Hermann Remsperger: Stabilising the economy and the financial system
- lessons and challenges for monetary policy and supervision
Keynote speech by Professor Dr Hermann Remsperger, Member of the Executive Board of
the Deutsche Bundesbank, at the 16th Central Banking Seminar of the Bank of Korea
on "Global Stagflation Threat and Monetary Policy", Seoul, 21 October 2008.
* * *
I Introduction
Governor Lee,
Members of the Governing Board of the Bank of Korea,
Ladies and Gentleman,
It is a great honour for me to be invited to deliver the keynote speech at the 16th Central
Banking Seminar of the Bank of Korea on "Global Stagflation Threat and Monetary Policy".
Given the ongoing turmoil in the global financial system and the related risks for the world
economy, the topic of this seminar is well chosen and timely. Three closely interlinked
developments are currently shaping events.
The public focus is, of course, first and foremost on the financial crisis. Starting from the
United States in August 2007, the global financial system has been repeatedly shaken by
new waves of heavy turbulence. These were driven by rapid and dramatic changes in market
sentiment. Investors and lenders have moved from trusting anybody to trusting nobody. A
situation in which liquidity was simply assumed to be given has turned into a situation in
which funding markets are frozen and dysfunctional. Emergency measures have been taken
by central banks and governments in many countries. These measures were often
unprecedented in scale and unconventional in nature.
With the financial storm intensifying in recent weeks, an increasing number of financial
institutions in advanced economies have been encountering severe difficulties. What started
as a liquidity crisis is turning out to be more and more of a solvency crisis. It represents a
growing danger to the supply of credit and the proper functioning of the economies in
advanced economies. Moreover, the effects of the crisis are being increasingly felt in
emerging markets, too. Many of these economies are faced with capital outflows and
reduced export demand. Hence, we are confronted with a truly global challenge.
This brings me to my second observation. Surging commodity prices, until very recently, and
the current financial market turmoil have resulted in a marked slowdown of global economic
activity. With the financial crisis deepening, uncertainty about the outlook for the global
economy is increasing, while growth risks are biased strongly to the downside. Following a
roughly 5% increase in each of the past few years, the IMF now expects global economic
growth to slow to close to 4% this year and to 3% in 2009. The economic slowdown is
especially marked in the advanced economies. In these countries, the word recession has
re-entered the public debate.
Third, with global economic activity weakening, inflation worries have abated. However, I
would caution against the temptation to "declare inflation dead", as some observers have
done. We saw a sharp rise in inflation worldwide, in particular from the end of 2007 up to the
middle of this year. For the current year, the IMF is forecasting a rise of 3.6% in consumer
prices in advanced economies and an increase of as much as 9.4% in the emerging markets.
Fortunately, the crest of the current wave of inflation seems now to have broken due to falling
oil and commodity prices, reflecting weaker global growth. But it should not be overlooked
that inflation in a whole number of countries has doubled within a relatively short space of
time. In more than half of the emerging market economies, inflation spiked to double digits
only recently. And, more importantly, at the moment inflation is diverging considerably across
individual countries and regions. If this divergence were to persist or even widen, it is likely to
complicate monetary and exchange rate policy for emerging markets with an exchange rate
peg.
At this point, it might be useful to mention the so-called impossible trinity: Countries that peg
their exchange rates to an anchor currency either have to control capital movements or cope
with the interest rate policy of the anchor currency. Fixed exchange rates are sustainable
only as long as there is no major divergence in inflation and growth vis-à-vis the anchor
currency. This was the case during the period of the "great moderation". The risks posed by
exchange rate pegs are now becoming increasingly obvious and in many emerging markets
are rendering a stability-oriented monetary policy more difficult.
In my view, in an increasingly integrating world, the global economy needs more exchange
rate flexibility in dealing with large shifts in relative prices that affect advanced and emerging
countries differently. While interest rates in advanced economies are at comparatively low
levels, significantly higher interest rate levels are required in emerging markets, given their
still relatively high rates of growth. At the same time, history tells us that capital controls are a
short-term solution at best. Therefore, interest rate differentials corresponding to different
macroeconomic circumstances at home and abroad can be achieved only through sufficient
exchange rate flexibility.
