Stanley Fischer: Central bank lessons from the global crisis
Dinner lecture by Professor Stanley Fischer, Governor of the Bank of Israel, at the Bank of
Israel conference on "Lessons of the Global Crisis", Jerusalem, 31 March 2011.
This lecture is slightly modified from a series of lectures given during recent months: the Brahmananda Lecture at
the Reserve Bank of India in February 2011; a lecture at the CEPR/ESI conference in Izmir on October 28, 2010;
and a lecture at the conference of the Cyprus Economic Society in October 2010. I am grateful to colleagues at
the Bank of Israel with whom I have discussed and lived through the issues of monetary policy during the last five
years, and to Joshua Schneck of the Bank of Israel for research assistance.
* * *
During and after the Great Depression, many central bankers and economists concluded that
monetary policy could not be used to stimulate economic activity in a situation in which the
interest rate was essentially zero, as it was in the United States during the 1930s - a
situation that later became known as the liquidity trap. In the United States it was also a
situation in which the financial system was grievously damaged. It was only in 1963, with the
publication of Friedman and Schwartz's Monetary History of the United States that the
profession as a whole1 began to accept the contrary view, that "The contraction is in fact a
testimonial to the importance of monetary forces".2
Twenty years later, in 1983, Ben Bernanke presented the view that it was the breakdown of
the credit system that was the critical feature of the Great Depression3 - that it was the credit
side of the banks' balance sheets, the failure or inability to make a sufficient volume of loans,
rather than the behavior of the money supply per se, that was primarily responsible for the
breakdown of the monetary transmission mechanism during the Great Depression. The
Bernanke thesis gained adherents over the years, and must recently have gained many
more as a result of the Great Recession.
In this lecture, I present preliminary lessons - ten of them - for monetary and financial policy
from the Great Recession. I do this with some trepidation, since it is possible that there will
later be an eleventh lesson: that given that it took fifty years for the profession to develop its
current understanding of the monetary policy transmission mechanism during the Great
Depression, just two and a half years after the Lehmann Brothers bankruptcy is too early to
be drawing even preliminary lessons from the Great Recession. But let me join the crowd
and begin doing so.
Lesson 1: Reaching the zero interest lower bound is not the end of expansionary
monetary policy
Until this crisis, the textbooks said that when the nominal interest rate reaches zero,
monetary policy loses its effectiveness and only fiscal policy remains as an expansionary
policy instrument - the pure Keynesian case. Now we know that there is a lot that the central
bank can do to run an expansionary monetary policy even when it has cut the central bank
interest rate essentially to zero - as did the Fed, the Bank of England, the Bank of Japan,
and other central banks during this crisis.
quantitative easing
In the first instance there is the policy of - the continuation of purchases
of assets by the central bank even when the central bank interest rate is zero. Although
these purchases do not reduce the short-term interest rate, they do increase liquidity.
Further, by operating in longer-term assets, as in QE2, the central bank can affect
longerterm interest rates, which may have an additional impact on the private sector's demand for
longer-term assets, including mortgages and corporate investment.
During the crisis several attempts were made to calculate how much quantitative easing was
needed at a particular point in time. The calculation used a Taylor Rule to calculate what the
(negative) interest rate should have been in the given circumstances, combined that with an
estimate of the increase in the money supply or central bank assets that would normally be
needed to reduce the interest rate by one percentage point, and thereby calculated the
needed increase in central bank assets. This is a logical approach, but we should note that it
extrapolates economic behavior far beyond the range of the experience on which the
4
estimated Taylor rule is based.
Second, there is the approach that the Fed unsuccessfully tried to name "credit easing" -
actions directed at reviving particular markets whose difficulties were creating major
problems in the financial system. For instance, when the commercial paper market in the
United States was collapsing, the Fed entered on a major scale as a purchaser, and
succeeded in reviving the market. Similarly it played a significant role in keeping the
mortgage market alive. In this regard the Fed became the market maker of last resort.5
In a well-known article, James Tobin in 19636 asked in which assets the central bank should
conduct open market operations. His answer was the market for capital - namely the stock
market - since that way it could have the most direct effect on the cost of capital, later known
as Tobin's q, which he saw as the main price through which the central bank could affect
economic activity. Although central banks have occasionally operated in the stock market
- most notably the Hong Kong Monetary Authority in 1997 - this has not yet become an
accepted way of conducting monetary policy.7
Lesson 2: The critical importance of having a strong and robust financial system
This is a lesson that we have all thought we understood for a long time - not least since the
financial crises of the 1990s - but whose central importance has been reaffirmed by the
recent global crisis.
