Encyclopedia of Money

A Comparative Examination of Political Institutions' Effect on Economic Growth

A Comparative Examination of Political Institutions' Effect on Economic Growth

Political institutions play a pivotal role in shaping the economic trajectory of nations, serving as a key determinant in fostering or hindering growth. The complex interaction between political governance and economic development has been the subject of intense debate among economists, political scientists, and policymakers alike. This article aims to explore the varied effects that different political systems—democracies, authoritarian regimes, and hybrid systems—have on economic performance, drawing on historical case studies and empirical data to provide a comprehensive understanding of this crucial relationship.

Understanding Political Institutions

Political institutions encompass the formal and informal rules, policies, and practices that define the way in which political power is exercised and authority is distributed. These structures range from democratic governments, where power is vested in the hands of elected representatives, to authoritarian regimes, where power is centralized, often in the hands of a single leader or a small group of elites. Hybrid political systems combine elements of both democracy and authoritarianism, leading to a more complex interaction between political control and economic management.

Democracy and Economic Growth

Democratic systems, characterized by free and fair elections, rule of law, and protection of individual rights, are often associated with higher levels of economic growth. One key argument is that democracies provide a stable environment that encourages investment by offering protection for property rights and fostering transparency in government dealings. As governments in democracies are accountable to the electorate, they are more likely to implement policies that promote long-term economic growth rather than engaging in short-term populist measures.

Empirical studies have consistently shown that countries with robust democratic institutions tend to experience higher rates of economic growth. For instance, the advanced economies of Western Europe and North America, such as the United States, Canada, and Germany, have prospered under democratic systems that emphasize the rule of law, a free press, and respect for human rights. These nations have been able to build strong institutions that support market-based economies, attract foreign direct investment, and foster innovation.

However, it is important to note that democracy alone does not guarantee economic success. The effectiveness of democratic institutions depends heavily on the quality of governance and the level of political stability. Countries with weak democratic institutions, such as those struggling with corruption, inefficiency, and political polarization, may fail to leverage the potential benefits of democracy, resulting in slower economic growth.

Authoritarianism and Economic Growth

In contrast to democracies, authoritarian regimes often prioritize political control over individual freedoms, with economic decisions concentrated in the hands of a few powerful individuals or political elites. While many authoritarian regimes have achieved rapid economic growth in the short term, the long-term sustainability of such growth is often questioned. China's rise as an economic powerhouse is a prime example of the potential benefits of authoritarian governance, where the centralization of power allowed for swift decision-making, long-term strategic planning, and large-scale infrastructure projects.

Nevertheless, authoritarian regimes face inherent challenges. The absence of political freedoms, such as the right to protest or free elections, often stifles creativity, entrepreneurship, and innovation—key drivers of sustainable economic development. Furthermore, authoritarian systems are prone to corruption, cronyism, and a lack of accountability, which can lead to inefficient allocation of resources, economic mismanagement, and social unrest.

Economic growth in authoritarian regimes may also be unsustainable, as seen in countries like Russia and Venezuela. While these nations have seen periods of economic expansion, the absence of democratic checks and balances often leads to systemic weaknesses, making these economies vulnerable to external shocks, corruption scandals, and poor long-term policy decisions.

Hybrid Systems: A Middle Ground?

Hybrid political systems—those that combine elements of both democracy and authoritarianism—pose an interesting middle ground. These systems, often described as "illiberal democracies" or "competitive authoritarianism," maintain a veneer of democratic processes (e.g., elections and political parties) while limiting the actual power of opposition forces and curbing civil liberties. Countries like Turkey, Hungary, and some Eastern European nations exhibit characteristics of hybrid regimes, where leaders consolidate power through undemocratic means while maintaining some democratic features.

The economic performance of hybrid systems is mixed. On one hand, the centralized decision-making of authoritarianism can lead to rapid economic growth, as seen in some hybrid regimes with strong leadership. On the other hand, the erosion of democratic norms and the suppression of opposition can lead to instability, inefficient governance, and lack of innovation. In these systems, the lack of accountability and transparency can deter foreign investment and inhibit long-term growth prospects.

Conclusion: The Role of Political Institutions in Shaping Economic Outcomes

The relationship between political institutions and economic growth is multifaceted and complex. Democracies generally provide a stable and predictable environment that supports economic growth through the protection of property rights, rule of law, and government accountability. However, the quality of governance within democracies is crucial—without it, democratic institutions may fail to deliver economic benefits.

Authoritarian regimes can foster rapid economic growth in the short term, particularly through centralized decision-making and long-term planning. However, the lack of political freedoms, corruption, and inefficient governance can undermine their long-term economic prospects.

