Stefan Ingves: Central bank policies - the way forward after the crisis
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel
Committee on Banking Supervision, at the Royal Bank of Scotland, Stockholm, 4 October
2013.
* * *
How should the Riksbank and other central banks act to contribute to the best possible
development of the economy? This is a question that one might need to contemplate from
time to time. Because at the end of the day, there is probably some truth in the old joke that it
is not a problem if the questions in the Economics exam are the same year after year - the
answers will change anyway.
The international financial and debt crisis that started around five years ago, and which still
afflicts many countries, makes it particularly important to consider whether the answer to the
question has changed - whether the central banks should conduct their operations differently
from before the crisis, and if so, how. This issue is currently being discussed internationally,
both in research and in policy. We do not now know exactly where this discussion will lead,
although it is possible to distinguish some main conclusions.
Prior to the crisis - most of the pieces of the puzzle appeared to be in place
Before the crisis, everything seemed quite simple. The global economy had experienced an
unusually long period of good growth, relatively minor cyclical fluctuations, and low and
stable inflation. This coincided with monetary policy being increasingly aimed at holding
inflation in check. A growing number of countries had introduced explicit or implicit inflation
targets and monetary policy had increasingly been delegated to independent central banks.
Once inflation expectations had been anchored, it became easier to stabilise the real
economy as well. Many felt that an important reason for the favourable developments in the
world economy was that these changed enabled monetary policy to be conducted in a better
manner than before.1
Moreover, during the period prior to the crisis financial stability was increasingly being taken
for granted. It was assumed that the financial markets were on the whole efficient and
functioning smoothly. Financial crises did occur, but most of the countries affected were able
to get back on their feet relatively quickly. The successful management of the IT bubble at
the turn of the millennium supported the impression that if crises occurred, they could be
dealt with relatively simply and efficiently. Japan, where the problems following the crisis at
the beginning of the 1990s nevertheless had been long-lasting, was regarded as a special
case. Although developments in Japan were regarded as interesting, the lessons perceived
were not thought to indicate that anything similar could happen in, for instance, the United
States or Europe.
In this apparently stable macroeconomic environment, interest in research into the interaction
between the financial sector and the real economy gradually declined. As Jordà, Schularick
and Taylor (2011, p. 1) observe, it was "an historical mishap that just when the largest credit
boom in history engulfed Western economies, consideration of the influence of financial
factors on the real economy had dwindled to the point where it no longer played a central
role in macroeconomic thinking."
Few traces of the debate on leaning against the wind
A few years before the crisis a debate had arisen on whether central banks should raise their
policy rates to counteract the rapid increases in asset prices that had been observed in
several regions. Should central banks, as it was often expressed, "lean against the wind" to
"burst bubbles" on the asset markets? But this debate made little mark on practical policy.
The dominant opinion at this time, among both researchers and representatives of central
banks, was that the central banks should not try to take preventive action, but make do with
"cleaning up afterwards" if a crisis did occur.2 It was considered too difficult and too costly to
use the policy rate for preventive purposes. Moreover, it was considered - possibly with
Japan as the exception that proves the rule - that it need not be so difficult to clean up after
a crisis.
In other words, the situation around six or seven years ago was such that we were more or
less prepared to believe we had found the final solution as to how monetary policy should be
conducted, and that financial crises no longer offered a severe threat.
An illustration
The international financial and debt crisis made it painfully clear that things were not that
simple. There are several lessons that can be learned from the crisis. But if one were to
choose the most important, for me there is no doubt that it is that a substantial increase in
indebtedness in society can entail major problems, particularly if it is linked to price increases
on an important asset market, in particular the housing market. This danger was definitely
underestimated prior to the crisis.
The underlying problems can be illustrated using a stylised figure (see Figure 1). The red line
represents the usual cyclical fluctuations in the economy - the business cycle.
Figure 1
Business and credit cycles
Business cycle
Credit cycle
Let us, for the sake of simplicity, assume that inflation follows the business cycle, so that the
curve can also represent developments in inflation. Of course, the business cycle and
inflation do not normally coincide so well in reality, but this has no significance for the points I
will make here.
The second curve in the figure represents variations in the amount of credit or degree of
indebtedness in the economy. There are slightly different terms for these cycles in academic
literature - credit cycles, leverage cycles or financial cycles.3 They can have slightly different
meanings in different contents, but essentially refer to the same thing. For the sake of
simplicity, I shall use the term credit cycles here.
