In his Stamp Memorial Lecture (pdf here) at the LSE, Mervyn King, the Governor of Bank of England, had this to say about the challenge with using expansionary policies to mitigate the economic impact of financial market crises,
Misperceptions mean that unsustainable levels of spending, and associated levels of debt, can build up over many years. When those misperceptions are eventually corrected, they lead to sudden large changes in asset values, a synchronised de-leveraging of balance sheets, a large downward correction to spending and output, and defaults. Keynesian policies to smooth the path of adjustment by supporting aggregate demand can help in the short run, but their effectiveness is limited by the fact that a significant adjustment to spending – from consumption to investment – is required.While undoubtedly, there is the hope that low interest rates will provide the time and conditions for all agents to repair their balance sheets and for recovery to take hold, it also runs the risk of aggravating the problem. Gangrene cannot be treated with a sustained high dose of steroids. Fundamental adjustments, with short to medium-term pain, may be necessary to sustainably address this problem. There are two related risks
1. There is the risk that the monetary accommodation may not be able to solve the fundamental problems that caused the crisis and it may only be delaying the inevitable adjustments. If that is the case, then it also carries the risk that by kicking the can down the road, we may be actually aggravating the crisis by making the necessary adjustments larger than would have been the case if it were done now. By the time the inevitable amputation happens, the gangrene infected patient would also have undergone untold suffering.
2. The other risk is more political. It cannot be denied that central banks across the world have come to assume the center-stage in national economic policy making. But unfortunately their rise has mirrored the reluctance of governments to bite the bullet when faced with severe economic and financial crises. In fact, the aggressive monetary accommodation may have contributed to this trend. As Martin Feldstein wrote recently in the context of the US, "By keeping the long-term interest rate low, the Fed has removed pressure on the president and Congress to deal with deficits". Much the same motivations are evident elsewhere as governments sit back paralyzed goading central banks to cover for their own inaction.
There is the danger that ultra-low rates will come in the way of decisions that are necessary to wring out the excesses built-up during the boom times. For example, the assumption that all major asset categories will recover close to its pre-crisis valuations and thereby eliminate the balance sheet problems of financial institutions is questionable. In the circumstances, central banks provide the alibi for governments to abdicate on their fundamental responsibilities.