Loose monetary policy

After the 'dotcom' bubble burst in 2000, Allan Greenspan, heading the Federal Reserve at the time, feared that US aggregate demand would fall sharply and thus throw the US economy into a full-blown recession. He swiftly responded by radically lowering interest rates to 1 per cent. Greenspan's loose monetary policy initially worked well: the US economy remained strong, but in the medium term a housing bubble built up. Low interest rates created a very competitive environment for financial institutions, which could only achieve high returns if they made ever-riskier investment decisions (Roach, 2009; Roubini and Mihm, 2011). But it would be a mistake to single out American monetary policy and deregulated finance as the sole culprit of the crisis. Many European banks invested in large quantities of securitized US mortgages and other innovative financial instruments. Over time, European financial institutions ended up even more leveraged than their American counterparts. In addition, the introduction of the EMU brought interest rates down in the previously high-interest southern periphery of the EU and in Ireland, providing cheap funding to financial speculators in these countries (Tsoukalis, 2009). The result was an enormous housing and lending boom, especially in Ireland and Spain. This, combined with the lack of a pan-European system of financial governance, explains why the instabilities in American financial markets contaminated Europe so quickly.