The credit cycle and the business cycle may occasionally coincide quite well, but can at
times develop differently. In the figure, the two cycles are for illustrative purposes assumed to
evolve rather differently. One occasion when the two cycles coincide, however, is when the
credit cycle shows a rapid downturn, as at the end of the figure. Such a downturn is more
likely when the preceding upturn has been unusually strong and characterised by
exaggerated optimism and risk has been underestimated and under-priced.
Credit boom that "goes wrong" - credit and business cycles coincide
At some stage it becomes clear that the large amount of credit and the high level of
indebtedness are based on overly optimistic calculations. Interest in selling the asset, usually
housing, at the base of the credit expansion suddenly becomes greater than interest in
buying it and a downward price spiral starts. The value of the collateral falls and the banks
become cautious and reduce their lending. Households on the other hand see the value of
their assets plummeting while the size of their loans remains unchanged. In other words,
their balance sheets look much worse than they had anticipated. Households who have
found themselves in this situation in many other countries have reduced their consumption
and begun to save to achieve a better balance between assets and debts. Not only the
supply, but also the demand for credit thus declines. The consolidation of households'
balance sheets gives a fall in demand that tends to be fairly long-lived.4 The fall in the
economy can be reinforced if the weaker economic activity means that borrowers,
households and companies, experience difficult in meeting their obligations and the banks
suffer loan losses. This process often leads to a substantial weakening in public finances,
too, partly because of the rapid decline in economic activity and partly because the banking
system may in a worst case scenario require support.
In this way, one can say that the credit cycle and the economic cycle pull one another down.
Sometimes one uses the expression "credit boom gone wrong" to describe this kind of
development.5
Of course, not all credit cycles look like this, but history shows that it is difficult to avoid it
happening now and again. There is fairly good empirical evidence to support this description.
For example, Schularick and Taylor (2012) find in a study of more than 200 recession
periods in 14 economies during the years 1870-2008, that the more households and
companies borrow during an economic upturn, the greater the risk that the upturn will be
followed by a deep recession and a slow recovery - regardless of whether or not a financial
crisis occurs. They also find that recessions linked to a financial crisis are more costly than
normal recessions as production then falls more. An obvious example of a credit cycle that
went wrong close to home is the boom that contributed to a bank and property crisis and
deep recession in the early 1990s.
After the crisis - pay greater attention to the credit cycle!
Figure 1 is a good basis when one wants to illustrate different questions regarding monetary
policy and central bank operations that have arisen due to the crisis and are now being
discussed both internationally and in the debate here in Sweden.
The perception prior to the crisis could be described, in a rather simplified, but not
misleading, manner as central banks in principle being able to disregard the credit cycle and
focus solely on the economic cycle. It was assumed that those cases in which the credit
cycle pulls down the economic cycle, which were presumed to be fairly rare, would be
relatively easy to manage.
Correspondingly, the current international discussion on how central banks should act from
now on - the question I began with - can essentially be about how one should take the credit
cycle into account in a good way and incorporate it into the economic analysis and into
practical policymaking. As the origin of the economic recession is the earlier excessive credit
boom, much of the focus is on the question of how one can best ensure that this increase in
credit becomes more balanced and that the credit boom thus does not go wrong.
It is not merely a question of avoiding crises. A high level of indebtedness can cause what
one might call debt dominance in the economy, which put constraints on economic policy
and leads to general unease over how debt will be reduced - whether this can be achieved
in an orderly manner or whether it will be a rapid, abrupt process with substantial negative
effects on the economy.
Riksbank quick to point out the risks with a credit boom
I mentioned earlier that prior to the crisis there was a discussion on whether central banks
should try "leaning against the wind" to dampen the credit boom and the upturn in housing
prices that could be observed in a number of countries. One could actually claim that the
Riksbank was one of the first central banks to clearly highlight the risks linked to household
indebtedness and housing prices in its monetary policy agenda, and it was also one of the
few central banks that in practice conducted a policy prior to the crisis that to some extent
entailed "leaning against the wind".6 I myself discussed the Riksbank's policy at the annual
conference in Jackson Hole in 2007.7 This was before the crisis had really made itself felt
and there was considerable scepticism of a "leaning against the wind" policy. When the crisis
came, opinion changed and as I see it, there is today considerably more understanding and
acceptance for the policy we conducted. During the recovery phase after the crisis, the
Riksbank has also tried to reduce the risk of exaggerated indebtedness and overly-inflated
housing prices by conducting slightly less expansionary monetary policy than would
otherwise have been the case.
