Time for unorthodox monetary policy

John Muellbauer

27 November 2008



The world economy is trapped in a dangerous global downward spiral of falling asset prices, shrinking credit, and rising bankruptcies, foreclosures and unemployment – all of which feed into more of the same – and drag commodity and now goods prices down with them.1 We were among the first to give a research-based warning of the coming price deflation in our 10 October 2008 column on VoxEU.org.2

No country is exempt. International policy coordination is needed and made easier by the obvious commonality of interests. Fiscal stimulus packages, though helpful, are not timely enough and suffer the usual free rider problems. The rapidity of the current contraction means governments must do more.

Lead with non-conventional monetary policy

That is why monetary policy should be the first line of action – particularly in the US which suffers from a policy interregnum until the Obama administration comes to power. Conventional monetary policy, however, has gone almost as far as it can in the US and Japan. The failure of the European Central Bank and the Bank of England decisively to respond in October was very damaging3, but that is now history. Policy rates will fall further in December, but may make only a modest contribution to stabilising demand, given the further decline in bank balance sheets and rising levels of fear.

It is time for unorthodox policy – one far more effective than Milton Friedman’s helicopter drops of money – because it is reversible. Indeed it is akin to ‘stabilising speculation’ by central banks.

The world’s main central banks should collectively buy mainstream securities (not the obscure assets as initially proposed under TARP). This is the best way to put liquidity into the pockets of consumers and companies. But these securities must be targeted to relieve the critical credit blockages impeding recovery. Many of the assets discussed below are now at the lowest real prices seen in decades. The influx of cash and credit will stabilise global activity, eventually increasing the real value of most of these assets. In due course, the central banks will be able to sell back the assets to the private sector. Assuming the stimulus works, this operation will be profitable for the central banks – a important difference when comparing this to fiscal measures that raise national debts.

The financial accelerator

A key part of the economic logic behind this unconventional monetary policy is provided by what economists call the financial accelerator, well explained by Bernanke (1983), building on Irving Fisher’s 1933 theory of debt deflation. Just as financial factors accelerate the downward spiral as described above, the financial accelerator also operates in business cycle upswings. As higher profits and higher asset prices increase access to credit and credit creation (in part via bank balance sheets) and this, in turn, further stimulates economic activity. There is wide-spread agreement that the Basel II capital adequacy rules increase the pro-cyclicality of this credit creation process.

Historical precedence

A good example of this kind of unorthodox action was undertaken by the Hong Kong Monetary Authority during its successful defence of the currency peg in the 1997-98 Asian crisis (see Liew and Wu 2002). The HKMA intervened in the currency market, but more important, was its purchases of Hong Kong equities, which speculators had sold short. When markets returned to normal, the HKMA sold these equities for a profit of US$14 billion. The fact that many asset prices around the world are below fundamentals creates a parallel opportunity in the current global crisis.

Which assets to buy

The choice of assets to be purchased requires careful consideration. Buying commercial paper relieves short term cash and credit problems for companies and has historical precedents in the UK and in the US, currently. Getting the municipal bond market to function again will finance capital and other spending now on hold. Funding corporate debt does the same for companies. Mainstream mortgage-backed securities are another obvious asset class: the market is now discounting worst-case default rates and mortgage markets need a blood transfusion. On November 25, the Federal Reserve announced it would buy up to $600 billion worth of MBS stock from Fannie Mae and Freddie Mac. It also announced a $200 billion lending facility to holders of shorter term asset backed securities supported by car, credit card, student loans and business loans. This is exactly the kind of imaginative policy response being called for here.

Why buy on the open market?

Buying bank shares on the open market is a crucial but more controversial part of my proposal. One can ask why central banks should benefit existing share holders rather than inject cash directly as have ministries of finance.4

One fundamental reason is that this is likely to be a multi-shot game. Many major banks’ shares are worth one tenth or less of levels of only two years ago. Buying at these prices, and threatening to re-use their fire power, central banks will put a floor under the market value of the sector. This greatly reduces the risk for private investment in the banking sector, opening the gates up to new private funding. Ultimately the private sector has far more resources potentially available for investment than do central banks. Shoe-horning in these funds is important. In current market circumstances, central banks can also participate in new issues of corporate debt and bank shares as well as buying in the secondary market, though it is harder in new issues to avoid charges of favouritism, see below.

Creating a powerful new monetary policy tool

There is a second reason for buying bank shares. Buying a major stake in bank shares – as well as in long-term debt contracts at current depressed prices – would give central banks a once-in-a-generation opportunity to acquire a powerful new monetary policy tool. This new tool could be deployed to dampen the boom-and-bust nature of the credit cycle.

