Does Loose Monetary Policy Cause Crises?

Editor's Note: Thorsten Beck is a former contributor to the PSD blog. Now a professor at Tilburg University, he worked at the World Bank for eleven years and is still involved in activities in the research group and Africa and the Eastern Europe and Central Asia regions. Welcome!

The loose monetary policy in the first years of the 21st century has been one of the culprits for the boom and subsequent bust in the U.S., but rigorously testing this hypothesis is difficult since it is hard to identify cause and effect; the Fed typically lowers interest rates in times of financial fragility and uncertainty, such as after the collapse of Long-Term Capital Management in 1998.

But perhaps we can learn something from a small open economy for which monetary policy decisions can be considered exogenous.  A recent paper by Vasso Ioannidou, Steven Ongena and Jose Luis Peydro does exactly this, using a unique dataset on Bolivian borrowers.  During the period 1999 to 2003, the local currency was pegged to the U.S. dollar and the relevant short-term benchmark rate was the U.S. federal funds rate.  The paper shows that reductions in short-term interest rates do indeed lead to excessive risk taking by banks, which can eventually lead to banking fragility when interest rates rise back to “normal” levels.  So, cheap money is no free lunch and an excessively high variation in interest rates will eventually catch up with you!  These findings emphasize that bank regulation and supervision cannot act independently of monetary policy.