One of the big historical lessons of this crisis for economic policy is that bringing down the risk-free cost of money – central bank rates or government bond yields – and injecting liquidity into the banking system cannot on their own fix broken credit markets.
Quantitative easing by central banks may help to solve short-term liquidity problems for domestic borrowers and lenders, by going around broken markets during times of extreme financial and economic uncertainty. However, this is no substitute for efforts to restore international credit markets back to health.
Effective policy measures would contain the economic fear and channel private sector incentives – the foundation of free markets – in a way that alters the behaviour of lenders, companies and consumers. The end-game policy strategy cannot be to replace free markets.
So why have traditional monetary stimuli failed to end this crisis? And what should be done next?
The textbook understanding of the relationship between easier central bank money and the supply of liquidity in the broader economy assumes that there is a direct, causal link between banks’ capacity to generate credit and actual lending growth.