The background to this policy is that debt in the Swedish household sector has shown a
rising trend over the past 15-20 years and now appears high, both from an historical and
an international perspective (see Figure 2). Unlike many other countries, housing prices in
Sweden have not shown any significant fall. In terms of Figure 1, it can be said that in
many other countries, heavy falls in housing prices have led to a downturn in the credit
cycle, which has then pulled down the economic cycle. This has not been the case in
Sweden, where the slowdown we have experienced in connection with the crisis has so
far largely stemmed from the weak developments abroad. If we were also to experience a
severe fall in housing prices and a rapid decline in the credit cycle, the consequences
would be much greater and probably about as difficult to manage as they have proved to
be in other countries.
Figure 2
Household debt ratio
Debt as a percentage of disposable income
350 350
Ireland
Spain
300 Denmark 300
USA
United Kingdom
250 250
Sweden
200 200
150 150
100 100
50 50
0 0
95 97 99 01 03 05 07 09 11
Source: OECD
Countries that have experienced a fall in housing prices in connection with the crisis have
also had a fairly severe fall in unemployment (see Figure 3) and in many cases the recovery
is still progressing very slowly.
Figure 3
Unemployment
Unemployed as a percentage of the labour force, index, 2007 = 100
350 350
Ireland (-47.2 %)
Spain (-30.8 %)
Denmark (-27.6 %)
300 300
USA (-26.7 %)
United Kingdom (-12.9 %)
Sweden (0.0 %)
250 250
200 200
150 150
100 100
50
50
00 02 04 06 08 10 12
Note. The figures in brackets refer to the fall in real housing prices from the peak to the trough.
Source: OECD
It is also worth emphasizing that the countries that have been hit hardest include ones with
both stronger and weaker wealth positions than Sweden (see Figure 4).
Figure 4
Households' total financial assets
Per cent of disposable income
550 550
Ireland
Spain
Denmark
500 500
USA
United Kingdom
Sweden
450 450
400 400
350 350
300 300
250 250
200 200
96 98 00 02 04 06 08 10
Source: OECD
Policy in line with international debate and our mandate
The policy conducted by the Riksbank has sometimes been characterised as "difficult to
grasp" and "strange" in the debate in Sweden - that we are conducting housing policy" and
that we "are not following our mandate".8 I hope that this description has put forward two
points in particular. The first is that the policy conducted by the Riksbank has been well in
line with the international discussion that arose after the crisis and concerns how best to take
into account risks linked to household indebtedness and developments in the housing
market. If anything, as I noted earlier, the Riksbank was among the first to highlight these
problems.
The second point that I hope has come across is that the policy the Riksbank has conducted
is well in line with the mandate we have been given. The Riksbank has not acted on the
basis of any hidden agenda to try to attain some other purpose, whatever that might be. The
purpose of our policy has been to prevent Sweden falling into the deep recession suffered by
many other countries in connection with the crisis.
It has thus been a question of wanting to manage our task of maintaining price stability and
macroeconomic balance in the best way possible.9 As I see it, there is no doubt that the
Riksbank's mandate allows us and even requires us to take into account risks linked to a
credit boom and rising house prices. So, neither in the light of the international debate
conducted today nor the mandate given to the Riksbank, has the monetary policy conducted
been particularly "unusual" or "strange".
The monetary policy strategy the Riksbank has applied in recent years is also worth
mentioning. What we have tried to do is to find a suitable balance where we support the
recovery, but at the same time do not accelerate as hard as we might have done if we did not
need to take into account housing prices and indebtedness. This has not, as one might
sometimes think, been a question of braking hard. When all is said and done, the repo rate is
currently no higher than 1 per cent.
Difficult balancing act if the repo rate is the only tool
But let me now return to Figure 1 and the discussion I started with. Stabilising two cycles
- the business cycle and the credit cycle - with the aid of only one tool - the policy rate - is
of course not easy. In reality, the problem is further complicated by the fact that inflation must
be stabilised. Here I assumed for the sake of simplicity that inflation would entirely follow the
business cycle.
As the credit cycle and the business cycle develop in different ways, a change in the repo
rate intended to affect one cycle will sometimes have an undesired effect on the other.
Although a stable credit cycle - one that does not "go wrong" - is ultimately necessary for a
stable business cycle, in the short term it may be necessary to make a trade-off between
them. This is not without its problems. An ambition to hold the credit cycle in balance may
require a slightly higher policy rate. This would also dampen the economic cycle and inflation
could undershoot the target. This can be regarded as normal and acceptable for a period of
time. But if the period becomes prolonged, it may sooner or later become difficult to gain
understanding and support for this policy - despite its purpose being to prevent a much
worse development further ahead. This could be a dilemma.
