Yet the optimism did not last. With the beginning of the new millennium and, more precisely, in March 2001, the stock market crashed with the Nasdaq suffering unprecedented losses, comparable to those experienced in the 1930s. Astute observers remarked that the internet bubble had imploded, but the consensus view was that everything was normal. The consensus view gained widespread support as the recession that followed was shallow and short-lived. Pundits asserted that had the internet been a bubble, it would have had devastating effects on the economy. The small impact of the stock market on the economy was taken as prima facie evidence in support of the view that the internet was not a bubble. The fact that the recovery that followed the 2001 recession was anaemic did not cause any concern to the consensus, which continued to hold the view that internet was not a bubble. After all, the previous recession in the early 1990s was also anaemic. Policy makers and central banks did not react any different than in previous recessions. Alan Greenspan, the then Chairman of the Federal Reserve System (Fed), was adamant that there was no reason to change policies. Targeting the growth in asset prices would have required the central bank to outsmart investors, a task that was regarded as impossible. This led to the emergence of the doctrine that it is better for central banks to deal with the consequences of a bubble than to try to prevent it, which was immediately accepted by almost all of the major central banks. But Alan Greenspan fearing the worst reacted with an unprecedented monetary stimulus; the fed funds rate was cut no less than 13 times to 1 per cent from 6.5 per cent.

With a prodigious fiscal and monetary stimulus, the anaemic recovery finally became sustainable. The nightmare of an asset and debt deflation had been averted! However, the new cycle was again short-lived. After the boom in 2004, growth slowed to below potential and the USA finally succumbed to recession at the end of 2007. Astute observers again pointed out that what the Fed had achieved was to transform the internet into a housing bubble that would soon burst, dragging the economy to the dreaded asset and debt deflation process that had plagued the US economy in the 1930s and Japan in the 1990s. However, such views were brushed aside and policy makers continued with the policy of ‘business as usual’. Alan Greenspan kept interest rates at the 1 per cent level until mid-2004 and then removed the accommodation bias too slowly, thereby fuelling the housing bubble. For astute observers the role of the housing market was telling. The housing market ameliorated the early 2001 recession thanks to the prodigious monetary stimulus. The prognosis was that the bursting of the housing bubble would have a disastrous effect on the stock market. Ben Bernanke, Alan Greenspan’s successor at the helm of the Fed, carried on with the same speed in removing the accommodation bias. But he was too late in lowering rates by at least eight months. High interest rates had already inflicted a terrible blow to the housing market, which had peaked at the end of 2005. Yet up to 2007 the fall in house prices was orderly and the Fed saw no reason to alter the course of its monetary policy. The summer of 2007 saw the eruption of the credit crisis and the Fed began a policy of aggressive easing, but it was too late. The financial system became insolvent and it had to be bailed out to prevent a complete meltdown. The economy fell into a deep decline that was dubbed the ‘great recession’. In March 2009 the Obama Administration made a U-turn in term of its attitude and policies in relation to financial institutions. It rejected a House bill that had aimed to tax the bonuses of Wall Street; it adopted a ‘business-as-usual’ model for banks; and it allowed them to price their distressed assets at their own discretion by purging the standard mark-to-market method. This boosted confidence, triggering a period of restocking by companies on a worldwide basis. With the adoption of substantial fiscal and monetary stimuli by all important governments a recovery emerged. But after a year the recovery once again ran out of steam. This led to the development of a sovereign debt crisis in Europe and policy makers adopted austerity measures to deal with the new crisis, thus further undermining the recovery. At the time of writing Europe has fallen back into recession and the question now is whether it will drag the rest of the world back into recession.

Housing was not the only asset bubble. Commodities were another bubble that went unchecked in the first half of 2008 when the USA was already in a mild recession. This bubble burst when the USA fell off the cliff in the second half of 2008, dragging the global economy into recession. With the recovery in 2009 the commodities bubble re-emerged as it was widely believed that China and the other rapidly developing nations, the so-called BRICs,² could sustain growth even as the western world experienced little or no growth. The renewed commodities bubble dealt a terrible blow to BRIC countries as inflation, which had been reignited because of overheating, accelerated to dangerous levels, thereby triggering an aggressively tight monetary policy. As a result, the BRIC countries are now slowing rapidly at a time when Europe is falling into recession and the US economy is experiencing only a weak recovery.

Policy makers have opted for a stricter regulatory environment as a means of preventing another systemic crisis. For example, and in the US case, the Dodd–Frank Act, and at the international level the Basel III have emerged, along with similar measures in other countries that will be discussed at length in chapter 9.