To a European observer, this line of reasoning sounds familiar. It has been at the heart of the
discussion on European monetary and exchange rate policies ever since the collapse of the
old Bretton Woods system. And in the following 26 years that preceded the creation of the
euro, European countries tried almost every possible exchange rate regime to cope with the
challenge of conducting independent monetary policies on an increasingly integrated
continent. In the end, the corner solutions prevailed: a hard peg among European countries,
and the euro area itself operating an independent float.
I will not go further into exchange rate issues.1 Instead, I would like to invite you to join me on
a journey through recent economic history - a journey with three stops. Our first stopping
place will be the period of stagflation in the 1970s and early 1980s (section II). I believe that
a number of important monetary policy lessons can be drawn from that episode. We shall
then move on to our second stopping place. It is the period of the "great moderation"
(section III), which began in the early 1990s and now seems have come to an end with the
recent increase in macroeconomic volatility. This episode has another set of interesting
lessons to teach us. Third, and finally, our journey will end with the current financial crises
and a discussion of the many challenges facing central banks and supervisors in stabilising
the financial system (section IV).
II Lessons of the period of stagflation: Anchoring inflation expectations at a low
level by means of a credible monetary policy
Let us start our journey with some monetary policy implications of the period of stagflation in
the 1970s and early 1980s, when high inflation rates and recessionary developments were
simultaneously triggered by oil price shocks.
I do know that likening the recent past to the 1970s and early 1980s is an oversimplification.
Currently, the global economy is faced with multiple shocks. And it is precisely the heavy
turbulence in the international financial markets that sets the present situation apart from the
period of stagflation in the 1970s and early 1980s. Even so, this episode provides some
important monetary policy lessons for the present.
I believe these lessons can be summed up in one key message: anchoring inflation
expectations at a low level is crucial for monetary policy to be successful. Anchoring both
inflation and inflation expectations is essential in order to contain the risk of second-round
effects induced by the oil price shocks and thus to counter the emergence of wage-price
spirals. However, the first-round effects of oil price shocks - in other words, the direct
increase in consumer prices due to the higher cost of energy - impose costs that have to be
borne. The real transfer of wealth to the oil-exporting countries cannot be compensated by
loose monetary policy.
With firmly anchored low inflation expectations, risks to price stability can be averted with a
less tight monetary policy than would be the case with higher inflation expectations. Once
high inflation expectations have become entrenched, monetary policymakers have to
respond with high interest rates. The real economic costs of a disinflation process, which is
inevitable sooner or later, are correspondingly high. Here, I would like to point to the
experience of the Fed in the 1980s under Chairman Paul Volcker, known as the "Volcker
disinflation".
And perhaps I may also recall that monetary policy was the subject of in-depth discussion
during the period of high inflation in the 1970s and early 1980s. Concurrently, there was a
growing willingness - or perhaps I should rather say "a growing necessity" - to implement
newly developed monetary policy strategies. The Bundesbank and the Swiss National Bank
were among the first central banks - following the collapse of the Bretton Woods system - to
enter uncharted monetary policy territory with the introduction of monetary targeting.
Although the road to price stability under the new strategy was bumpy at times, the final track
record was convincing. The gearing of monetary policy to a quantitative objective and
resolute interest rate responses pushed inflation in Germany down from a peak of nearly 8 %
in the beginning of 1974 to 2 1⁄2 % by the end of 1978.
With this monetary policy strategy, the Bundesbank also mastered the second oil price shock
very well: at just over 6 % in the spring of 1980, inflation in Germany remained below the
1974 peak, while inflation in the USA went up to 14 1⁄2 %. The rapid lowering of inflation
expectations to a low level meant that Germany succeeded in "opting out of the great
inflation" at an early stage.2
Put in a nutshell, the success of monetary targeting was based on the explicit, transparent
and credible commitment to a quantitative objective. To be sure, institutional conditions and
supportive measures also played a crucial part. These include the central bank's
independence, a flexible exchange rate and, not least, an active communication policy. But
the be-all and end-all of a successful monetary policy remain the three "C"s - credibility,
credibility and credibility.
For me, the key lesson from the experience of the 1970s and 1980s is that a resolute,
forward-looking and credible monetary policy can anchor inflation expectations at a low level.
