Between Debt and the Devil

The Flaws of Pre-crisis Monetary Policy

Lasting from the the 1980s to 2007, the period of the Great Moderation had central banks fine-tuning base interest rates in response to signs of inflation. But that turned out to be disastrous monetary policy when a boom in lending, leverage and credit creation failed to move the inflation dial. Mainstream economists and authorities misplaced their faith in the concept that the free market would automatically provide an economy the optimal amount of credit. 

Before 2007, the consensus was also that the merits of free market innovation should permit actors within the financial system to create all the new products and contracts they desired. The erroneous belief was that this would improve the stability and robustness of the system by “completing” markets, better allocating risks and increasing liquidity. But the innovations in many cases allowed more credit creation and thus more speculation to feed a property bubble. When the tide went out and markets seized, it became clear that risk allocation was poor. 

The Wrong Kind...