U.S. Monetary Policy and its Role in the Global Financial Crisis: An Assessment after Ten Years

Abstract

This paper reviews three interrelated propositions advanced in the literature to explain the U.S. financial crisis of 2007 to 2009, and draws cogent implications for the roles of monetary and fiscal policies in improving macroeconomic management across countries to sustain global financial stability. The three propositions advanced to explain the U.S. financial crisis are: (1) the monetary-excess hypothesis (2) lax regulation and supervision of banks and financial institutions, and (3) large-scale foreign capital inflows. Of these interrelated explanations, the first appears to be the primary cause of the boom-bust cycle in the U.S. residential housing industry. It led to the financial crisis in an environment of lax regulation and supervision of banks and financial institutions, which intermediated large-scale inflows of foreign capital to finance large, sustained budget deficits. The U.S. financial crisis engulfed the global economy from 2007 to 2009. Its consequences continue to be felt internationally, especially in the context of the debate on the role of monetary policy in reviving an economy in recession in a low-inflationary environment. The body of literature that has emerged since the peak of the financial crisis suggests that the monetary and fiscal stimuli, aimed at rescuing the U.S. and other major economies from the recession, had limited effect. The key lesson that can be drawn from the U.S. financial crisis in a global setup is that rules-based monetary and fiscal policies can be more effective at not creating a boom-bust level of volatility in one or more economies. In addition, this paper concurs with the view that rules-based monetary and fiscal policies should be associated with improved financial regulation and supervision, in order to maintain global financial stability under the current regime of deregulated global capital markets.