Hybrid systems offer a middle path, combining elements of both democratic and authoritarian governance. While they may achieve short-term economic success, the lack of political freedoms and accountability can lead to systemic issues that hinder sustainable development.

Ultimately, the type of political system matters, but the quality of governance, the rule of law, and the protection of civil liberties are just as important in determining the long-term economic growth of a country. Political institutions shape the environment in which economic policies are formulated and implemented, and their impact on economic growth cannot be overstated.

The Monetary Policy: A Catalyst for Economic Growth

Monetary policy, a cornerstone of macroeconomic management, plays a pivotal role in shaping the trajectory of economic growth. It is a tool wielded by central banks to influence the money supply, interest rates, and ultimately, the economy's overall health. In a world where nations grapple with inflation, recessionary pressures, and global market volatility, the nuances of monetary policy have never been more critical.

Understanding Monetary Policy

Monetary policy operates through two primary mechanisms: expansionary and contractionary policies. Expansionary policies, aimed at stimulating economic growth, involve lowering interest rates and increasing money supply to encourage borrowing, investment, and consumption. Conversely, contractionary policies seek to temper inflation by tightening the money supply and raising interest rates.

These mechanisms, while conceptually straightforward, wield a profound influence on economic growth. Their effectiveness, however, is contingent upon factors such as fiscal policy alignment, consumer confidence, and external economic conditions.

The Direct Impacts on Economic Growth

Investment and Borrowing
Lower interest rates, a hallmark of expansionary monetary policy, reduce the cost of borrowing for businesses and individuals. This encourages investment in capital projects, infrastructure, and technology—critical drivers of economic growth. For instance, during the global financial crisis of 2008, many central banks, including the Federal Reserve, slashed interest rates to near-zero levels, fueling investments to stabilize and stimulate the economy.
Consumption Dynamics
When borrowing becomes cheaper, consumer spending typically rises. Increased demand drives production, creates jobs, and fosters a virtuous cycle of growth. However, if consumer confidence wanes, even low interest rates may fail to achieve the desired stimulus, as observed during pandemic-induced uncertainties in 2020.
Inflation Control
While monetary policy is vital for growth, unchecked expansionary policies can lead to inflationary spirals, eroding purchasing power. Contractionary policies, by contrast, aim to stabilize prices, ensuring sustainable long-term growth. Striking the right balance between these objectives remains a complex but essential task for central banks.

Transitioning Through Economic Cycles

The relationship between monetary policy and economic growth is particularly evident during economic transitions. In periods of recession, expansionary policies act as lifelines, fostering recovery. During booms, contractionary policies help prevent overheating by controlling inflation and maintaining macroeconomic stability.

Take, for example, the monetary tightening in the United States in 2022–2023. Faced with soaring post-pandemic inflation, the Federal Reserve aggressively raised interest rates to combat price pressures. While this slowed certain sectors, the broader goal was to stabilize the economy and lay the groundwork for sustainable growth.

Challenges and Limitations

Despite its potential, monetary policy is not a panacea. Structural economic issues, geopolitical risks, and global interdependencies can dilute its impact. Emerging markets, for instance, often struggle with the "trilemma"—managing monetary autonomy, exchange rate stability, and capital flows simultaneously.

Moreover, prolonged reliance on monetary tools can lead to asset bubbles, excessive debt, and distorted market dynamics. Central banks must navigate these challenges with precision, often adjusting policies in real-time based on evolving economic indicators.

The Role of Central Banks

Central banks, such as the European Central Bank (ECB) or the Bank of Russia, wield significant power in directing monetary policy. Their independence from political influence is crucial for maintaining credibility and effectiveness. Transparent communication, often in the form of forward guidance, ensures that businesses and consumers can make informed decisions in anticipation of policy shifts.

The Road Ahead

As economies adapt to 21st-century challenges—digital transformation, climate change, and shifting demographics—the role of monetary policy in fostering growth is evolving. Central banks are increasingly incorporating non-traditional tools, such as quantitative easing or green finance initiatives, to address these emerging dynamics.

However, for monetary policy to truly catalyze economic growth, it must operate in tandem with robust fiscal policies, structural reforms, and international cooperation. The interconnectedness of global markets demands coordinated efforts to navigate shared challenges and leverage opportunities for collective prosperity.

Conclusion

Monetary policy is more than just a mechanism to regulate money supply and interest rates—it is a dynamic and powerful tool that shapes the contours of economic growth. Its success lies in its adaptability, precision, and integration with broader economic strategies.

