Nout Wellink: Towards a new framework for monetary policy? Lessons
from the crisis
Speech by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel
Committee on Banking Supervision, at the workshop "Towards a new framework for
monetary policy? Lessons from the crisis", Amsterdam, 21 September 2009.
* * *
Over the past two years, we have all been surprised by the fast pace at which events have
unravelled. But ideas have also evolved rapidly. Only one year ago, at our monetary policy
workshop we were discussing whether financial imbalances ought to be incorporated in
monetary policy making. Since then, there has been an increasing consensus that monetary
policy should lean against the wind. At today's workshop, we will not focus on whether but on
how monetary policy can be used to lean against the wind.
In my remarks, I want to address three questions. First, what have we learned about the
runup to the crisis? Second, why did monetary authorities not lean against the emergence of
massive financial imbalances, which turned out to have disruptive macro effects? And third,
how can we use the answers to the first two questions to think about the next approach to
monetary policy?
What have we learned about the causes of the crisis?
Let me start with what we have learned about the run-up to the crisis. Looking back at the
years before this crisis - and more in general at all major crisis episodes in industrial
countries - five main, interrelated ingredients of an accumulating imbalance stand out.
1. The first - and in my opinion root - ingredient of the crisis lies in the large US
external imbalance and the high levels of US international debt. I consider these to
be a reflection of a country having lived beyond its means and, in particular, an
overleveraged private sector.
2. Second, low interest rates relative to a natural rate of interest - especially in a
context of a buoyant economy and low inflation - suggested that monetary policy
had been too easy in the years before the crisis. Fiscal policy was probably also too
easy.
3. Third, global imbalances and too low interest rates supported very strong credit
growth and excessive risk taking.
4. Fourth, asset prices rose sharply, particularly in equity and housing markets.
5. Fifth, a high level of private debt resulted from a prolonged period of strong credit
growth.
What we have learned is that it is necessary to recognize that the combination of these five
elements can have catastrophic consequences and to act upon this recognition.
Why did monetary policy not lean against the wind?
In the past, I have stated that "many of the risks that crystallised in the past year were on our
radar screen long before the crisis started".1 At the same time, I argued that these risk
assessments were not translated into an efficacious preventive action - at least not by
monetary authorities. But why did we not lean against the wind? I believe that this happened
for five main reasons.
1. First, there was an inability - by both academic researchers and analysts in the
policymaking world - to pay sufficient attention to the role of stocks. In 2007, high
levels of debt had resulted from a prolonged period of strong credit growth and
excessive risk-taking. These made the economy vulnerable to negative shocks,
such as the collapse of the US subprime mortgage market. The importance of the
stock of debt in the lead-up to the crisis is a manifestation of a more general
phenomenon, whereby in a context of disequilibrium - such as the accumulation of
financial imbalances - stocks dominate flows as determinants of macroeconomic
dynamics. This phenomenon cannot be captured in standard macroeconomic
models based on linear relationships.
In tranquil times, the relevance of stocks is modest, and flows as well as prices of
flows matter. Under these circumstances, policy is about fine tuning - mostly
through the anchoring of expectations. However, "ordinary" monetary policy that is
based on flows (monetary flows) and prices (inflation) cannot deal with the
implications of stocks that are typical of periods in which massive financial
imbalances can accumulate. We now know that looking after stocks is necessary
during good times as a means to prevent financial crises.
2. Second, macroeconomics and policymaking have focused on decision-making in
conditions of measurable risk, rather than immeasurable risk or what is known as
Knightian uncertainty. The concept of measurable risk may be appropriate during
"normal" times. But when we face a build-up of massive financial imbalances, it is
impossible to measure risks correctly because, like Keynes said, "we simply do not
know" the future.
The crisis has taught us that there are always events that - although possible - are
not accounted for in policy analysis. In the years before the crisis, the historically low
volatility observed in financial markets was seen as equivalent to no uncertainty.
And successful monetary policy - in the sense of low and stable inflation - was seen
as a guarantee of stability. In such a context, a global recessionary trend, such as
the one we have experienced this year, was unthinkable.
Accounting for such immeasurable risk would require a marked change to
macroeconomics. It implies moving away from the principle of optimizing agents, to
one of agents that would aim to insure against uncertain events. Rather than aiming
at identifying the best solution to a given problem, the aim would be to do "well
enough" - across a series of different problems irrespective of how likely they
maybe. This would not be without costs: it would insure against the effects of
undesirable events at the expense of a better performance in normal times.
3. Third, the existing monetary policy framework focuses on medium-term price
stability - defined over a horizon of two years. In the run-up to the crisis, this meant
that financial imbalances were left to be handled by micro prudential policy. But
financial imbalances are procyclical, and also have strong macro-dynamics and
implications for the macroeconomy. This calls for a macro prudential policy in
addition to a micro prudential response - a theme that will be picked up by some of
today's policy panellists - and, in addition, a role for monetary policy.
4. Fourth, it is important to acknowledge that policy makers are part of the environment
in which they operate. We now know that the prevalent behaviour in the years
before the crisis embodied an important element of irrationality. Like all members of
society, policymakers are partial to the prevalent consensus, and share its key
values and behavioural characteristics.
5. Finally, from a political economy point of view, it was hard for policymakers to sell an
unconventional line of action in a situation where inflation was well-behaved and
there was no firm proof that something was actually going severely wrong in the
financial sector.
How can we draw lessons for monetary policy?
I believe that monetary policy requires two fundamental changes. First, we need a new
culture that puts more emphasis on the role of stocks in creating potential macro-risks - in
particular for monetary authorities, risks for price stability in the medium-run. The new culture
would also focus on decision-making under uncertainty.
Second, central banks either need a shift in their monetary policy framework to deal explicitly
with financial imbalances, or interpret their current framework in a way that gives them more
freedom in pro-actively trying to avoid that financial imbalances burst, with major
macroeconomic consequences.
One approach would be to keep a mandate of price stability - that is not introduce financial
stability or asset prices as a second goal for monetary policy - but follow a two-track
approach to monetary policy. The first track would be a sufficient guide of action when no
imbalances accumulate. Under these conditions, the "traditional" monetary policy could be
followed. The second track would focus on monitoring the build-up of stocks (for example the
debt to GDP ratio) and associated potential macro-risks (in particular risks for price stability)
in the medium-run.
This approach would require greater flexibility, since at times the policy rate could be
changed even if inflation looks perfectly anchored. It would also require a horizon longer than
two years, since the cycle of accumulation and unwinding of imbalances typically draws out
further than two years. Greater flexibility and a longer horizon imply a more challenging role
for communication. How should we communicate a tightening of monetary policy when
inflation is low but there are some concerns that financial imbalances are accumulating,
which have a very small chance of unwinding in a very disruptive way five years ahead?
Another important ingredient of this approach is the close coordination, both with supervisory
authorities and, once a crisis erupts, with fiscal authorities.
Do central banks need to abandon their current monetary framework to follow the approach I
have outlined? I believe not. In practice, both the ECB's second pillar and the Bank of
Japan's long-term perspective can lend themselves to - and in fact already capture elements
of - this new approach. The same might be true for a flexible inflation targeting framework as
it is currently followed by the Reserve Bank of Australia.
I hope that the academic scholars, policymakers and market participants that are joining us
today for this workshop, will help us gain further insights into these important issues.