Introduction

Prompted by two keynote papers by Spencer Dale (Chapter 9, this volume) and Richard Harrison (Chapter 5, this volume), both from the Bank of England, this chapter raises the question of whether the most effective instrument in dealing with the financial crisis was unconventional monetary or fiscal policy. Quantitative monetary easing – unconventional monetary policy – is given most of the credit, but a strong case can be made in favour of the recapitalisation of the banks and guarantees to deposit holders which are unconventional fiscal policy as they involve the tax payer’s money. The chapter argues that the crisis was a consequence of failing to price risk correctly and that the shortage of liquidity, which prompted quantitative easing, was due to difficulties in pricing default risk. This diagnosis has a major bearing on how to avoid a repetition of the crisis in the future. The chapter concludes with a brief discussion of how the academic literature on macroeconomic modelling has responded to the crisis – unconventional macroeconomic modelling – and how it should amend its models.

Unconventional monetary policy

When the Bank of England was made independent in 1997 its role was changed. Since then its prime task has been to control inflation using interest rates and, according to the Bank Act of 1997, only subject to achieving this, to take account of the government’s other macroeconomic objectives. Responsibility for supervising banking and finance was transferred from the Bank to a new body, the Financial Services Authority. In effect, the Bank became the main player in macroeconomic policy instead of the Treasury, which focused instead on the microeconomics of budgetary matters. Prior to the financial crisis, the Bank had been extremely successful in achieving its inflation target, as had the US Fed and the ECB, which suggests either a benign environment or good monetary policy. Either way, confidence in the future and low real interest rates stimulated heavy borrowing by the private sector and a readiness to provide cheap loans by the banking sector.