In an era marked by rapid changes and uncertainties, the ability of central banks to deploy monetary policy effectively will determine not only the resilience of economies but also their capacity for innovation, inclusivity, and sustainable growth. The stakes are high, but so are the opportunities for transformative impact.

How to save money in college.

College life can be expensive, but with careful planning and smart strategies, students can significantly reduce their financial burden. Here's a comprehensive guide to help you save money while pursuing your education:

Budgeting Basics

Track Your Spending: Use budgeting apps or spreadsheets to monitor your income and expenses.
Set Realistic Goals: Determine how much you want to save and create a plan to achieve it.
Prioritize Needs Over Wants: Focus on essential expenses like tuition, rent, and groceries.
Cut Back on Unnecessary Expenses: Limit dining out, streaming services, and other discretionary spending.

Smart Shopping Strategies

Generic Brands: Opt for generic or store-brand products, which are often cheaper than brand-name items.
Couponing and Cashback Apps: Use coupons and cashback apps to save on groceries, clothing, and other purchases.
Buy Used Textbooks: Consider renting textbooks or purchasing used copies to save money.
Shop Online: Compare prices online to find the best deals and use online coupons.

Frugal Living Tips

Cook at Home: Prepare meals at home instead of eating out to save money.
Carpool or Use Public Transportation: Reduce transportation costs by carpooling or using public transportation.
Limit Social Spending: Find free or low-cost activities, such as picnics, board games, or hiking.
Shop Secondhand: Buy clothes, furniture, and electronics from thrift stores or online marketplaces.

Maximizing Financial Aid

Complete the FAFSA: The Free Application for Federal Student Aid (FAFSA) can help you qualify for grants, scholarships, and work-study programs.
Explore Scholarships and Grants: Research scholarships and grants based on your academic achievements, extracurricular activities, or demographics.
Work-Study Programs: Consider part-time jobs on campus to earn money and gain work experience.
Summer Jobs: Work full-time during the summer to earn extra money for the upcoming academic year.

Additional Tips

Live Off-Campus: Renting a room or apartment with roommates can be more affordable than living on campus.
Sell Unused Items: Sell textbooks, electronics, and clothing to earn extra cash.
Use Student Discounts: Take advantage of student discounts on food, entertainment, and travel.
Build Good Credit: Pay bills on time and avoid excessive debt to improve your credit score.

By implementing these strategies, you can significantly reduce your college expenses and build a strong financial foundation for your future.

Never borrow money from friends.

The age-old adage, "Never a borrower nor a lender be," carries profound wisdom. While borrowing money from friends may seem like a convenient solution in times of financial hardship, it can have far-reaching consequences that can strain relationships and lead to emotional distress.

Financial Implications

One of the most immediate concerns is the potential for financial strain. When money changes hands between friends, it can create a sense of obligation and expectation. If the loan is not repaid on time or in full, it can lead to tension, resentment, and damaged friendships. Moreover, borrowing money from friends can mask underlying financial problems, preventing individuals from addressing the root causes of their financial difficulties.

Social Implications

The social implications of borrowing money from friends can be even more significant. Money can be a sensitive topic, and discussing financial matters can often lead to uncomfortable conversations. When money is involved, it can be easy for emotions to run high, and misunderstandings can arise. If a loan is not repaid, it can damage trust and erode the foundation of the friendship.

Practical Advice for Avoiding Financial Pitfalls

To maintain healthy financial boundaries and avoid the pitfalls of borrowing from friends, consider the following tips:

Prioritize Budgeting:
- Create a realistic budget to track income and expenses.
- Identify areas where you can cut back to save money.
- Set financial goals and work towards them.
Emergency Fund:
- Build an emergency fund to cover unexpected expenses, such as medical bills or car repairs.
- Aim to save at least three to six months' worth of living expenses.
Seek Professional Help:
- Consult with a financial advisor to develop a personalized financial plan.
- Consider seeking credit counseling or debt management services.
Explore Alternative Financing Options:
- Consider taking out a personal loan from a bank or credit union.
- Explore options like peer-to-peer lending or crowdfunding.
Honest Communication:
- If you must borrow money from a friend, be upfront about the terms of the loan, including the repayment schedule and interest rate.
- Maintain open and honest communication throughout the process.

By following these guidelines, you can protect your friendships and your financial well-being. Remember, borrowing money from friends can be a risky proposition. It's always best to exhaust other options before turning to friends for financial assistance.