The purpose of this book is to throw light on the causes of the credit crisis and the ensuing ‘great recession’. It traces the origins of the ‘great recession’ in the USA and outlines the distributional effects, deregulation and financial liberalisation that laid the foundations for the financial engineering, which assumed gigantic dimensions following the repeal of the Glass–Steagall Act in 1999. The book examines the emergence of the excessive liquidity that has financed a series of bubbles over the past ten years. But it also investigates the role played by the growing redistribution of income in encouraging excessive leverage in the banking sector which enabled the personal sector to become over-indebted and therefore vulnerable to shocks.

At a deeper and more theoretical level the book examines the role played by the Efficient Market Hypothesis (EMH) and the New Consensus Macroeconomics in providing the intellectual basis for the neo-liberal model and the policies pursued by central banks and the fiscal authorities. It deals with the issue of whether such conduct of monetary policy leads to instability and how future monetary policy should be formulated to avoid the mistakes of the past. Furthermore the book examines the reasons for the anaemic recovery and compares and contrasts it with the anaemic recovery of the two previous cycles. It also investigates the sovereign debt crisis that has plagued Europe and why it has developed there rather than in the USA. It also considers the contagion channels from the euro area debt crisis to the rest of the world and the risks of a US sovereign debt crisis for the world economy. The book examines the role of financial stability and how it should best be served. At the same time it offers an analysis of the regulations that are under progress in many countries as a means of deterring another systemic crisis and the lessons, in terms of both theory and policy that can be learned.

The EMH was regarded as an extreme hypothesis, at least in academia, and therefore one key question is what was the theoretical model upon which central banks based their policies. This is the third major issue covered in this book. The Grand Neoclassical Synthesis lost its appeal in the 1970s since it was increasingly thought that it was unable to explain what was happening in the real world. Great efforts were subsequently put into the development of models based on optimising behaviour that could explain nominal rigidities in labour and product markets in the context of rational expectations and yet be able to explain the real world. This led to the development of New Consensus Macroeconomics (NCM) models, which have provided the intellectual basis for the conduct of monetary policy from the 1990s onwards. The pillars of the NCM models are that inflation is under the control of the central banks, whereas growth and unemployment are not, in the long run. Moreover, the control of inflation helps to stabilise the economy around its potential output path, which is exogenous to the system, and is influenced by matters such as multi-factor productivity and the growth of the labour force. The policy implications of the NCM models are that by placing inflation targeting at the top of the policy agenda it upgraded monetary policy and downgraded fiscal policy as a tool of stabilisation. The principal objective of fiscal policy was to balance the budget and trim public debt, in the belief that doing so would shrink the ‘inefficient’ public sector and enable the corresponding expansion of the ‘efficient’ private sector. However, the ‘great recession’ has now cast doubt on the wisdom of inflation targeting to the exclusion of other targets. One key question is whether monetary policy should also aim to affect the output gap and even asset prices in an effort to stabilise the economy and achieve financial stability. Another key question is whether the policies pursued by central banks operating under the assumptions of NCM lead to instability. Another major drawback of the NCM models is that monetary aggregates, liquidity, and banking are not necessary as long as we know how central banks set the short-term interest rates. The implication of this is that the objective of financial stability cannot be served by inflation targeting.

There can be no bubble unless there is a corresponding expansion of credit to finance it. In traditional bubbles, such as occurred in Japan in the 1980s, the Asian–Russian crisis in 1997–98 and China recently, the expansion of credit was reflected in monetary aggregates. Hence the bubble could be detected by central banks and monitored through measures of liquidity. Yet there was no increase in monetary aggregates in the USA and other countries where housing bubbles emerged. How is this possible? This is the second major issue covered in this book. Financial engineering made that possible by creating the liquidity and hence the credit that was required to finance the bubbles; it led to the development and growth of a parallel or shadow banking which was outside the control of the monetary authorities. Central banks, therefore, did not detect the bubbles and did not monitor the corresponding expansion of liquidity and credit. Hence, the Fed and other central banks were taken by surprise when the housing bubbles burst around the world. The most important development in terms of the financial liberalisation of the USA was the repeal of the Glass–Steagall Act in 1999, which had been introduced in 1933 with the aim of separating commercial from investment banking. There was a simple rationale behind this act. Its aim was to permit investment banks to take as much risk as they liked with their own capital and the degree of leverage they wanted to take, but not with the deposits of ordinary savers. These would be placed with commercial banks who would be subjected to strict regulation over the risks they would be permitted to take. Sure enough, in the period between the 1930s and the late 1990s, when it was in force, the Glass–Steagall Act prevented any systemic financial crisis. By contrast, the period after its repeal led to a series of bubbles, each one being a transformation of the previous one. Thus the housing bubble is a transformation of the internet bubble and the commodities bubble is a transformation of the housing bubble.

