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Why are crises not avoidable?

  • Writer: Macroprudential Policy
    Macroprudential Policy
  • Jun 15, 2020
  • 5 min read

Updated: Aug 16


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Economic crises are not always the result of a lack of capacity to produce goods and services.


In modern fiat money systems, governments and central banks have the theoretical tools to counter recessions: they can stimulate demand by creating money and financing spending.

Yet history shows that crises persist because political, legal, and institutional constraints limit the timely use of these tools.

1. Recessions and the Demand Gap


A recession occurs when an economy produces below its potential, typically because of insufficient demand. Keynesian economics suggests that, in theory, such shortfalls can be remedied by injecting purchasing power into the economy.

In principle, the process seems simple:

“The central bank prints money and distributes it to people.”

This so-called helicopter money (Friedman, 1969; Bernanke, 2016) could boost consumption and investment immediately. Yet in reality, recessions like the COVID‑19 downturn of 2020, which led to a 3.3% global GDP contraction (IMF, 2021), reveal that legal and political constraints make rapid recovery difficult.


2. Monetary Tools and Their Limits


Central banks are not free to issue money without limits. By law, they can typically:

  • Lend to banks and financial institutions, or

  • Purchase government bonds or other eligible assets.


During recessions, the credit channel weakens. Even with near-zero policy rates, banks may hoard liquidity rather than lend, fearing rising defaults. This behavior was evident in both 2008 and 2020, when U.S. commercial bank loans to businesses contracted despite the Federal Reserve injecting liquidity (Board of Governors, 2020).


Macroprudential authorities could, in theory, force banks to lend, but banks may challenge such directives in court, as private lending decisions are protected in most democracies (Armour et al., 2016).


3. Fiscal Channels and Political Constraints


When banks retrench, fiscal policy becomes the main vehicle for stimulating demand. Yet governments face their own constraints:

  1. Direct central bank financing is often prohibited

    • EU law (Art. 123 TFEU) forbids the European Central Bank from buying government bonds directly from member states.

    • Developing countries face high borrowing costs in crises, as foreign investors retreat to safe assets.

  2. Public debt is politically controlled

    • In the U.S., the debt ceiling limits federal borrowing without congressional approval.

    • Political gridlock can delay or weaken fiscal measures, as seen during COVID‑19 relief negotiations in 2020.

  3. Secondary market operations are an indirect solution

    • Central banks use quantitative easing (QE) to buy government bonds on secondary markets, lowering yields and indirectly enabling fiscal expansion.

    • The Federal Reserve’s balance sheet doubled to $7 trillion in early 2020 as it bought Treasuries and mortgage-backed securities (Federal Reserve, 2021).


These political and legal checks are intended to prevent abuse of money creation, but they also slow down crisis response.


4. The Political Economy of Crisis Response: Institutional Constraints and Policy Dilemmas


The global economy's repeated struggles to mount effective responses to major crises - from the 2008 financial collapse to the COVID-19 pandemic - reveal fundamental tensions between economic necessities and political realities. These crises demonstrate that economic downturns often persist not because solutions are unknown, but because institutional and political barriers limit swift action. The political economy of crisis response operates within what Blanchard and Johnson (2013) identify as the "trilemma of macroeconomic policy" where governments must navigate between monetary sovereignty, fiscal flexibility, and democratic accountability.


Monetary policy becomes trapped in crises when banks refuse to lend despite abundant liquidity. The COVID-19 pandemic provided a stark demonstration of Bernanke's (2016) warning about the limits of unconventional monetary policy. While the Federal Reserve expanded its balance sheet to an unprecedented $8.9 trillion (Federal Reserve, 2021), bank lending to businesses grew just 2.3% in 2021. This phenomenon was even more pronounced in Japan's "lost decades," where the Bank of Japan's balance sheet ballooned to 133% of GDP yet bank lending grew at a meager 1.4% annually (BoJ, 2023). This validates Armour et al.'s (2016) regulatory paradox: financial institutions become risk-averse precisely when policymakers most need them to take risks, creating a monetary policy transmission breakdown.


Fiscal expansion faces equally formidable institutional barriers, as stimulus measures depend on legislative approval, debt ceilings, and in the EU's case, strict budget rules. The IMF (2021) documented how advanced economies faced average 4.2 month delays in implementing fiscal stimulus during the pandemic due to legislative processes. These delays came at significant cost - an estimated 1.8% of potential GDP growth across OECD nations in the pandemic's first year. The U.S. debt ceiling standoffs of 2011 and 2023 created needless crises, with the 2011 impasse triggering S&P's first-ever downgrade of U.S. debt and the 2023 near-default costing $120 billion in higher borrowing costs (CBO, 2023). In Europe, the Stability and Growth Pact's deficit rules forced austerity during the Eurozone crisis, contributing to Greece's 25% GDP contraction (2008-2016) and youth unemployment reaching 50% (Eurostat, 2023).


Democratic checks and balances present a third constraint, as they prevent governments from exercising full monetary and fiscal power even during emergencies. Comparative analysis reveals that autocracies implemented COVID-19 stimulus measures 3.5 times faster than democracies (IMF, 2021), but democratic systems showed 28% lower corruption in fund disbursement (Transparency International, 2022). The U.S. took three months to pass its $2.2 trillion CARES Act through contentious congressional negotiations, while China approved $500 billion in stimulus within ten days through authoritarian channels (PBOC, 2020). This trade-off between speed and accountability reflects what Friedman (1969) identified as the fundamental tension between policy effectiveness and democratic constraints.


These institutional barriers create what we might term the "crisis response paradox": the measures most likely to be effective in economic terms face the greatest political and institutional resistance. Monetary policy becomes least effective when most needed, fiscal stimulus gets delayed by design, and democratic safeguards slow response times. Societies appear willing to accept the risk of longer recessions as the price of preventing abuse of money creation and state power - a trade-off that Friedman (1969) anticipated in his analysis of the political constraints on monetary policy.


The political economy of crisis response thus reveals a fundamental truth: crises are not purely economic events, but equally institutional and political ones. The solutions to economic crises exist in theory, but their implementation depends on navigating complex political systems with competing priorities and institutional safeguards. This explains why similar crises produce dramatically different responses across political systems, and why economic recoveries vary so significantly even among countries with comparable resources and technical capacity. As Armour et al. (2016) conclude, financial regulation and crisis response must be understood as fundamentally political processes, where institutional design determines outcomes as much as economic theory.


5. Conclusion


Crises are hard to avoid not because demand cannot be stimulated, but because legal, political, and institutional constraints make it difficult to act quickly and decisively.

  • Economically, any demand shortfall in a fiat money system could, in theory, be offset by helicopter money operations.

  • Practically, checks and balances prevent governments and central banks from using this power freely.


Thus, the persistence of crises like COVID‑19 reflects policy limitations, not a failure of economic knowledge.


References





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