TROUBLED ASSET RELIEF PROGRAM

The Troubled Asset Relief Program, known as TARP, was the cornerstone of the United States program to address the U.S. financial crisis that began in 2008. It came into being in October 2008 with the enactment of the Emergency Economic Stabilization Act of 2008. The legislation was commonly billed as a $700 billion bailout for banks.

The TARP plan evolved over time but originally its purpose was to buy bad loans, mortgage-backed securities, and collateralized debt obligations from banks. These assets went by the term “toxic assets” because they had no market value, and amounted to a severe threat to solvency of the banking system. At first it was thought that the government might be able to recover its investment because it would be purchasing these assets at bargain basement prices, and selling them for a profit later when the financial crisis had passed. Further consideration brought the realization that purchasing these assets at low prices undercut the capitalization of the banking system. Two weeks after the program’s enactment, the secretary of treasury shifted the focus of the program to emphasize the purchase of preferred stock in banks and guaranteeing troubled assets. If a bank recovers with the benefit of the government’s help, and its stock climbs, the government can sell its stake and recover at least some of the taxpayers’ investment.

Citigroup was one of the large banks that benefited from the program. The United States Treasury first purchased $25 billion in preferred stock in Citigroup, and later another $20 billion. The United States government in addition guaranteed troubled loans and securities on Citigroup’s balance sheet on the order of $306 billion. In return for the guarantees, the government received another $7 billion stake in Citigroup (Curran, November 25, 2008). The government forced the top banks to participate in the government bailout. Otherwise, banks that elected not to participate would appear financially stronger, which might give a competitive advantage over the banks that did participate. For smaller banks, participation was voluntary. In the beginning, many smaller banks worried that participation in the program was equivalent to a confession of financial weakness. Once the government let it be known that it would not let banks that were fundamentally unhealthy participate in the program, perceptions changed. Banks began to fear that not applying for participation might be regarded as financial weakness.

TARP drew criticism from the outset.

The government did not seem to be doing enough to track how banks were using the infusions of government capital. Homeowners facing foreclosures received no relief from TARP funds. People wondered why it was more important to bail out Wall Street than to bail out families facing bankruptcy and home foreclosure. None of the TARP funds helped homeowners refinance mortgages that they could not pay. In December 2008, President Bush used his executive authority to make TARP funds available to U.S. automobile manufacturers. Both General Motors and Chrysler received TARP funds. The most controversial beneficiary of TARP funds was American International Group, a large insurance company. In January 2009, the new administration of President Obama vowed to revise the TARP plan to alleviate the rate of home foreclosures.

Bank bailouts became a global phenomenon in 2008. The United Kingdom established a plan similar in strategy and scale to the one in the United States. The Royal Bank of Scotland was the largest beneficiary of government bailout money in the United Kingdom. In 2008, Sweden announced a sweeping bailout plan to save its banking system. Belgium bailed out a large bank in October 2008. Germany and Iceland both bailed out financial institutions. Switzerland, eager to protect its status as global banking center, put together a massive recapitalization of the United Bank of Switzerland.

UNIVERSAL BANKS

In addition to the traditional commercial banking activities of holding deposits and extending loans, universal banks offer a full range of financial services, including underwriting, issuing new offerings of stocks and bonds, and brokering stocks and bonds. Some universal banks provide insurance. Banks that only engage in underwriting new securities, floating new offers of securities, and brokering securities are called “investment banks.” Universal banks combine deposit banking of traditional commercial banking with investment banking.

In the 1800s, banks in continental Europe and Germany in particular developed along the lines of universal banks, whereas in Britain deposit banking and investment banking tended to remain separate. In the United States, financier moguls such as J. P. Morgan introduced universal banking in the United States in the last decades leading up to World War I. Congress cut short the development of universal banking in the United States with the enactment of the Glass–Steagall Banking Act of 1933. Aimed at restoring public confidence in banks, this act prohibited commercial banks from investing in the stock market or providing investment bank services. In the German model of the 19th century, universal banks purchased corporate stock for customers. In exchange, customers yielded to banks proxies entitling banks to vote the customers’ shares in shareholder votes. The banks also purchased corporate stock on their own accounts. The control of a large piece of shareholder power ensured that the banks held positions on corporate boards of directors. The universal banks were also lenders to corporations. By holding seats on boards of directors, the banks had a voice in the management of companies that owed them money. In addition, they had an incentive to watch out for mismanagement at the expense of stockholders and creditors. It was an arrangement that put a large amount of power in the hands of banks.