This crisis has been far worse in many of the advanced countries - among them the United
States, the United Kingdom, and some other European countries - than it has been in the
leading emerging market countries. This was not the situation in the financial crises of the
1990s, and it is not a situation that I expected would ever occur.
The critical difference between countries that have suffered from exceptionally deep crises
and those that had a more or less standard business cycle experience during this crisis
traces to what happened in their financial sectors. Those countries that suffered financial
sector crises had much deeper output crises.
This Time Is
In their important book, Different, Carmen Reinhart and Ken Rogoff8 document
the fact that over many centuries, downturns that also involved a financial crisis were more
severe than those that did not. This is not coincidental, for the collapse of the financial
system not only reduces the efficiency of financial intermediation but also has a critical effect
on the monetary transmission mechanism and thus on the ability of the central bank to
mitigate the real effects of the crisis.
If the financial system is intact, the standard anti-cyclical monetary policy response of cutting
interest rates produces its response in the encouragement of purchases of durables, ranging
from investment goods and housing to consumer durables. This happened during this crisis,
in that many countries that did not suffer from a financial crisis but had cut interest rates
sharply to deal with the negative effects of the global crisis returned to growth more rapidly
than other countries, and soon found asset prices, particularly the price of housing, rising
rapidly. Among these countries are Australia, Canada, China, Israel, Korea, Norway and
Singapore.
The next question is what needs to be done to maintain a strong and robust financial system.
Some of the answers to this question are to be found in the blizzard of recommendations for
financial sector and regulatory reform coming out of the Basel Committee - now extended to
include all the G-20 countries plus a few more - and the Financial Stability Board (the FSB).
In particular the recommendations relate to the capital requirements of the banks, which the
Basel Committee and the FSB recommend raising sharply, including by toughening the
requirements for assets to qualify as Tier 1 and Tier 2 capital. In addition, there are
recommendations on the structure of incentives, on corporate governance, on the advisability
of countercyclical capital requirements, on risk management, on resolution mechanisms
including eventually on how to resolve a SIFI (systemically important financial institution,
typically a bank with major international operations) - and much more.9 Further, there has
been a focus on systemic supervision and its organization, a topic to which we will return
shortly.
These recommendations make sense, and the main question relating to them is whether and
how they will be implemented, and whether political pressures will either prevent their
implementation and/or lead to their gradual weakening. There is already cause for concern in
that some of the recommendations are to be implemented only by 2019 - a period
sufficiently long for everyone to forget why such drastic changes are regarded as essential,
and why they are indeed essential. One element of the conflicting pressures can be seen in
the concern in many countries that the banks not tighten capital requirements too fast, since
an expansion in credit is needed to fuel the recovery.
Lesson 3: The need for macroprudential supervision10
There is not yet an accepted definition of macroprudential policy or supervision, but the
notion involves two elements: that the supervision relates to the entire financial system; and
that it involves systemic interactions. Both elements were evident in the global financial
crisis, with analyses of the crisis frequently emphasizing the role of the shadow banking
system and of the global effects of the Lehman bankruptcy.
Thus we are talking about regulation of the financial system at a very broad level, going
beyond the banking system. We are also going beyond bank supervision in considering
macroprudential policy instruments - and we are therefore also discussing an issue that
requires coordination among different regulators.
It is not clear whether the inclusion of a responsibility for (or contributing to) financial stability
in modern central bank laws, such as those of the ECB, the Bank of England and many
others, including the Bank of Israel, reflects the concerns that have led to the emphasis on
macroprudential supervision, or rather primarily the traditional role of the central bank as
lender of last resort. No-one who has read Bagehot on panics can think that understanding of
the potential for systemic crises is a new problem. However its importance has been
reinforced by the dynamics of the most recent crisis, in which a problem initially regarded as
manageable - the subprime crisis - gradually developed into the worst financial crisis since
the Great Depression, involving financial instruments built on mortgages, and after the
Lehman bankruptcy which revealed interactions among financial institutions to be much
stronger than policymakers must have thought at the time.
