Klaas Knot: Monetary policy and the Great Financial Crisis
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the Third Annual Nyenrode
Finance Day, Breukelen, 28 October 2011.
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The past four years have been tumultuous for the global financial system and the global
economy in an unprecedented way for all of us. The eruption of a systemic financial crisis of
quite unusual intensity and international reach has been compared to the widespread
shutdown of international capital markets on the eve of the First World War. The violent
unraveling of events has shaken many beliefs in the economics profession. And the threat of
a collapse of the world economy similar to the Great Depression has prompted
unprecedented policy responses. Monetary policy makers reacted to the crisis by deploying
both conventional and unconventional tools.
In this speech, I want to discuss how the conduct of monetary policy in the euro area has
evolved during the different stages of the crisis and the challenges it is currently facing.
To put this discussion in perspective, let me start by recalling the ECB's mandate to deliver
price stability, as is anchored in the Maastricht Treaty. Pursuing this mandate requires that a
number of elements are in place.
First, there has to be a credible commitment to price stability as a primary goal of monetary
policy. A credible commitment implies that the public's long-run expectations about inflation
are anchored by the ECB's definition of price stability - HICP inflation below but close to 2%.
Second, monetary policy has to be transparent and monetary authorities must be
accountable for their decisions. This implies a need for clear and effective communication.
Third, monetary policy decisions have to be taken in full independence from political
influence. This principle is laid down in the Maastricht Treaty. It implies the strict prohibition
of monetary financing.
Fourth, monetary policy has a medium-term orientation, given the long and variable lags of
the monetary transmission mechanism.
Fifth, monetary policy is underpinned by a comprehensive analytical framework, which rests
on two pillars: the economic analysis and the monetary analysis. I should note that the crisis
has shown how the monetary analysis can play an important role in signalling financial
imbalances and vulnerabilities. It is an important input in a strategy of "leaning against the
wind".
Finally, monetary policy follows a so-called "Separation principle", which distinguishes
decisions about the monetary stance aimed at achieving price stability from tools directed at
implementing monetary policy decisions through liquidity management.
With these principles in mind, let me turn to the monetary policy responses to the crisis. At a
very general level, the ECB used conventional tools - an aggressive easing of the policy
rate - to counter deflationary pressures and unconventional tools, which aimed at restoring a
well-functioning transmission mechanism. These policies were pursued in four phases.
1. Between July 2007 and the fall of 2008, the ECB responded to disruption in
interbank markets by expanding its liquidity provision to commercial banks.
2. Between the fall of 2008 and end-2009, as the financial crisis escalated and turned
from a liquidity crisis into a solvency crisis, the ECB lowered its policy rate in quick
steps to an unprecedentedly low level. In addition, it also employed a range of
unconventional tools - such as fixed-rate full-allotment at the weekly tenders,
longer-term refinancing operations.
3. The third phase extends from end-2009 to mid-2011. As the macroeconomy
rebounded and financial market conditions improved in late 2009, the ECB started a
gradual exit from its unconventional measures. When the sovereign crisis hit euro
area bond markets in the early months of 2010, the Eurosystem responded to an
increasingly dysfunctional monetary transmission mechanism, by activating a
Special Markets Program (SMP).
4. When the sovereign crisis intensified in August 2011, the gradual exit from
unconventional was stalled. Also, additional unconventional measures were taken to
support the monetary transmission mechanism.
These policy responses went a long way in supporting the ECB's goal of price stability, and
to address problems in the monetary transmission mechanism.
At the same time, these measures - and the SMP in particular - entailed a number of risks.
As I mentioned in earlier speeches and interviews, I see four main risks.
First, these measures tended to reduce pressure that markets exerted on governments to
pursue fiscal discipline.
Second, treading further along the path of interventions in government bond markets implies
increasing risks of monetary financing of fiscal debt.
Third, purchases of assets in markets under stress implies a financial risk for the
Eurosystem's balance sheet, which may eventually lead to fiscal transfers.
Fourth, there is a risk that the Eurosystem will enter political waters, which will make the
conduct of monetary policy more difficult.
With our experience during the crisis and the connected risks in mind, we need to rethink the
role and set-up of monetary policy after the crisis. Where are we headed? And how do we
get there?
I see three main elements of monetary policy after the crisis. For the monetary policy
framework, the crisis has shown that the monetary analysis can play an important role in
signaling financial imbalances and vulnerabilities. It is an important input in a strategy of
"leaning against the wind".
For the operational framework for monetary policy, it is crucial that after the crisis we will
return to the principles that guided the framework before the crisis. In particular, we need to
return to a clear and transparent separation principle between monetary policy stance, on the
one hand, and liquidity management, on the other hand.
Finally, there is a clear need for a sustainable institutional framework for the euro area. This
framework will need to center on budgetary discipline and sound economic governance. In
the long-run, as a closing piece, I see joint financing through euro bonds as the only
sustainable solution to self-fulfilling liquidity/solvency problems in individual member states
and domino-effects/contagion between euro area member states.
How do we get there? In a transition to a post-crisis monetary policy, it is important to exit
gradually from unconventional and conventional instruments that are being used during the
crisis. In this phase, communication will play a very important role. And fiscal and prudential
policies need to play a primary role in addressing problems that originate in the fiscal and
financial spheres.
Let me conclude. As Stan Fischer said in a recent Tinbergen Lecture in Utrecht, the big
question monetary authorities face in these times is - what do you do if policymakers that
should tackle problems do not act sufficiently? My answer is that monetary policy cannot
solve the crisis, since it is rooted in fiscal policy and the vulnerability of the banking system.
All monetary policy can do is to buy time, at the cost of stretching its mandate to the limit, if
not beyond.