In the post–World War II era, universal banks enjoyed the greatest legal acceptance and experienced the fullest development in Germany. German universal banks hold large equity positions in corporations, have representatives on their boards, and exercise proxy votes for customer shareholders. Japan and Switzerland also followed the universal banking model. The economic success of these countries, and particularly the rapid economic growth in Germany and Japan, began to restore confidence in universal banking. Banks in these countries help to minimize conflicts between debt and equity holders and keep corporate management under tighter rein. By ensuring access to long-term financing, universal banks shield corporate managers from short pressures from fluctuations in stock market prices.

Particularly in Germany, critics raised the issue of universal banks dominating the German stock market. It is said that rather than earning high dividends, banks were more interested in making loans to corporations on whose boards they had representation. In the 1990s, Germany experienced several corporate failures. In 1998, the German government enacted the Control and Transparency in Corporate Field Act. This act prohibits a bank holding more than 5 percent of a company’s shares from controlling the proxy voting rights for its bank customers who also own shares in the company.

In the 1990s, momentum began to build to approve universal banking in the United States. Critics worried that universal banks would choose riskier investments because under a system of FDIC insurance the cost of funds to a bank does not vary with the riskiness of its investments.

In 1999, the U.S. Congress lifted the ban on universal banking with the passage of the Financial Services Modernization Act of 1999. Replacing the Glass–Steagall Act of 1933, this act allowed the integration of banking, insurance, and stock-trading. By 2007, the United States boasted three large universal banks, Citigroup Inc., JPMorgan Chase & Co., and Bank of America Corp (Wall Street Journal, September 6, 2007). As the subprime financial crisis of 2008 unfolded in the United States, some observers felt the financial woes stemmed directly from dismantling the wall between deposit banking and investment banking. They were referring to the repeal of the Glass–Steagall Act. At first, the universal banks seemed to fare better than the investment banks. The financial crisis could be interpreted as a symptom of the shake-out and consolidation that analysts expected from the enactment of the Financial Services Modernization Act of 1999. As the financial crisis widened, however, the stock values of Citigroup, JPMorgan Chase, and Bank of America crashed, and the future of the institutions was very much in doubt. All three of the banks received large infusions of preferred stock investments from the United States Treasury.

See also: Glass–Steagall Banking Act of 1933, Troubled Asset Relief Program

References

Esen, Rita. “The Transition of German Universal Banks.” Journal of International Banking Regulation, vol. 2, no. 4 (2001): 50–57.

Fohlin, Caroline. “Relationship Banking, Liquidity, and Investment in the German Industrialization.” Journal of Finance, vol. 53, no. 5 (October 1998): 1737–1758.

Sidel, Robin. “Do-It-All Banks’ Big Test; Universal Model So Far Weathers Credit Crunch, Remains Controversial.”

Wall Street Journal (Eastern Edition, New York) September 6, 2007, p. C1. Wall Street Journal (Eastern Edition). “Glass and Steagall Had a Point.” May 31, 2008, p. A10.

FEDERAL OPEN MARKET COMMITTEE (FOMC)

The Federal Open Market Committee (FOMC) is the chief policy-making group within the Federal Reserve System. It makes the key decisions for monetary policy in the United States. Monetary policy has to do with interest rates, credit conditions, and growth in the money supply.

The FOMC consists of 12 members. All seven members of the board of governors of the Federal Reserve System serve on the FOMC. The president of the Federal Reserve Bank of New York is also a permanent member of the FOMC.

The presidents of the 11 other regional Federal Reserve Banks hold the remaining four seats on a rotating basis. The seven presidents of regional Federal Reserve Banks who do not hold a seat attend meetings of the FOMC as nonvoting members. The chair of the board of governors of the Federal Reserve System also serves as chair of the FOMC. The president of the Federal Reserve Bank of New York serves as vice-chair. The seven members of the board of governors wield a powerful sway over monetary policy. They hold the majority of the voting seats on the FOMC and are permanent members. FOMC decisions are made either by consensus or near consensus. The president of the Federal Reserve Bank of New York owes his precedence over the other presidents to the special role played by the Federal Reserve Bank of New York. The Trading Desk at this bank carries out the day-to-day operations required to implement the policies decided by the FOMC. The account manager for the FOMC is the chief supervisor of the New York bank’s Trading Desk. That person is in daily contact with members of FOMC subcommittees. Normally, the FOMC meets eight times per year to assess monetary policy and make adjustments. If developments in the economy warrant quicker action, the FOMC holds additional meetings either in person or by conference call. Immediately after a meeting, the FOMC announces its decisions to an eagerly awaiting Wall Street and financial media. Financial markets often react within minutes of an announcement from the FOMC. Financial markets may react right before a meeting as speculators try to make money by betting on what action the FOMC will take.