Suppose the central banks eventually owned 25% of the private banking sector, and also had significant holdings of long-term private debt contracts. In the next upswing – when credit creation threatens to get out of hand – central banks could sell bank shares and corporate debt to drive up the cost of credit without changing interest rate policy.

This new policy instrument should be particularly attractive in the Eurozone because it gives the local underemployed central banks something important to do; something that is honed to the needs and financial structures of their particular countries. It will also generate interesting new research questions for economists in how best to operate this new open market instrument. Moreover with a 25% stake, central banks could exercise some shareholder influence over what happens inside private banks, for example, policies on executive compensation.

Avoiding favouritism

To avoid charges of favouritism, central banks should buy index funds or individual securities in proportion to market cap on transparent and organised security exchanges.5 This is also conservative since less cash will tend go to securities that have fallen the most, and whose prospects look most risky to the market.

This feature would make this policy radically different from the initial TARP proposal and from the treasuries’ piecemeal interventions in bailing out institutions such as AIG and Citigroup. Snower (2008) recently criticised this case-by-case approach, expressing concerns about the moral hazard, and excessive taxpayer sacrifice it entailed, and also about potential exit strategy problems. Under the proposed new monetary policy, large banks may still fail and to that extent, moral hazard is minimised while the system as a whole is supported. As noted above, the exit strategy is more likely to yield stabilisation benefits than to be problematic.

A beneficial aspect of the proposed multiple asset strategy is portfolio diversification. Commercial paper and some corporate bonds are of short duration, returning cash to the central banks over fairly short horizons. Mortgage backed securities and corporate bonds will have different risk, return and duration profiles, and in turn different from bank equity. This reduces longer term risk for the strategy. It is also worth noting that the judgement that the majority of these assets is now under-priced is not a judgement on the stock market as whole, but reflects the particular liquidity, credit access and solvency problems underlying the class of targeted assets.

International coordination

International coordination will avoid the policy being seen as a sign of weakness or panic at the individual country level, with costs to currencies and government bond markets. The incentive structure for central banks to join such concerted action is less likely to create free rider problems than is the case for fiscal policy. Any central bank considering such action has an incentive not to delay since the potential profitability is likely to be lower for late participants, given that prices of assets in this class will generally be bid up in the process.

Central bank discussions of such coordinated action could probably not remain entirely secret. Rumours could help stabilise markets, however. Some investors are beginning to fear that a growing government debt mountain induced by a slump will create incentives for future inflation. The reversible, self-financing and immediately applicable nature of the above monetary policy plan should reduce these fears. A concerted and well-designed monetary stimulus at this time of maximum danger will actually reduce the burden on future tax-payers and hence future inflation risk.

Complement not substitute for traditional stimulus

Of course, none of this is meant to imply that complementary policies should be abandoned, including fiscal expansions, further bank re-financings, using the World Bank’s access to cheap bond finance to expand its lending programme to emerging markets and primary good exporters, and for a reformed IMF to expand its role. Until those policies can take effect, however, households and firms need a financial lifeline.


Janine Aron and John Muellbauer, “US price deflation on the way”, October 10, 2008, VoxEU.org.

Ben S. Bernanke (1983). “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”, American Economic Review, 73( 3 ), 257-276.

Irving Fisher (1933). "The Debt-Deflation Theory of Great Depressions," Econometrica, October, 1, 337-57.

John Muellbauer, “The Folly of the Central Banks of Europe”. October 27, 2008 VoxEU.org.

Leong H. Liew and Harry X. Wu, “Not All Currency Traders Believe in Unfettered Free Markets: Currency Speculation and Market Intervention in Hong Kong,” China Quarterly, Cambridge University Press, 2002, 448-9.

Dennis Snower, “A Long Way to Go”, Wall Street Journal, Nov 12.


1 This is a substantially extended version of an article which appeared in the Financial Times, Nov. 25, 2008. The author is grateful for helpful comments from a range of economists including central bank economists from a number of countries. However, responsibility for views expressed rests with the author.

2 See Aron and Muellbauer VoxEU.org 10 October 2008.

3 See Muellbauer VoxEU.org 27 October 2008.

4 Even though these now include substantial tax-payer interests.

5 This should also encourage the development of such exchanges for Credit Default Swaps in the hope that central banks might extend the range of assets considered for purchase in this direction.



Topics:  Monetary policy

Tags:  monetary policy, financial markets, banking sector, global crisis

Senior Research Fellow, Nuffield College; Professor of Economics, Oxford University; and Senior Fellow, Institute for New Economic Thinking, Oxford Martin School