What macroprudential policy tools do central banks have? In the first place they have their
analytic capacities and their capacity to raise policymakers' and the public's awareness of
critical issues. These are reflected in the financial stability reports that some central banks
have been producing for over a decade.
What about other macroprudential policy tools? Central banks have been engaged in a
search for them since the financial crisis, but the search has not been especially fruitful.
Some have defined countercyclical capital requirements11 as a macroprudential policy tool,
presumably because they reflect a macroeconomic assessment and because they apply to
the entire banking system. Nonetheless they are not particularly aimed at moderating
systemic interactions, and thus it is not clear that they are the archetypical macroprudential
policy tool.
More generally, it seems that there are few specifically macroprudential policy tools, and that
the main tools that central banks and financial supervisors will be able to deploy to deal with
systemic interactions will be their standard microprudential instruments or adaptations
thereof.
Like other economies that did not suffer from a domestic financial crisis during the global
crisis, Israel has had to deal with the threat of a housing price bubble in the wake of the
global crisis. Housing prices, after falling gradually for over a decade, grew by around
40 percent in the last two years. The Bank's housing sector model suggests that while prices
in the middle of 2010 were not far above their long-run equilibrium level, a continuation of
their recent rapid rates of increase would definitely put them well above the equilibrium level.
Further, the atmosphere in the housing market was becoming increasingly bubble-like, with
discussion of the need to buy before prices rose even further.
Because the exchange rate had been appreciating rapidly, the Bank preferred if possible not
to raise the central bank interest rate too rapidly. Since bank supervision is located within the
Bank of Israel, policy discussions in the Bank resulted in the supervisor undertaking
measures that in effect increased mortgage interest rates, without affecting other interest
rates. These, together with tax and other measures undertaken by the government, along
with government measures to increase the supply of land for building, appear to have begun
to dampen the rate of increase of housing prices - though it will take some time yet to know
whether that has happened.
In announcing the new measures, the Bank of Israel emphasized that they were
macroprudential, and that our aim was to ensure financial stability. In speeches we noted
that our measures operated on the demand for housing, and that it would be preferable to
undertake measures that would increase the supply - as some of the measures undertaken
by the government soon afterwards were designed to do.
In this case the central bank was in the fortunate position of having at its disposal policy
measures that enabled it to deal directly with the potential source of financial instability.
Further, the banks are the main source of housing finance, so that the Bank of Israel's
measures were unlikely to be circumvented by the responses of other institutions not
supervised by the central bank. Even so, we knew there were better ways of dealing with the
price rises, and that it was necessary to cooperate with the government to that end.
Even within a central bank that is also the banking supervisor, questions arise about how
best to coordinate macroprudential policy. In the case of the Bank of Israel, which still
operates under the single decision maker model (but will shortly cease to do so as a new
central bank law goes into effect), it was relatively easy to coordinate, since it was possible to
include the bank supervisor in the non-statutory internal monetary policy advisory committee,
and to use the enlarged committee as the advisory body on macroprudential decisions.
More generally macroprudential supervision could require actions by two or more supervisory
agencies, and there then arises the issue of how best to coordinate their actions. A simple
model that would appeal to those who have not worked in bureaucracies would be to require
the supervisors to cooperate in developing a strategy to deal with whatever problems arise.
However, cooperation between equals in such an environment is difficult, which is to say
inefficient, all the more so in a crisis.
It is thus necessary to establish mechanisms to ensure that decisions on macroprudential
policy are made sufficiently rapidly and in a way that takes systemic interactions into
account. The issue of the optimal structure of supervision was discussed well before the
recent crisis, with the FSA in the UK being seen as the prototype of a unitary regulator
outside the central bank, the twin peaks Dutch model as another prototype, and various
models of coordination and non-coordination among multiple regulators providing additional
potential models.