The wording of the formal instructions to the New York Trading Desk is decided at the FOMC meeting. Once the FOMC decides to change policy, the new policy is implemented immediately. The policies are implemented through the purchase and sale of U. S government securities. The Federal Reserve’s trading in U.S. government securities are called “open-market operations.” The New York Trading Desk decides the amount of securities to buy or sell to carry out the instructions handed down by the FOMC.

The main interest rate the FOMC aims to influence is the Federal Funds Rate, which is the rate of interest commercial banks charge each other for overnight loans. The FOMC decides on a target for the Federal Funds Rate and instructs the New York Trading Desk to conduct the open-market operations necessary to maintain the targeted rate. To ease monetary policy, the FOMC lowers the targeted rate, and to tighten monetary policy, the FOMC raises the targeted rate.

References

Meade, Ellen E. “The FOMC: Preferences, Voting, and Consensus.” Review, Federal Reserve Bank of St. Louis, March 2005, pp. 93–101.

Thornton, Daniel L. “When Did the FOMC Begin Targeting the Federal Funds Rate? What the Verbatim Transcript Tells Us.” Working Papers, 2004-015, Federal Reserve Bank of St. Louis, 2005.

ANNOUNCEMENT EFFECT

Central banks publically announce intentions of maintaining a key policy interest rate at a certain level called the “target rate.” The practice of announcing targets is relatively recent, and represents a sharp departure from the confidentiality and secretiveness that was once thought to be a necessary part of monetary policy and open market operations. The “announcement effect” refers to a central bank’s ability to control a key interest rate merely by announcing its intentions.

In the United States, the key policy interest rate targeted by the central bank is the federal funds rate, and the central bank is the Federal Reserve System. The federal funds rate is the interest rate at which commercial banks can borrow funds from each other overnight. The federal funds rate reflects the market tightness for these funds. The Federal Reserve can ease tightness in this market by purchasing U.S. government bonds, and can tighten this market by selling U.S. government securities. Buying U.S. government securities injects additional funds into the banking system, allowing banks to increase lending and enlarge the money supply in the process. Central bank purchases and sales of government securities are called “open market operations.” In the Federal Reserve System, a policy-making group called the Federal Open Market Committee (FOMC) formulates the policy for open market operations.

Until 1994, the Federal Reserve kept directives involving open market operations a secret until 45 days after an FOMC meeting, keeping current financial market participants unaware of the Federal Reserve’s policy stance at a given point in time. In 1976, the Federal Reserve successfully defended itself against an inquiry filed under the Freedom of Information Act to obtain copies of the minutes of FOMC meetings without the 45-day delay. Federal Reserve cited an “announcement effect” that might lead to volatility and uncertainty in financial markets, and maintained that secrecy was a necessary part of monetary policy.

On 4 February 1994, the FOMC, amidst a two-day meeting, announced that it planned to apply slight pressure to commercial bank reserve positions, and that short-term interest rates could be expected to rise, breaking the Federal Reserve’s long stance policy of secrecy in these matters. It was an experiment in clearly communicating policy decisions to financial markets, and using public announcements as a method of communication. The experiment had none of the dire consequences that the Federal Reserve cited in its 1976 defense against a Freedom of Information inquiry. The practice of publically announcing policy decisions and targets became a standard part of central banking in the United States and in numerous other countries. What became known as the “announcement effect” enabled central banks to control a targeted interest rate with fewer interventions in the open market. It gave central banks the ability to control a targeted interest rate merely by announcing its intentions and taking little or no immediate action.

References

Belongia, Michael T., and Kevin Kliesen. “Effects on Interest Rates of Immediately Releasing FOMC Directives.” Contemporary Economic Policy, vol. 12, no. 4: 79–91.

Demiralp, Selva, and Oscar Jorda. “The Response of Term Rates to Fed Announcements.” Journal of Money, Credit, and Banking, vol. 36, no. 3 (June 2004, part 1): 387–405.

LIQUIDITY TRAP

A liquidity trap is a macroeconomic condition in which injecting additional money and liquidity into an economy exerts very little impact on overall price levels, output, or employment. It is a macroeconomic phenomenon, meaning that it applies to the economy as a whole and not to industries individually. Only an economy at a low point in a business cycle is at risk of developing a liquidity trap. During a recession, a liquidity trap can become a major hindrance to economic recovery, considerably complicating the task of designing an effective economic policy.

The liquidity trap at first seems more of a puzzle than a trap. It seems paradoxical that the money stock can grow without commiserate growth in spending. Theories of inflation assume that money stock growth does lead to comparable growth in spending, and the growth in spending drives inflation. Only economies experiencing deflation or near deflation seem to be at risk of developing a liquidity trap.

