We have not yet, as a profession, teased out the contribution to the business cycle from monetary policy actions. This is, in part, because there is not only considerable dispute on how to measure monetary actions but also we know that any results will be heavily dependent on the particular model that is chosen. There is another reason. We tend to think of policy as acting to stabilise the economy from shocks, so that agents will plan over the longer run in a manner consistent with the policymakers key objectives. But what if policy gets it wrong from time to time? Then it has the ability to increase as well as reduce the volatility of the economic cycle. And so working out the contribution to an event from something that both may have caused it and responded to it, turns out to be quite hard.
On Friday, at both my lectures, I reminded my students of the events of 19th October 1987, so-called Black Monday. Or rather given their youth, offered the historical account. Although this was a global event, I concentrated on the FT100. The index of leading companies, see Figure, was based to 1000 in January 1984. So we can see that by New Year’s Day on 1987, there had been a 68% increase in three years, implying an annual return of just under 19% and the index stood at 1679. By 16th July, the index had gained another 764 points to reach 2443, giving a further 46% return in just over half a year. The correction to this boom was rapid. There was an 11% fall in the index on Monday, followed by further falls on Tuesday, Thursday and Friday. So by the end of that week, the index was at 1684 and nearly 27% down on the previous Friday close. There are a number of contemporary accounts of the proximate causes of this large correction: margin calls, automated stop-loss trades, trading desks-cum-ghost towns as a storm prevented people manning the desks but all seem to suggest to me simply that any downward correction may have been somewhat amplified (See Carlson, 2007, for a nice summary of the the US view).
The question facing policymakers was whether this fall in equity prices was a bubble bursting or a market re-valuation of firms’ profitability. The former implies some form of correction back to fundamentals but the latter change in the underlying profitability of the large firms and by association the economy. Either way, of course, the possibility of panic remained so perhaps something had to be seen to be done. Indeed there was a considerable attempt to co-ordinate the responses across central banks throughout the world. And so Bank Rate was cut from 9 7/8 by 150Bp in three steps, starting on Friday 23rd, to fall to 8 3/8 by early December. Equity prices reached their lowest point after this crash on 9th November at 1565 and some sort of recovery in prices commenced. Certainly there was no Great Depression as some doomsters (I should look up who they were) were arguing and the business cycle expansion continued until the last quarter of 1990. With the benefit of considerable hindsight, it would appear that Black Monday was simply a correction and the policy response initially helped adjustment to the new path for equity prices. In practice, subsequently, house prices were stoked up to a great extent, households became rather indebted and the economy subsequently could not bear the real rates required from continued membership of the ERM but I can tell that story another time.
And so when we turn to list the reasons for the financial crash of 2007/8, we do, I think, tend to overlook the role of excessively accommodative monetary policy in stoking the imbalances that the crisis finally revealed. Equity market turbulence in the early years of this century led to super-accommodative monetary policy, alongside levels of transparency in policymaking that were designed to reduce uncertainty about the level and path of policy rates. Casually, at least these policy choices seemed to have played a role in prolonging the business cycle and also supporting asset prices rather like the situation in the late 1980s. A representative policy maker in their late forties or early fifties in 2003, would have been in his or her mid-to-late 30s in 1987 and I wonder to what extent the experience of 1987 was instructive. I doubt we shall be able to point the finger for the causes of this crisis at policymakers who had learnt formative lessons as to how to respond to a crises with the Big One in 1987 but I wonder if they did grow up to become bubble blowers?