As background for our monetary policy decision making, we at the Federal Reserve have spent a good deal of effort attempting to understand the reasons why the economic recovery has not been stronger. Studies of previous financial crises provide one helpful place to start. This literature has found that severe financial crises - particularly those associated with housing booms and busts - have

 
often been associated with many years of subsequent weak performance. While this result allows for many interpretations, one possibility is that financial crises, or the deep recessions that typically accompany them, may reduce an economy's potential growth rate, at least for a time. The accumulating evidence does appear consistent with the financial crisis and the associated recession having reduced the potential growth rate of our economy somewhat during the past few years.

European Central Bank Governing Council member Jens Weidmann said the bank's crisis-fighting measures may encourage governments to delay tackling the root causes of the problem and make the situation worse. "It is certainly true that if the house is burning, putting out the fire has to be the most pressing concern," Weidmann... said... "But we have to also make sure that with all the fire fighting and new fire insurance that we're handing out, we're not unwittingly preparing the ground for the next fire."

Weidmann, an outspoken critic of the [European Central Bank's] planned bond-purchase program, cited the central bank's 1 trillion euros (US$1.29 trillion) of three-year loans to banks as an example of the risks inherent in its crisis-fighting measures. While those loans averted a credit crunch, they were used by banks to buy government bonds, increasing the risks on their balance sheets and potentially exacerbating the debt crisis, he said.

"The crisis has blurred the boundaries between monetary policy and fiscal policy... The impression that you can escape this with temporary easy policies, through monetary policies, just aggravates the problems we face in the future. Monetary policy is seen by politicians as an easy way out. It is not a panacea."

Crisis-stricken euro zone states may do better by pushing through tough budget cuts early rather than seeking to stretch them out over a longer period, the head of Germany's central bank said... "It is sometimes better to have a hard cut at the beginning" which leads to visible success, than to have a long process that seems never to end, said Jens Weidmann, President of Germany's Bundesbank and a member of the European Central Bank's governing council... Asked about the social costs of austerity in Greece and Spain, Mr. Weidmann said 'one thing is clear. The adjustments in those countries cannot be avoided.' The developments that took place prior to the crisis 'and which led to the crisis can't simply continue,' he said."

Exiting from accommodative monetary policy will become more difficult over time... Weidmann said Friday. ... Weidmann acknowledged that these were "not normal times" but warned it is "important to keep in mind the long-term consequences of what we are doing." "The balance of risks and benefits will shift over time and it is getting more and more difficult to exit," Weidmann said, arguing that central bank actions continue to "distort" markets...

Weidmann... reiterated that monetary policy should not be "overburdened" in the current crisis and warned that central bank interventions risked delaying government reforms. "Monetary policy is seen by many politicians as the easy way out... " While it "buys you time," it might "lead to behavior where you just sit and wait," he warned. Weidmann said the "experience so far is not very comforting in this respect... you buy time that is not being used."

... Crisp numerical thresholds may work well in the classroom models used to illustrate policy principles, but one or two economic statistics do not always capture the rich array of policy-relevant information about the state of the economy.

When the Fed expands reserves by buying private assets, it extends public sector credit to private borrowers. To the extent that purchases of private claims have any effect, they do so by distorting the relative cost of credit among different borrowers. Such differential effects are unlikely to be beneficial, on net, unless borrowers in the favored sector would otherwise face artificially high rates. I think it's difficult to make this case for agency MBS [mortgage-backed securities] , a sector that historically has benefited from heavy subsidies, which arguably contributed to dangerously high homeowner leverage.

So I do not see the rationale for reducing the interest rates paid by conforming home mortgage borrowers relative to those paid by, say, small-business borrowers. Moreover, purchasing agency MBS encourages the continuation of a housing finance model based heavily on government-sponsored enterprises, at a time when the housing sector would be better served by a new model that relies less on government credit subsidies...

An immediate consequence of a central bank's independence is the capacity to use its balance sheet to direct the flow of credit toward particular market segments, circumventing the constitutional checks and balances that would otherwise apply to such fiscal initiatives.

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