The equation would be simpler to solve if there were further tools that could be used to
stabilise the credit cycle. This is where the new policy area that has arisen after the crisis
- macroprudential policy - comes in. The international discussion of how the credit cycle
should be taken into account and incorporated into the analysis and policy has to a large
degree centred on how macroprudential policy should be conducted.10
Decision on responsibility for macroprudential policy
Many countries have already made some progress here. In many cases, the central bank
has been allocated a central role in macroprudential policy, either as an important participant
in some form of macroprudential policy organisation, quite often as chair or it has sole
responsibility for macroprudential policy. In the United Kingdom, for instance,
macroprudential policy has been allocated to a special committee within the Bank of
England, the Financial Policy Committee (FPC). The governor and two other committee
members are on both the FPC and the Monetary Policy Committee.
In Sweden we are lagging behind somewhat with regard to the development of
macroprudential policy. It has been unclear what framework politicians intended to establish.
The question has been investigated by, for instance, the financial crisis committee, which
presented an interim report at the beginning of this year.11 But the proposal presented by the
committee still entailed a fairly unclear allocation of responsibility and the Riksbank assessed
in its consultation response that this could lead to uncertainty over who should take action
and thus weaken decisiveness too far.12 We advocated that responsibility should be given to
one decision-making body with a clear responsibility for macroprudential policy.
A few weeks ago, the Government came to a decision.13 Many details still remain to be
decided, and it will take some time still before a complete framework is in place. But it is clear
that Finansinspektionen (the Swedish Financial Supervisory Authority) will have the overall
responsibility for macroprudential tools. The Riksbank will be part of a financial stability
council that also includes the Government, Finansinspektionen and the National Debt Office.
The council is to identify risks and discuss measures, but it should function as a discussion
forum and not give explicit recommendations.
The most important thing is that the uncertainty surrounding the allocation of responsibility
has now been resolved in that it has been made clear and that responsibility will rest with
one authority. I do not believe that the institutional set-up is otherwise of absolutely critical
importance - within reasonable boundaries. Various solutions may very well prove to
function equally well in practice and provide equally good economic development. Ultimately,
it remains to be seen how things work out - "the proof of the pudding is in the eating".
10
In addition to these cyclical risks, macroprudential policy is also assumed to need to manage what are referred
to as structural risks, or cross-section risks, see the Riksbank (2012). The latter concern financial companies
having become so closely interwoven and the degree of concentration in the financial system so high that if
problems arise in one area they risk spreading rapidly. The effects on the real economy will be similar to those
in Figure 1. Of course, these risks may also change over time.
11
Financial Crisis Committee (2013). Parts of macroprudential policy are also discussed in Swedish Government
Official Reports (2013), Förstärkta kapitaltäckningsregler[Stronger capital adequacy rules], which was
presented on 16 September. The potential design of a Swedish macroprudential framework is also discussed
by Goodhart and Rochet (2011), Bryant, Henderson and Becker (2012) and Vredin, Flodén, Larsson and
Ravn (2012).
12
The Riksbank (2013).
13
Ministry of Finance (2013).
Interplay between macroprudential and monetary policy important to consider
In principle, of course, if monetary policy were initially to try to stabilise both the business
cycle and the credit cycle, and there arose a new policy area focusing on the latter - then
this would almost by definition ease some of the earlier pressure on monetary policy.
But even if we have now made some progress in attaining a framework for macroprudential
policy, there are some questions of principle that still need consideration. Something one
should always bear in mind, but which I do not intend to discuss further here, is that
decisions we make regarding conditions in Sweden must also be incorporated into a broader,
European context. There are also a number of questions, particularly with regard to the
interplay between macroprudential policy and monetary policy, that sooner or later may need
to be dealt with in practice and it would be wise to have thought them through.
Coordination...
Some of the research into macroprudential policy - which is in general still in its infancy -
tries to analyse the importance of coordinating macroprudential policy and monetary policy.
The idea is roughly as follows: Monetary policy and macroprudential policy act through
largely the same channels. Both the policy rate and most macroprudential tools affect, for
instance, credit growth in the economy and developments in various asset prices. This also
means that the two policy areas affect one another's objectives. Monetary policy affects the
credit cycle - which was the whole point of "leaning against the wind", and macroprudential
policy has effects on the business cycle. It is therefore desirable to find the right policy mix -
the combination of policy rate and macroprudential tools that give the best overall outcome
for the economy. The conditions for finding the right mix are normally improved if the two
types of policy are coordinated, rather than determined separately.14
The importance of coordination is also pointed out in more practical economic policy
contexts. One example is the recently implemented review of the monetary policy framework
in the United Kingdom. There, for instance, the fact that some members sit on both the Bank
of England's monetary policy committee and its committee for financial stability, is regarded
as a means of fostering coordination between monetary policy and macroprudential policy.15
In Sweden, it will not be possible to coordinate macroprudential policy and monetary policy
as closely as in the United Kingdom, for instance, as we have chosen a different framework
for responsibility. It is at present difficult to foresee what the consequences of this will be -
and even if there will be any significant consequences. After all, neither research nor the so
far limited practical experiences give any particularly clear answer regarding exactly how
important coordination is. It is once again quite possible that the solution we have chosen in
Sweden will turn out to work very well in practice - only time will tell.