The credit crisis of August 2007 and the ensuing ‘great recession’ unleashed an asset and debt deflation process for the personal sector not only in the USA, but also in other countries. Thus another issue that arises is how important is the deflation process in accounting for the hitherto anaemic nature of the recovery. This is yet another issue covered in this book. The asset and debt deflation process is common practice following the ballooning and the bursting of an asset bubble. The bubble on this occasion was related to the housing market, which in the USA peaked at the end of 2005. The fall in house prices was initially orderly, but it became disorderly from mid-2007 onwards. The essence of the asset and debt deflation process is that a plunge in the prices of one important constituent component of personal sector wealth, such as housing, leaves households with negative equity, meaning that the value of the house is less than the mortgage. This destruction of wealth forces households to save a higher proportion of their current income in an effort to repay the excess debt and rebuild the impaired wealth. This will involve the shrinkage of the liability side of the personal sector balance sheet in order to match the impaired asset side and bring the system back to equilibrium. For this reason the asset and debt deflation process is also called deleveraging in the jargon of financial markets. The process is a long and painful one as consumers have no access to capital markets and the result is many years of subdued consumption growth. One way of ameliorating the adverse impact of the asset and debt deflation process on the housing market and the economy is through mortgage refinancing at lower interest rates. However, this channel may be thwarted by a negative spiral of falling house prices and foreclosures. The more precipitous the decline in house prices is, the greater the number of foreclosures, as more households are caught in the insolvency net with their houses foreclosed by lenders and put up for sale in the market. This negative spiral may swamp the positive impact of mortgage refinancing, leading to a free-fall in house prices.

But there may be yet another reason for the so far anaemic recovery, which may be acting in addition to the constraints that the housing market is imposing on the consumer. This is the role that is played by expectations in affecting the decision of companies to hire and invest. This is another matter that will be considered in this book. Companies are aware of the asset and debt deflation process in the personal sector. As a result, in their decisions in terms of hiring and investment they form expectations of low final demand and, in particular, of consumption. This is a self-fulfilling prophecy that leads to a vicious circle of low consumption and low investment. Thus another reason for the anaemic recovery is the deficiency of demand. This can only be resolved by a stimulus coming from outside the system, such as external demand (that is, exports) or a fiscal stimulus. But such a fiscal stimulus has not materialized yet; even worse, the dangers of the fiscal-cliff are still there. With Europe falling into recession and China slowing in 2012 there is little hope that foreign demand can provide an alternative stimulus to the US economy.

In the midst of the credit crisis many governments around the world bailed out their financial systems. The aim of these actions was to avert an insolvent financial system from triggering its own meltdown. However, by bailing out their insolvent financial systems, governments have threatened their own solvency. This has resulted in the transformation of the banking crisis into a sovereign debt crisis. This may be another reason for the so far anaemic recovery; it even involves the risk of throwing the world economy back to recession. Although the USA poses a far greater risk than the EU in terms of its budget deficit and the level of federal debt, a sovereign debt crisis emerged in the euro area rather than in the USA. This paradox is the result of the different policies pursued in the EU and the USA and their monetary union structure. Because of the importance of such matters the book will attempt to consider a number of key issues: the causes of the euro area debt crisis; why the crisis has dragged on for so long; what, if any, has been wrong with the policies that have been pursued to resolve the crisis; the existence of alternative viable policies; and the channels through which the crisis could spread to other parts of the world.

An important issue is what lessons should be drawn from the credit crisis in terms of both theory and policy. As stated earlier, for many of the world’s leading central banks inflation targeting has been the single most important goal of monetary policy; sometimes to the exclusion of all other targets. In this respect, recent experience suggests that price stability does not guarantee the stability of the economy as a whole and even less so the goal of financial stability. Microprudential policy was the basis of the regulatory framework prior to the credit crisis. But in the aftermath of the crisis macroprudential policies are emerging as the necessary tool to deter future systemic crises. There are a wide range of macroprudential policies: time-varying capital requirements; higher-quality capital; corrective action targeted at capital as opposed to capital ratios; contingent capital; the regulation of debt maturity; and the regulation of the shadow banking system. We therefore discuss the new regulatory framework that is emerging at some length, emphasising the recent initiative on this front by President Barack Obama, summarised under the acronym of the ‘Volcker Rule’. This initiative emerged as the Dodd–Frank Act of 2010, and it is the focus of the discussion on this front, along with other similar schemes proposed and implemented around the globe.

The most important lesson for economic theory is that the initial acceptance of the EMH has been largely discredited by the events that led to the ‘great recession’. Moreover, the New Consensus Macroeconomics models are in need of reformulation – something that is addressed by this book.