José Manuel González-Páramo: Address for the 2008 Bernácer Prize
Award Ceremony in honour of Markus Brunnermeier
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the 2008 Bernácer Prize Award Ceremony in honour of Markus
Brunnermeier, Madrid, 10 June 2009.
* * *
Ladies and Gentlemen,1
It is a great pleasure for me to be given the honour of addressing a few words to you on the
occasion of this year's award ceremony of the Bernácer Prize to Professor Markus
Brunnermeier from Princeton University. Guillermo de la Dehesa asked me to share some
thoughts with you about the importance of scientific research for the European Central Bank
and its monetary policy. In this context, I would like to express my appreciation for the
influential contributions made by this year's laureate to the academic debate in fields which
are of particular relevance for central bank policymakers. Markus Brunnermeier has to be
particularly praised for helping us to improve our understanding of some of the main causes
and mechanisms behind the current financial crisis, as well as for his scholarly advice to
policymakers and the general public as to how the global financial system can be put on a
more stable and solid footing through regulatory reform. But I will revert to this later.
Let me first emphasise that research plays a crucial role for the Eurosystem as much as for
other central banks. Research provided an essential input to the definition of the ECB's
pricestability monetary policy strategy as well as to the design of its operational framework.
Besides, in order to conduct monetary policy on a regular basis, the ECB needs to
accumulate knowledge and information on how the dynamics of the economy tend to evolve,
how specific markets work, how its policy instrument influences price and output
developments through the various transmission chains. Moreover, the ECB also performs
core functions and tasks in supporting a smooth operation of payments systems and
contributes to safeguarding financial stability which likewise requires substantial theoretical
and empirical knowledge. It should go without saying that such detailed information about the
financial markets and the economy as a whole mainly originates from research efforts,
whether they are undertaken from within or outside the ECB.
Central banking will certainly always remain an art as much as a science in the sense that a
clear rulebook prescribing the best policy action in all specific circumstances does not exist.
Uncertainty is simply pervasive. For example, the quantitative knowledge of central banks on
the monetary transmission process remains imperfect and fragile due to the preponderance
of data, estimation and model uncertainty in macroeconomic model building, compounded by
the constant risk of structural change in evolving economies and societies. Central bankers
also regularly face situations which are unique and unprecedented, and where the alternative
states (or their likelihood) are not really well known or understood. These situations of
socalled Knightian uncertainty clearly defy measurement and thus pose challenges for
empirically-validated policy advice. In the face of uncertainty, to arrive at a certain decision
monetary policymakers need to combine knowledge derived from a variety of models with
individual experience and judgement. Notwithstanding this, the way monetary policymakers
filter the information they receive and the experiences they have made usually depends on
some theoretical concepts adopted and internalised during their professional lives. It is the
responsibility of a central bank as an institution to ensure that the fundamental ideas behind
actual monetary policymaking reflect as far as possible the "state of the art" of the respective
disciplines, and not invalidated or even falsified ideas of some "defunct economist", to loosely
The General
quote from John Maynard Keynes's famous conclusions to Theory.
The ECB attempts to cope with this responsibility by fostering a very intense exchange of
information and manpower with the academic world at all levels. Leading experts in
economics and finance regularly visit the ECB to discuss their most recent findings at
seminars, conferences or workshops, often co-hosted with other major central banks and
research institutions, as well as to provide consultancy. The members of the Governing
Council and the Executive Board of the ECB play an active part themselves in this regular
exchange of views between the theory and practice of monetary policy. It should be
emphasised that a close relationship between theory and policy making gives rise to
crossfertilisation. Scientific progress definitely improves the conduct of monetary policy and other
central bank tasks over time; but it is likewise true that academics often benefit from
practitioners ́ deep knowledge of data and institutional detail as well as their broad
experience in all aspects of real-world monetary policymaking.