...or at least concordance
But even if macroprudential policy and monetary policy may not necessarily need to be
coordinated in a more formal sense, there may be reason to consider whether there should
be a certain amount of concordance between them. My personal opinion is that there must
be what one can call a holistic, or comprehensive, view when formulating both types of
policy. If both the credit cycle and the business cycle are to be stabilised in a good way, I do
not believe that they can be too far from the policy mix implied by full coordination, at least
not over a long period of time. The two types of policy could then counteract or reinforce one
another in ways that would be harmful to the economy. It is probably also the case that this
interplay is particularly important in sensitive situations, such as preventing a credit boom
going too far and ensuring that the credit cycle has a slow, soft downturn instead of a rapid,
dramatic one.
This relates to an international discussion on whether the policy rate can play a role in
stabilising the credit cycle, even when macroprudential policy is in place.16 One reason why it
might play a role is that it can be difficult to design a system for macroprudential policy that
functions efficiently enough and cannot be circumvented by innovative market participants. If,
for instance, the policy rate is kept low for a long period of time at the same time as
macroprudential policy is relatively restrictive, there is a risk that a grey credit market will
arise. The interest rate is of course a blunt instrument to use in stabilising the credit cycle, as
it has a broad impact on the economy and a substantial effect on the economic cycle.
However, one advantage of the broad impact of the policy rate is that it is therefore difficult to
"avoid", even for those who might be able to circumvent macroprudential policy.17 Some
countries are also fairly explicit about giving the policy rate a role to play in subduing the
credit cycle, as a complement to macroprudential tools.18 In the same way as
macroprudential policy can help ease the pressure on monetary policy, monetary policy can
give support to macroprudential policy by leaning against the wind. Thus, there are a number
of questions regarding the interplay between macroprudential policy and monetary policy that
require further consideration.
Central banks after the crisis - increased differences and country-specific solutions
Let me conclude by returning to the question I asked at the beginning - whether the central
banks will conduct their operations differently after the crisis than they did before. The
answer to that question is that it all depends. It is quite clear that a general conclusion from
the crisis is that greater effort must be made to stabilise the credit cycle by preventing overly
rapid upturns. However, the role given to the central bank in this regard varies from country
to country. In some countries, the task has been more or less entirely allocated to the central
bank, while in other countries the central bank has a less prominent role.
One consequence of this is that, while there was a trend prior to the crisis for central banks'
policy to look increasingly similar - with flexible inflation-targeting as a basic model - it
appears as though the trend is towards greater differences after the crisis. Flexible inflation
targeting is still the linchpin, but as management of the credit cycle differs between the
16
See, for example, Blanchard, Dell'Ariccia and Mauro (2013), Carney (2013) and Stein (2013).
17
Jeremy Stein at the Federal Reserve's Board of Governors has expressed it as the advantage of monetary
policy being that it "gets in all of the cracks" (Stein, 2013, p. 17). The Riksbank has also raised this argument
in various contexts, see for instance, Ingves (2010) and Nyberg (2011). Donald Kohn, former deputy chairman
of the Federal Reserve Board of Governors and now member of the Bank of England's Financial Policy
Committee, recently put forward another aspect: "When one policy is leaning so hard in a particular direction,
the other can't compensate, can't achieve its objectives. ... So for example, the example that's often used,
very easy monetary policy builds imbalances that may be so large, that may become so large they can't be
countered by regulation." (see Talley, 2013).
18
For example, Norges Bank writes in an article about the countercyclical capital buffer: "The countercyclical
buffer will strengthen the resilience of the banking sector during an upturn. It may also, to some extent,
counteract the build-up of financial imbalances, but the effect is uncertain. Thus, Norges Bank cannot
disregard taking financial imbalances into consideration when setting the key policy rate." (Norges Bank, 2013,
p. 23)
central banks, one could say that one consequence of the crisis has been an increased
divergence in central bank policies.
As in other countries, we in Sweden must now try to find good solutions, on the basis of the
conditions applying, for designing the interplay between macroprudential policy and
monetary policy. I am convinced that we will succeed in this task, with join efforts and as we
gain greater knowledge of how the new upcoming framework for macroprudential policy
functions in practice.
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