And let me add that the ECB was well advised to take due account of the monetary policy
lessons of the 1970s and 1980s. According to survey data, average long-term inflation
expectations since the introduction of the euro were broadly in line with our target figure of
close to, but below 2%.
III Lessons of the period of the "great moderation": Increasing globalisation
calls for a long-term, symmetric interest rate policy based on a broad
monetary policy analysis
And with this remark I would like to turn to the second part of our journey through recent
economic history. From the early 1990s, low inflation rates were accompanied by an
accelerated globalisation of the world economy. Cheap imports from emerging market
economies with low production costs have dampened the rise in consumer prices in the
industrial countries. This is supported by a number of empirical studies covering the period
from the mid-1990s up to the middle of this decade.3
However, I would caution against drawing premature conclusions. We have been witnessing
a reverse development, in particular since the middle of last year. The fact that the emerging
market economies are becoming more closely integrated into the global economy means that
their demand for commodities is also growing. This additional demand - along with some
supply-side constraints - is playing a crucial role in the steep increase in global oil and
commodity prices. The global surge in inflation until the middle of this year should teach us to
regard the globalisation dividend of low inflation rates as not being permanent.
Moreover, I would like to emphasise that shifts in supply and demand in individual markets
- either nationally or on a global scale - merely lead to a change in relative prices. Even in
an increasingly globalised world, a broad-based increase in the general price level is and
remains a monetary phenomenon. This generally accepted fact of monetary policy seems to
have been overlooked somewhat in the period of the "great moderation", when globalisation
kept inflation down for quite some time.
I would, in fact, like to go one step further: Central bankers can never afford to sit back and
relax - even in periods of low inflation. It seems that price stability based on a credible
monetary policy is not, by itself, enough to ensure financial stability. There are even some
observers who advance the hypothesis that a credible monetary policy which anchors
inflation expectations at a low level actually sows the seeds for a build-up of imbalances in
the financial sector later on. In the literature, this is described as the "paradox of credibility".4
Has credibility - the be-all and end-all of a successful monetary policy - unintentionally
become a risk to financial stability? In order to throw more light on this, I would like to explain
briefly how financial imbalances could arise in the period of the "great moderation" despite
stable prices - imbalances that ultimately became a threat to the real economy.
The years prior to the outbreak of the current financial crisis were marked by low nominal
and real interest rates and abundant liquidity. The main driving forces were the
accommodative monetary policy stance around the world in combination with excess savings
in parts of the emerging world, in particular in emerging Asia - the so-called saving glut.5
In this environment, investors intensified their search for yield and increasingly
underestimated underlying risks. This is suggested, at least, by the low and steadily falling
cost of insuring against credit risk, in particular in the period from 2005 to mid-2007. High risk
appetite boosted the demand for complex financial products: The risks of these financial
instruments were not recognised or were ignored in many cases. At the same time, we
observed a credit boom and strong output growth which neared the point of overheating,
while the benign impact of globalisation kept consumer inflation in check.
In addition, the propensity to lend normally follows a cyclical pattern. The quality of credit is
generally better in an upturn than in a downturn. During the period under consideration, this
contributed to the emergence of asset price bubbles. Developments on housing markets in a
number of countries, including the United States, the United Kingdom, Spain and Ireland but
also some emerging market economies, are a case in point. Higher house prices lifted the
value of real estate collateral, which, in turn, made lending easier. In countries where
mortgage equity withdrawal played a role, rising house prices also created an income
illusion. This explains at least part of the over-consumption in the United States.
Recent events make us painfully aware of the fact that asset prices do not rise forever. Asset
price corrections, too, can generate risks to sustainable growth. Falling asset prices tend to
reduce the value of collateral and to increase banks' holdings of bad loans, thus reducing
their scope to provide new credit.
The fact that adverse financial developments have a huge negative impact on the real
economy is shown not only by the current events. A recent comprehensive study by the IMF
demonstrates for the long period from 1960 to 2007 that recessions last longer when they
are accompanied by tensions in the financial markets and the collapse of asset prices.6
Although a build-up of tensions can remain unnoticed or deliberately be ignored for a long
time, financial imbalances do have a destabilising impact in the end.