The issue of the optimal structure of supervision came into much sharper focus in the wake
of the financial crisis, with the failure of the FSA to prevent a financial crisis in the United
Kingdom having a critical impact on the debate. Major reforms have now been legislated in
the United States, Europe, and the United Kingdom. In the Dodd-Frank bill, the responsibility
for coordination is placed in a committee of regulators chaired by the secretary of the
treasury. In the UK, the responsibility for virtually all financial supervision is being transferred
to the Bank of England, and the responsibility will be placed with a Financial Policy
Committee, chaired by the Governor. The structure and operation of the new Committee will
draw on the experience of the Monetary Policy Committee, but there are likely to be
important differences between the ways in which the committees will work. In other countries,
including France and Australia, the coordination of financial supervision is undertaken in a
committee chaired by the Governor.
At this stage it is clear that there will be many different institutional structures for coordinating
systemic supervision, and that we will have to learn from experience which arrangements
work and which don't - and that the results will very likely be country dependent.
It is also very likely that the central bank will play a central role in financial sector supervision,
particularly in its macroprudential aspects, and that there will be transfers of responsibility to
the central bank in many countries.
Lesson 4: Dealing with bubbles
One casualty of the crisis has been the Fed doctrine that the central bank should not react to
asset prices and situations that it regards as bubbles until the bubble bursts. This is known
as "the mopping up approach" - which is to say, to wait for the bubble to burst, and then to
mop up the mess that results.
The origin of this approach may lie in the expansion and stock market boom of the 1990s. As
is well known, Chairman Greenspan announced in a speech in 1996, at a point when the
Dow Jones was about 6400, that the stock markets were showing "irrational exuberance".
Despite the Chairman's authority, the markets paused for only a few days before resuming
their upward climb, eventually rising above 10,000. The Fed was widely praised for allowing
the boom to continue during that period, based on their conclusion that the rate of
productivity growth had increased, and that the economy could grow faster than previously
thought without generating inflation.
When the dot-com bubble burst in 2000, the mopping up approach appeared to have been
successful. The Fed cut interest rates rapidly and the recession was relatively mild. The
damage seemed to have been slight. There is of course much debate about whether in the
wake of the recession the Fed kept the interest rate too low for too long, thus laying the
groundwork for the next - and far more serious - crisis. But even those who argue that way,
do not suggest that the subsequent crisis was an inevitable result of the decision not to try to
prick the bubble in the late 1990s.
I believe that the mopping up discussion was misleading. The issue was generally put as
"should the central bank try to prick the bubble?" with the "no" side of the debate arguing that
the interest rate would have had to be raised by so much to prick the bubble that doing so
would have caused a serious recession. If the question had been "should the Fed react to
asset prices in setting the interest rate?", the answer might well have been yes, though it
would likely have been provided through the lens of the inflation targeting approach - that is
to say, if excessively high asset prices were expected to influence future price or output
levels, the central bank would be justified in taking them into account in its interest rate
decision.
If the same question were asked today, it would likely be answered in terms of
macroprudential supervision, and with reference to the possibility that regulatory measures
might be employed to supplement the effects of the interest rate on asset prices.
It seems clear from the general acceptance of the need for macroprudential supervision that
the mopping up doctrine is in retreat, though there could be circumstances - particularly a
stock-market boom whose collapse would have no major implications for the rest of the
financial system - in which the approach could be justified.12
Lesson 5: The lender of last resort, and too big to fail
The view that the central bank should be the lender of last resort has a long and
distinguished heritage, and central banks operated as lender of last resort in several
countries in the recent crisis. The case for the central bank to be the lender of last resort is
clear in the case of a liquidity crisis - one that arises from a temporary shortage of liquidity,
typically in a financial panic - but less so in the case of solvency crises.
The key difference is that in the case of a liquidity crisis, decisive central bank action along
the lines advocated by Bagehot can resolve the situation without a long-term financial cost to
the public sector.13 In the case where a financial institution is insolvent, intervention to
restructure it may cause a long-term financial cost to the public sector - although in several
crises in which the central bank and the government intervened massively to deal with a
panic, the public sector ended up making a profit from the intervention.14
Given that the profits of the central bank are generally sooner or later transferred to the
government, almost every financial action that the central bank takes has fiscal implications
for the government. This is particularly so when the central bank is involved in actions to
support financial stability, such as providing emergency liquidity to specific banks or to the
financial system as a whole.