A liquidity trap becomes possible because money, particularly bank balances, can act as a substitute for stocks and bonds, and may even become an attractive substitute if interest rates drop to very low levels. Money pays little or no interest, but it is the most liquid of all financial assets. Liquidity confers certain advantages. It puts one in a position to exploit speculative opportunities or handle financial emergencies. To offset the advantages of liquidity, stocks and bonds pay dividends and higher interest. The danger of a liquidity trap occurs when interest rates reach very low levels, probably lower than 1 percent. Unusually low interest rates of this order occurred in the United States during the 1930s, and again in Japan in the 1990s. Extremely low interest rates, coupled with fear of deflation, makes bank balances a highly attractive financial asset compared to much less liquid stocks and bonds. Low interest rates involve the expectation that interest rates will be higher in the future. Investors do not want to lock in a low interest rate by purchasing longer term financial assets when interest rates are low.

The practical significance of a liquidity trap is that it leaves the monetary authority powerless to stimulate the economy by increasing the money supply. The main ingredient of a monetary stimulus is the purchase of government bonds with newly printed money. Called “open-market operations,” this action makes the bond market more of a seller’s market, meaning bond sellers can sell bonds at lower expected yields. In other words, interest rates fall. In a liquidity trap, the preference for holding bank balances over bonds becomes so strong that open-market operations can no longer reduce interest rates. Falling interest rates no longer accompany above average growth in the money supply.

As a recession unfolds, the market for used capital goods is likely to see severe deflation, which will undercut the prices of new capital goods. Businesses become hesitant to purchase capital goods if they come to expect that capital goods can be purchased at lower prices in the future. Falling demand for finished goods further undermines the willingness to purchase capital goods. With the liquidity trap acting as a floor under interest rates, openmarket operations cannot push interest rates low enough to stem the tide of falling investment spending. The economy sinks deeper into recession.

The cure for a liquidity trap involves a high level of government deficit spending to compensate for the absence of business investment spending. In the 1990s, the Japanese government baulked at enlarging the public debt on the scale needed to lift Japan out of the liquidity trap. The Japanese economy languished in recession during much of the 1990s.

U.S. FINANCIAL CRISIS OF 2008–2009

The U.S. financial crisis of 2008–2009 owed its origins to a failure of institutions to adjust to rapid innovation in the home mortgage industry. The size and importance of the United States in the global economic and financial system left little doubt that the outcome would take on global dimensions.

The roots of the U.S. financial crisis go back to the aftermath of the 1990s economic prosperity. The 1990s saw the longest economic expansion recorded in U.S. history. The long expansion received its thrust from an investment boom in information technology industries. Easy credit fed the investment boom for a time. When the United States started tightening credit, a high-tech stock bubble burst, the investment boom ended, and the United States entered into recession. In a bid to resuscitate the United States economy, the government again turned to easy credit and bargain basement interest rates.

Low interest rates and easy credit between 2002 and 2005 sparked a boom in housing, creating a housing bubble comparable to the high-tech stock bubble of the 1990s. A housing bubble posed special risk to the financial system because houses are one asset that can be purchased with small down payments. Compared to purchasers of corporate stock, purchasers of houses can put in a much smaller share of their own money.

Dodd and Mills (June 2008) lay out every step in the development of the crisis. A long upswing in house prices had put creditors at ease about the risk of home mortgages. A house seemed to be bullet-proof collateral. Lenders began granting riskier loans and being less thorough in verifying the income, jobs, and assets of borrowers. Some mortgage originators went so far as to offer interest-only loans and negative amortization payment options. Negative amortization meant the borrower’s monthly payment was not even covering all the interest charges, much less paying down the principal. Lenders felt that escalation in house prices assured that a house could always be refinanced for larger amounts, or sold to pay off a mortgage. Rising house prices should translate into falling loan-to-value ratios for creditors.

Another weak link in the stability of the financial situation was in the process of packaging home mortgages into financial securities. Investors buying these mortgage-backed securities had to rely on the same credit rating agencies that rated bonds. Well-established and reputable rating agencies such as Standard and Poor’s and Moody’s had performed well in rating bonds but had little knowledge or experience in mortgage-backed securities. Since mortgage-backed securities were new, no historical data existed to estimate past performance and risk. These agencies awarded top ratings of AAA to over 90 percent of the mortgage-backed securities based on subprime loans (Dodd and Mills, June 2008).

