The causes of the recent financial crisis and the role of central banks in avoiding the next one

The recent financial crisis revealed that in a world of large asymmetries of information, of complex financial innovations and incomplete regulatory frameworks "self regulation" obviously does not work. But we have also seen that the governmental stabilisation policies have not worked well either. This paper argues that there have been, at least, two main contributors to the recent financial crisis. The one is supervision and regulation policy, the other is monetary policy. Easy monetary policy designed to ward off perceived risks of deflation in 2002-04 contributed to the boom in the housing market in 2004 and 2005 by keeping interest rates too low for too long. Particularly the US-Fed has played a crucial role by fuelling the asset-price, boom-bust cycle that led to the sub-prime crisis and the following global financial crisis. Moreover, this paper analyses what central banks can do to help avoid a next financial crisis. In particular, the role and limits of supplementary macro-prudential instruments are discussed. © 2010 Springer-Verlag.