Munchau: Blame Central Bank Policies

FT columnist Wolfgang Munchau places blame for the recent credit market turmoil squarely on central bank policies of a few years ago:

…to blame ratings agencies is like blaming shopkeepers for inflation. If you look for an underlying cause of this credit bubble, one of the biggest of all time, then surely you are looking at something bigger than a couple of ratings agencies. I believe that the explosive growth in credit derivatives and collateralised debt obligations between 2004 and 2006 was caused by global monetary policy between 2002 and 2004. In parts of 2002-04, both the US and Europe experienced negative real interest rates – nominal rates adjusted for expectations of future inflation…A negative real interest rate is…a troubling concept. It means that those who have access to credit at that rate – in this case commercial banks – have an interest in borrowing an infinite amount. Individuals and companies generally borrow at higher rates but the closer a real interest rate gets to zero, the greater the incentives become for people to take on large amounts of debt. In a world of perfect credit markets, one would expect negative real interest rates over a long period to cause a credit bubble. Oddly, economists seem perplexed by the fact that something that was supposed to occur in theory actually happened in practice…

Munchau makes the argument that an increasingly well developed financial system makes credit more widely available, and that credit activity and asset prices should therefore be taken into account by central banks in addition to price indices.

…..it is time to learn the main lesson of this crisis, which is that credit matters for monetary policy, a fact over which many central bankers are still in denial.