This brings me to an important lesson regarding the monetary policy decision-making
process. Monetary policy analysis should be broad in design in order to detect financial
imbalances at an early stage. It is precisely in a setting characterised by uncertainty that a
diversified analytical approach is of particular value. For that reason, it is essential to
enhance and strengthen both the monetary analysis and the analysis of financial market
developments. I believe that it is necessary to interpret particularly pronounced price
developments in the asset markets as a "leading indicator of financial instability".
The fact that financial sector imbalances are reflected in the development of various
monetary indicators applies especially in the longer term. Recent empirical work tends to
confirm the view that the correlation of medium and especially longer-term trends in
monetary developments and inflation was underestimated in the period of the "great
moderation".7
If the underlying monetary dynamics signal price risks in the medium to long term, monetary
policymakers have to respond, for at least two reasons. First, a monetary policy that "feeds"
asset price developments in an upturn may amplify the dynamics of the financial markets and
encourage procyclicality. Second, the monetary policy response to downturns in the asset
markets has an impact on market participants' risk perception in the following upturn. This is
especially evident where monetary policymakers lower rates asymmetrically in times of
severe financial market downturns and, at the same time, more than is warranted by the
baseline outlook for prices and growth. Monetary policy should be applied symmetrically.
In the words of Axel Weber, Bundesbank President and member of the ECB Governing
Council: "A more symmetric approach would treat boom and bust episodes not as isolated
events but would try to look through the financial cycle in order to steady policy. To be more
specific, a more symmetric policy would also realise implicit risks in times when money and
credit growth is dynamic, asset prices go up and risk perceptions decline. This can create the
need to act despite sufficiently low current inflation rates.
This, however, does not mean that monetary policy should downgrade the price stability
objective for the sake of other objectives. Rather, it means that central banks should take a
longer-term perspective which takes into account the future inflationary consequences of
such unfavourable developments."8
IV Challenges for the stabilisation of the financial system: refining and
implementing the Basel II framework, addressing procyclicality, and
strenghtening the institutional setup of supervision9
The last part of our journey brings us right up to the present day, where we are facing a
financial crisis of historic dimensions. While my topic is not crisis management but rather
long-term crisis prevention, let me nevertheless begin with a few general remarks on the
measures that have been undertaken so far by the central banks and governments in
response to the deepening financial crisis.
Central banks' main objective, from the very beginning of the financial turmoil, has been to
address the liquidity squeeze in funding markets, first and foremost in the money market.
Responses have varied among major central banks and have evolved as the crisis unfolded.
Essentially, central banks have provided short term-liquidity on a massive scale, including in
foreign currency. They have also increased the supply of longer-term funding, sometimes in
an internationally coordinated manner.
In addition, central banks have extended both the range of eligible collateral for their lending
operations and the range of eligible counterparties for collateralised lending. At the level of
operational instruments and procedures, the crucial need for a central bank's monetary
policy framework to be broad and flexible in design has been clearly confirmed.
Moreover, central banks have adjusted their monetary policy stance at various stages as the
crisis unfolded, taking into account differences in their mandates and in the expected impact
of the financial turbulence on inflation and growth in their respective countries and regions.
The coordinated interest rate cut earlier this month has to be seen against the backdrop of
escalating financial market stress. In addition, the global economic outlook had taken a
distinct turn for the worse, with the possibility of a further deterioration, while inflation had
become less of a concern in view of falling oil and commodity prices.
With the financial crisis deepening and liquidity strains turning into solvency problems for an
increasing number of financial institutions, governments around the world have been forced
to adopt a broad range of emergency measures. These include the creation of various kinds
of funds and guarantees to keep ailing financial institutions afloat and help them clean up
toxic assets from their balance sheets. In addition, provisions have been made to inject
capital into banks and insurance companies to compensate for the asset losses that cannot
be recovered. Furthermore, many governments extended and strengthened bank deposit
guarantees. In all these cases, taxpayers' money is involved, or at least at risk.
Given the scale and range of the current crisis, these measures were indispensable in order
to prevent worse damage from occurring. But once the dust of the current financial turmoil
has settled, the underlying regulatory framework has to be carefully reviewed in the light of
the current experience.