In principle the distinction between liquidity and solvency problems should guide the actions
of the central bank and the government in a crisis. For instance, in Israel, the law provides
that the central bank can intervene on its own to deal with a liquidity problem but needs the
authorization of the Treasury and the government to take over an insolvent financial
institution. However in practice the distinction between a liquidity problem and a solvency
problem is rarely clear-cut during a crisis, and what initially appears to be a liquidity crisis can
very rapidly become an insolvency crisis. In short, judgment is needed at every stage of a
financial crisis - as it is in central banking in general.
The too big to fail issue and the associated issue of moral hazard have been recurrent
problems in dealing with financial crises. If a financial institution has what is purely a liquidity
problem, then the central bank in its financial stability role should act as lender of last resort
to that institution in case of need. Special difficulties arise when the institution is "too big" or
"too interconnected" to fail. That is to say, causing it to fail will significantly worsen the
financial crisis, for instance - to put the issue dramatically - by turning a recession into a
depression.
Ideally the regulatory and legal system should have developed a resolution mechanism
whereby an institution judged to be insolvent can be allowed to fail and to be wound down in
an orderly process. We have not yet seen such systems in operation for large financial
institutions (SIFIs), though one of the key lessons drawn from the recent crisis has been the
need to develop a framework of this type. The difficulties are manifold, especially for global
banks, which operate in many jurisdictions and under different sets of laws and
organizational frameworks (e.g. branches versus subsidiaries). The Basel Committee and
the Financial Stability Board are working on this issue, and finding it to be among the
thorniest with which they have to contend.
Moral hazard is usually present when governments intervene to help stabilize a financial
system - or under any system of insurance. In the case of a lender of last resort, the valid
concern is that the mere existence of such a lender encourages financial institutions to take
more risks, since they know that in an emergency they will be bailed out, that is, they will be
saved. The question here is "Who is 'they'?" It is generally accepted - and appropriately so -
that equity holders should not be saved when a financial institution goes bankrupt.15
Generally it is assumed that to preserve the payments mechanism, deposit holders up to a
certain size of deposits should be saved, perhaps up to deposit insurance limits - though
frequently in financial crises government extend deposit safety nets well beyond their normal
limits.
The most difficult issue concerns bondholders. If a financial institution goes bankrupt, the
bondholders will and should share in the losses. Nonetheless, governments sometimes
extend guarantees to holders of non-deposit claims on banks, for instance short-term paper.
Why? The answer may that in a financial crisis, governments are willing to go a long way to
prevent a cascade of bankruptcies, which is likely to develop if the bondholders have an
incentive to run. Or, to put it more simply, it may be difficult to draw the line between
depositlike obligations of banks and equity-like claims. Further, it may be argued that once the
markets realize that bonds - particularly short-term paper - are more likely to be written
down in a crisis, the costs of bank financing in normal times are likely to rise.
A similar issue was discussed about a decade ago, when the IMF pursued the possibility of a
sovereign debt restructuring mechanism (SDRM). It was argued at the time that it should be
easier to restructure sovereign bonds than it typically was in bonds issued in New York,
which required unanimity among their holders to be restructured. Accordingly it was
proposed that sovereign bonds should include CACs, collective action clauses, which would
permit majority (or at least less than 100%) approval for restructuring. This issue was highly
controversial and potential borrowers objected that its inclusion would increase their
financing costs. In the event it turned out that CACs already existed in some bonds issued in
London (so-called British Trust Deed instruments) and that their effects on the cost of
financing appeared to be small. Since then some sovereigns, including Mexico, have
included CACs in their bonds, apparently without important effects on their cost of financing.
In the case of financial institutions, some banks have begun to issue contingent capital,
bonds that automatically convert into equity when some objective criterion so signifies. In the
last two years, both Rabobank and Lloyd's have issues such bonds. Appealing as this
approach may be, the systemic dynamics of the triggering of these bonds in a crisis remains
to be tested in practice.