Investors purchased mortgage-backed securities with borrowed funds and counted on being able to trade out of these investments in a hurry to cut losses. Mortgage-backed securities, however, were sold in an over-thecounter market, and no dealers committed themselves to making a market for them. As the poor quality of the mortgages became evident, no dealers came forward willing to maintain an inventory of these securities. The market for mortgage-backed securities became a market where everybody wanted to sell and nobody wanted to buy.

The magnitude of investor losses from mortgage-backed securities would have been easily manageable if the problem had not had wider implications. Mortgage delinquencies and home foreclosures began to mount in 2006 and 2007 amid an otherwise expanding economy. It became clear that many homeowners could only make their mortgage payments if home prices continued to escalate, allowing them to refinance their homes before the teaser interest rates on their existing home mortgages expired. It was equally obvious that many loan applications had inflated measures of borrowers’ income and house appraisal values. Falling home prices triggered a wave of foreclosures. Upward interest rate adjustments on adjustable-rate mortgages worsened an already bad situation.

A related casualty of the mortgagebacked securities market debacle was investor confidence in the credit ratings agencies such as Standard and Poor’s and Moody’s. These agencies were forced to downgrade the credit ratings of mortgage-backed securities at a much faster pace than had ever been seen for corporate bonds.

The month of July 2007 saw a significant round of ratings downgrades for mortgage-backed securities. Wall Street hedge funds began trying to liquidate large positions in these securities. In August 2007, the French bank BNP Paribas suspended withdrawals from some money market funds that were heavily invested in U.S. mortgage-backed securities. The bank claimed it had no way of putting a value on these assets. Expecting a wave of customer cash withdrawals, other money market fund managers shifted these portfolios from medium- and long-term bank deposits and commercial paper to overnight deposits. The strong demand for liquidity drained the supply of funds for short-term commercial credit instruments. The market for what was called “asset-backed commercial paper” collapsed.

The collapse of the asset-backed commercial paper market brought to the surface the role of the structured investment vehicles that a number of banks sponsored as off-balance sheet entities. Banks sponsored these off-balance sheet entities to skirt banking regulations. They amounted to a hidden banking system. These structured investment vehicles raised funds by selling asset-backed commercial paper and invested the funds in longer-term assets that paid higher interest rates. Part of the arrangement was that the sponsoring banks were obligated to provide credit to the structured investment vehicle when necessary. When the market for asset-backed commercial paper collapsed, sponsoring banks had to meet unwanted and inconvenient loan commitments.

Banks, unable to raise funds by selling loans and fearful of depositor withdrawals, set to hoarding liquidity. They were caught in a squeeze between keeping loans on their books that they had planned on selling, and honoring loan commitments to hedge funds and corporate entities, commitments that they wished they had not made.

In March 2008, the Wall Street firm of Bear Stearns saw a run on its deposits that would have ended in bankruptcy if the Federal Reserve had not assisted in its acquisition by JPMorgan Chase. In September, the United States government announced a takeover of Fannie Mae and Freddie Mac, two government-sponsored enterprises concerned exclusively with the home mortgage market. Later in September, the Wall Street firm Lehman Brothers failed. The United States Treasury refused to bail out Lehman Brothers but did encourage other firms to acquire it. When no buyers appeared, Lehman Brothers went into liquidation.

Another important industry found itself drawn in to the mortgage-backed security debacle. Bond insurers usually provided investors with default insurance against municipal and infrastructure bonds. The firms had begun selling default insurance for the mortgagebacked securities. Rising mortgage delinquencies and foreclosures hammered the stocks and credit ratings of bond-insuring companies and left in doubt the ability of these companies to honor default insurance claims in the municipal bond market and the student loan market, making these investments much less attractive.

The outcome of these developments was a banking system less willing and able to make loans and demanding U.S. Financial Crisis of 2008–2009 | 415 Media and pedestrians gather in front of the Lehman Brothers headquarters in New York on September 15, 2008, the day the 158-year-old financial firm filed for bankruptcy. (AP Photo/ Louis Lanzano) tighter criteria of credit worthiness. A seizing of credit markets hobbled private initiative among producers and consumers. The forces of recession gathered strength as firms across industries reported falling earnings. October 2008, stock markets around the world entered a steep slide. The world braced for a global recession. Economic policy makers assumed that the economic situation in the United States was developing along the lines of a liquidity trap. The Federal Reserve System, the central bank of the United States, pushed its policy interest rate to near zero and allowed banks to use a wider range of assets to borrow funds. The U.S. government met the crisis with plans for massive increases in deficit spending. In a liquidity trap, massive government spending is needed to offset the combined effects of strong liquidity preference and pessimistic expectations.