The list of recommendations agreed by consensus and adopted by the Financial Stability
Forum (FSF) is at the heart of the longer-term international response to the financial crisis.
This includes, first, an improvement in the supervisory framework for capital and liquidity as
well as risk management within the context of Basel II. Second, the role of ratings and rating
agencies is under scrutiny. And, third, there has to be enhanced transparency of institutions
and markets in order to strengthen market discipline. Let me comment briefly on these three
issues.
Basel II, the new capital framework for credit institutions, was initiated long before the
outbreak of the financial crisis. By tailoring capital requirements more precisely to the specific
risk profile of the credit institutions, Basel II provides incentives to improve risk management.
I regard it as essential that the capital framework be applied worldwide.
Nevertheless, the current financial market turmoil has once again highlighted that we have to
continue working on increasing the capital requirements for complex securitisations and for
credit risks in the trading book.
As you are certainly aware, however, the recent events have raised fundamental issues of
regulation with regard to stabilising the financial system, not only in banking supervision and
securitisation business, but also, say, in connection with hedge funds and, as an especially
pressing issue, in the case of the rating agencies.
In the United States, rating agencies have to be registered with the SEC. Furthermore, it
should be borne in mind that Basel II relies on ratings for classifying the riskiness of bank
loans. In Europe there is therefore a procedure for authorising and mapping agencies' ratings
in determining a bank's minimum capital.
Following the experience with ratings in the recent financial crisis, the current practice of
having only a non-binding IOSCO code of conduct is generally perceived to be in need of
reform. The rating agencies themselves are in the process of reviewing their internal
procedures and rating methods.
Furthermore, the European Commission has now put forward a proposal for consultation
which envisages an authorisation procedure and the supervision of rating agencies - in other
words, sovereign regulation. I would like to make two comments, which are of general
importance beyond the European context.
First of all, every effort should be undertaken to ensure that solutions at the European or any
regional level are consistent with a level playing field internationally. A common framework
should be ensured by the IOSCO, since anything else might result in regional competitive
disadvantages.
Second, emphasis should be placed on the investors' own responsibility when using ratings.
Thus, for example, EU registration must not be seen as being "rubber-stamped in Brussels"
and thus interpreted as a seal of quality for individual ratings.
Turning now to transparency, I would like to emphasise how crucial the market players and
their behaviour are for financial stability. The key issue is the responsibility of the financial
players themselves - both directly for their own actions, but also indirectly for the system as
a whole. In order to reconcile the public interest in transparency with the marker players'
individual preference for confidentiality, transparency has to be enforced by appropriate rules
and regulations.
Beyond these specific improvements to be introduced into the regulatory framework, there is
a crucial conceptual challenge for stability-oriented supervision. This is right at the top of the
agenda internationally and, in my view, will also be under discussion for some time to come.
Basically, the question is whether the regulatory framework for the financial system, as well
as the provisions for accounting, act procyclically - and, if so, what can be done to counter
that.
For the sake of simplicity, I shall interpret the term "procyclicality" quite narrowly for once,
namely as a reinforcement of the natural cycle of the financial system. Procyclical policy and
procyclical elements of regulation would amplify the natural upswings and downswings of the
financial system. If this leads to boom-bust cycles, the viability of the financial system is
jeopardised.10
Naturally, considerable caution is called for when dealing with the topic of procyclicality as
we still know too little about the cyclical effects of regulatory provisions. To avoid any
misunderstanding, I wish to stress that the current regulatory framework, with the
risksensitive minimum capital requirements under Basel II and the use of fair value accounting
under IFRS (or US GAAP), does contain cyclical elements.
As you know, the risk-sensitive minimum capital requirements under Basel II are based on
probabilities of default, which fluctuate over the economic cycle. In a downturn, probabilities
of default increase - along with the minimum capital requirements. Similarly, fair value
accounting means that valuations fluctuate in tandem with market prices.
Let me start with possible procyclical elements in the Basel II framework. So far, it is unclear
- and how could it possibly be otherwise so soon after the introduction of Basel II? - whether
the cyclical fluctuations of the minimum capital requirements actually impact on the
propensity to lend - in other words, whether they really have a procyclical effect. The extent
to which this happens hinges on a large number of factors - for example, on how far the
capital buffers exceed the regulatory minimum, on the willingness of the banks to expand or
contract these buffers, and, naturally enough, on the use of alternatives, such as raising
additional capital.
