Now we have three monetary policy functions, normal monetary policy, financial stability policy and macro-prudential policy. The first concerns the setting of interest rates. The second concerns the avoidance of financial risk. The third concerns the use of regulatory levers to manage the business cycle in lending and finance. Similar frameworks are busily being put in place across other parts of the developed world. The assumption behind all this new paraphernalia is that the recent Great Recession was entirely the fault of the financial system, and specifically the banks.  Only on this basis would it make sense to interfere so actively in markets and consequent prices, since otherwise all one would need would be normal monetary policy and the usual eye on potential systemic dangers.  Furthermore, since one would not need macro-prudential intervention, one would note that it is highly distortionary of market processes, and for this reason should not be used as it is actively damaging to the economy. One must hope that, in time, sense will prevail and the monstrous new system put in place will be somewhat unwound and reduced in scale. The Bank of England has published its ambitious plans for research on these areas; so maybe it will learn the error of these ways from this new programmer. The first aspect is the building up of toxic derivatives on top of the subprime housing market which meant that once the housing market went bust, the financial securitization and the derivatives that were based on the housing market blew up leading to banks being unable to lend to each other and suffering losses.The next aspect is the fact that Americans and much of the rest of the world were deeply in debt (personal, corporate and governmental) which was unsustainable. The point here is that if one lives beyond one’s means, sooner or later the debts come due and the financial reckoning day would mean that one is either forced to pay up or go bankrupt. When this happens at the individual level, it usually results in foreclosure of homes, being declared bankrupt and hence unable to pay the credit card bills etc. When this happens across the economy and involves corporates, banks, governments (local, regional and national), and the net result is a credit crunch which in other words was the name given to the global economic crisis.

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