Insights from research have been invaluable particularly in times of the biggest financial
crisis since the Great Depression. Finding the correct policy prescriptions to alleviate the
consequences and resolve the current crisis requires a thorough understanding of the
underlying causes. Markus Brunnermeier's research has played a prominent role here. For
instance, his research on bubbles sheds light on how institutional frictions and strategic
considerations can lead to significant mispricings of assets.2 While market participants may
be aware of the flawed asset valuation, the lack of common knowledge can lead to a build up
of the bubble and hinder its bursting. This approach departs from the conventional market
efficiency view that rational traders will immediately stabilise prices by shortening overvalued
assets and, by contrast, integrates important aspects of trading behaviour into the
mainstream of economics and finance.
When a bubble bursts and risk is re-assessed, financial institutions suffer losses. In the
current crisis, uncertainty over the size and location of exposures of banks or
banksponsored conduits to "toxic" assets translated into funding liquidity problems. A paper by
Brunnermeier and Pedersen, "Market Liquidity and Funding Liquidity" explains how such
funding problems can affect market liquidity and lead to mutually reinforcing liquidity spirals.3
Balance sheet constraints of financial intermediaries can naturally lead to market illiquidity
and the expectations of future liquidity risk can lead to panic and more asset price declines.
Indeed, liquidity shortage was one of the key propagation mechanisms of the current crisis
which illustrates a negative externality that fire-sales by individual institutions can impose on
the financial system as a whole. It is also one of the factors that contributed to prolonged
tensions in the interbank market as banks were reluctant to lend to each other to minimise
counterparty exposures. These markets are crucial for banks' liquidity managements and
also for the transmission of monetary policy. The work on funding and market liquidity also
offers possible mechanisms for the resolution of liquidity spirals. The key policy prescription
is to improve the funding liquidity of financial institutions in order to prevent solvent
institutions from being driven out of business by protracted illiquidity. This policy has been
followed extensively by the Eurosystem over the recent past.
Liquidity spirals also create an important pro-cyclical mechanism in the financial system. This
issue is discussed in the draft notes on the next Geneva Report on the World Economy
written by Professor Brunnermeier and co-authors on "The fundamental principles of financial
regulation".4 The policy conclusions include both crisis prevention - with recommendations
like the introduction of macro-prudential regulation or liquidity regulation - as well as crisis
management with analyses of toxic asset purchases, asset guarantees or mortgage
subsidies, for example.
Notwithstanding the important theoretical advances to which Markus Brunnermeier
contributed substantially, there is still much to be learnt about the root causes, the triggers
and the propagation mechanisms of the financial turmoil, and how precisely it spread to the
real sector, causing a deep financial and economic crisis arising from negative feedback
loops between the two sectors. The severe challenges for policymakers posed by the
existing knowledge gaps are reflected in the very controversial debates about the optimal
responses to mitigate and resolve the current crisis and to prevent future crises from
occurring.
Quick progress on these and related research topics is essential for the ECB both from a
monetary policy and a financial stability perspective. While at present the ECB already
performs certain tasks which shall contribute to safeguarding the stability of the financial
system, it is foreseen that the range of tasks and responsibilities of the ECB related to
financial stability matters becomes substantially enlarged. According to the recent proposal
by the European Commission on the reform of financial supervision in the European Union,
drawing on the recommendations of the de Laroisière High-Level Group, the ECB would play
an important role in a new European Systemic Risk Council to be in charge of
macroprudential financial supervision in the European Union. For the ECB to effectively perform
such tasks requires, among other, major investments into a supporting macro-prudential
analytical infrastructure, for example the development and implementation of a suite of early
warning signal models and the significant extension of existing macro stress testing models.
But we also need innovative approaches on optimal policy responses once macro-prudential
risks have been identified, since the European Systemic Risk Council will also have to issue
policy recommendations. In contrast to the assessment of systemic risks where we have a
basis to build on and where our staff has also made research contributions to the literature,
macro-prudential regulation or policy is a relatively new concept for which a good analytical
basis still needs to be developed. This is an area where brilliant scholars like Markus
Brunnermeier can make an invaluable contribution. And he has already started to do so. I
herewith extend my sincerest congratulations to you - Markus - for winning the 2008
Bernácer Prize, which you very much deserve.