Nonetheless: while the use of contingent capital and other forms of financing that become
more equity-like in a crisis - and more generally, the development of resolution mechanisms
- will all help deal with moral hazard issues, the mere existence of a lender of last resort
raises moral hazard issues. That is true. But there is nothing that says that the optimal
reaction to moral hazard is to stop selling insurance. Rather its existence is one factor to be
taken into account in dealing with any situation in which the state provides explicit or implicit
forms of insurance - just as it has to be taken into account in private sector insurance
contracts, for instance the provision of fire insurance.
After having had to decide how to deal with moral hazard issues in a variety of financial
crises, I have arrived at the following guide to conduct: if you find yourself on the verge of
imposing massive costs on an economy - that is on the people of a country or countries - by
precipitating a crisis in order to prevent moral hazard, it is too late. You should not take the
action that imposes those costs. Rather in thinking through how a system will operate in a
crisis, you need to take into account the likelihood of facing such choices, and you need to
do everything you can in designing the system to keep that likelihood very small.
Lesson 6: The importance of the exchange rate for a small open economy
The (real) exchange rate is one of the two most important macroeconomic variables in a
small open economy, the (real) interest rate being the other. No central banker in such an
economy can be indifferent to the level of the exchange rate. But there are no easy choices
in exchange rate management.
There is first the choice of the exchange rate system, a choice that is tied up with the
question of capital controls. If capital flows can be controlled, then there may be advantages
for a country in trying to fix its nominal exchange rate. Nonetheless, and without entering the
long-running debate over exchange rate systems, I believe that it is better to operate with a
flexible exchange rate system and with a more open capital account.
"Flexible" does not mean that a country should not intervene in the foreign exchange market,
or that the capital account should be completely open. Rather it means that the country
should not draw an exchange rate line in the sand and declare "thus far, and no further";
countries should not commit themselves to defending a particular exchange rate.
Market participants often say that the central bank cannot stand against market forces.
However we need to recognize the asymmetry between defending against pressures for
depreciation and appreciation of the currency. In the case of pressures for depreciation, at
the existing exchange rate the market wants more foreign exchange. The central bank has a
limited supply of foreign exchange, and thus cannot stand against the pressure of the market
for very long - though as the recent crisis has shown, large foreign exchange reserves can
help the central bank deal with market pressures, as for example in Brazil, Korea and
Russia.
In the case of appreciation, at the existing exchange rate the markets want more domestic
currency. The central bank can produce unlimited amounts of domestic currency - that is, it
can intervene to buy the foreign exchange flowing into the country. Of course to prevent
inflation, it will have to sterilize the foreign exchange inflow. But that can be done, as the
Bank of Israel has shown over the last three years.
In the case of pressures for appreciation, the central bank has to balance the net costs of
holding additional reserves against the benefits of preventing unwanted appreciation. This is
a complicated calculus,16 one which has led to the development of various rules for reserve
holdings: when the current account was the dominant factor in the exchange market, the rule
was specified in terms of holding reserves equal to the value of X months of imports; now
that the capital account is at least as important, reserve holding rules of thumb relate to
capital flows, generally based on some form of the Greenspan-Guidotti rule that a country's
reserves should at least cover the economy's short-term obligations falling due over the next
year. The recent crisis has resulted in many countries deciding to hold more reserves than
the previous conventions implied. In addition, country-specific factors may be relevant, for
instance in the case of Israel the central bank has explicitly noted our geopolitical situation in
discussing our reserve holdings.
Central bankers used to say that they have only one instrument - the interest rate - and thus
can have only one target - the inflation rate. That view, which is based on the Tinbergen
result that there should be as many instruments as there are goals of policy, is not generally
correct.17 But in any case, I see the instrument of intervention in the foreign exchange market
as in effect giving the central bank an extra instrument (or at least an extra half instrument) of
policy, which enables it not only to target inflation but also to have some influence on the
behavior of the exchange rate.
As the pressures for appreciation increase, a country may want to limit further intervention,
and is likely to turn to the use of capital inflow controls. Such controls are rarely elegant, are
typically difficult to administer, and are continually being undermined by private sector
attempts to circumvent them. Central banks prefer to do without them. But sometimes they