In addition, the potential antidotes to procyclicality have not yet been researched and tested
in detail. This relates to components in the regulatory framework that dampen procyclicality,
or even automatic stabilisers, which have an anticyclical effect and which are now being built
into Basel II. For example, long-term averages are now to be used for the probabilities of
default. And, by means of "prudential filters", the banking supervisors have ensured that
fluctuations in the balance sheets do not impact fully on the level of regulatory capital.
Less than one year after the introduction of Basel II in Germany, the database is still very
narrow. Knee-jerk responses, such as the general introduction of additional general capital
buffers by means of Pillar 2, are therefore not appropriate in my view. What is called for
instead is the close monitoring of developments and a careful analysis of the complex
mechanisms of banks' capital management and of Basel II's impact over an adequate period
of time. And if, but only if, procyclical effects are found to exist on a significant scale, they
should be taken into account in a system-oriented supervisory approach.
I would also add that a possible procyclical nature of credit, in addition to its cyclical nature,
would be an instability factor not only for the financial systems. It would also represent a
further reason for focusing great attention on credit aggregates in the monetary policy
analysis.
Regarding fair value accounting, the case for procyclicality is somewhat more obvious. In an
environment like the current financial crises, where market prices are heavily influenced by
fire-sales of assets as well as significant risk and liquidity premiums, an obligation to mark
assets according to the mark-to-market principle can, in effect, exacerbate the downward
trend of prices. Against this backdrop, international efforts to modify accounting standards
with the aim of better reflecting the underlying value of assets are currently being
implemented in a number of countries. However, modified accounting rules should not
induce banks to postpone losses.
I would now like to talk about a number of fundamental institutional questions relating to the
stabilisation of the financial system and the allocation of competencies among the various
sovereign regulatory levels. I am doing this because, during the financial crisis, it has
become clearer to me than ever before just how much institutions matter. I am therefore
focusing my attention on the institutional framework for the monetary, supervisory and
regulatory infrastructure.
The US Treasury has presented an ambitious but cogent overall strategy for a longer-term
reform of financial supervision. The "blueprint" addresses the current fragmented structure of
financial supervision. It envisages a radically overhauled institutional structure, with a
complete change of design in its tasks. I see one particularly important aspect of this
blueprint in the fact that the Fed, in the role of a "market stability regulator", would, for the
first time, institutionalise a primarily macro-oriented perspective on the financial system. I
await the ongoing evolution of this debate with keen interest.
When I now look at the institutional structure for financial stability in Germany and in the
Eurosystem, I would like to highlight the synergy effects between operational money market
management and banking supervision. The financial market turmoil has shown us quite
clearly that these synergy effects can indeed be very large. As the Bundesbank is closely
integrated into banking supervision, we can also fully exploit such synergy effects. Our
deliberations on the time profile of liquidity provision and, hence, our stance in the
Eurosystem benefit from general information passed on from our banking supervisors.
Conversely, the insights gained from regular contact with the banking industry in the practical
conduct of refinancing operations and in payments are helpful to the banking supervisors.
Finally, I think that the international governance of the financial systems has to be subjected
to critical scrutiny. If we are thinking about changes, I believe we should strengthen those
institutional structures that did their job well during the financial market turbulence. For me,
this means that, first and foremost, the FSF should continue to play a key role. Its
membership drawn from central banks, ministries of finance, supervisors, regulators and
international institutions means that the holistic assessment of the financial system is one of
the main strengths of the FSF.
The International Monetary Fund should mobilise all its resources in the FSF, above all, with
an in-depth analysis of the way the financial system interacts with the real economy. For the
analysis of these interactions, the IMF can draw on decades of experience in Article IV
consultations and a decade of financial sector assessments.
V Conclusions
Ladies and gentlemen, what are the key lessons and challenges that we should take on
board from our journey through economic history, from the stagflation episode of the 1970s
and early 1980s to the financial crisis of today?
One simple but fundamental lesson consists in knowing the strengths, as well as the
limitations, of t