stream, will settle down the key variables which could be considered as the main source of the global financial crisis which took place in 2008 , and it is still making noise.-
So far, it is clear that a mix of wrong doings ranging from policy makers up to credit rating agencies , created the conditions for an over expansion of risk in the financial system . On this regard, it is important to make the point, that somehow that is what can be expected from banks and financial organizations. After all, their business is to manage risk up to make a profit out of it. By the same token, it is part of their business to explore new financial instrument for making that profit .A different matter arises when there is no supervision about the systemic implication of such a risk levels, and the quality conditions concerning to those new instruments ,which spread out higher risk along the all financial markets .-
Thus, we might leave aside the financial institutions responsibility as long as they do not manage everything on their own, but according the available regulatory framework. Therefore the focus move toward those variables which these institution work with: The interest rate and expectations about its fluctuation .
Following the year 2001, and for quite a while, the interest rate in the American economy was at very low levels . It was just in the mid of the year 2006, when it started out the process of normalization to a more credible long run level.
The question which arise with this issue, deals with the implications concerning the delays to implement that normalization process before 2006, and the incidence it might have had as a source to ignites an over risk financial expansion. In a nutshell, whether monetary policy failed to prevent such outcome and the subsequent near global financial collapse.
On this issue ,it is also important to make the distinction between the economic fact and the economic expectations. The fact means that with productivity level moving upward , any prices pressure might be contained. It follows that higher productivity levels, perform like a filter to control prices increases. Thus, on this regards, from the Monetary authorities point of view ,the economic fact(productivity increases at an annual rate of 2%) did not match with the imperative of increasing interest rate earlier than 2006.
But what about the expectations?. This is the real issue. Economic agents make decisions about the future based very much on both economic fact, but their expectations as well. As long as the monetary authorities did not make any comment about the transitory nature of low interest rate, it was assumed by market forces that interest rate would stay at low level for a long time.
The failure to manage expectations, was the last input for the financial disaster which were about to come. However, where this failure comes from?. After all economic agent were assumed to be rational ,so they did not need for someone to inform them what the course of interest rate would be. Economic Rationality(learning by the past experience ) suggested to be cautious about low interest rate for a long time. On the other side, economic rationality suggested that some asset like prestige and prudence, have economic value which is the business manager job, to take care of . Therefore at most, monetary authority trusted that the economic evaluation made by banker managers and economic agent, worked this way because that was the way it suggested by the paradigm of rational expectations. Well it did not. The real failure was to focus the behaviour of economic agent within a simplistic framework , leaving aside key parameters of human nature and economic behaviour .-