José Manuel González-Páramo: Monetary and fiscal policies in times of
crisis
Speech by Mr José Manuel González-Páramo, Member of the Executive Board of the
European Central Bank, at the conference of the Monetary and Fiscal Policies Network
(MONFISPOL), Goethe Universität Frankfurt, Frankfurt am Main, 19 September 2011.
* * *
I would like to thank Giovanni Lombardo, Günter Coenen, and Frank Smets for their inputs to this speech.
I. Introduction
Ladies and gentlemen,
Let me start by thanking the organizers for inviting me to this conference. These are
exceptionally hard times for policymakers around the world, and probably the most exciting
times for researchers. I am sure that the financial crisis will prove to be a source of
inspiration for the economics profession in general and for economic policy analysis in
particular.
The economic literature provides useful insights into the nature and causes of the current
crisis. I am thinking in particular of the literature highlighting the fragility of equilibria and the
possibility of self-fulfilling prophecies. A literature that includes the seminal work of Diamond
and Dybvig (1983) on bank runs, which has inspired a large number of papers dealing with
financial crises like the present one.1 Equally relevant has been the large literature on
selffulfilling sovereign debt crises, building on papers like Calvo (1988) and Cole and
Kehoe (2000), as well as the literature on public debt sustainability and fiscal and monetary
policy interactions, including Leeper (1991, 2011) among others.
That said, while the literature provides important insights, actual decision making during the
crisis, like in other exceptional circumstances, had to be based on practical experience and
necessarily involved judgment.
Furthermore, it is also clear that we cannot be content with the current state of economic
analysis. The rich body of economic knowledge that has helped us rationalize the crisis ex
post has not been equally helpful in foreseeing and avoiding it. Economic research has made
significant progress since its origins. Yet, recent events have reminded us how far we are
from the "end of economics".
This conference offers an example of the type of work that we should promote. As I
understand it, the MONFISPOL project aims at contributing to the evaluation of
macroeconomic policy by advancing the analysis of optimal fiscal and monetary policy in a
monetary union such as the euro area. At the ECB, we enthusiastically welcome and
promote this type of research.
In my talk I will discuss the challenges that the current crisis has posed to policymakers, and
central banks in particular. I will first try to give a brief account of the origins and evolution of
the crisis, of the policy interventions and of what I think needs to be done in order to prevent
the repetition of such events. I will then conclude by highlighting some of the issues that I
think should be among the priorities in our research agenda.
II. The unfolding of the crisis
II.1 The situation before the eruption of the crisis
The first seven years of the euro area were characterized by stability, both internally as well
as globally. Indeed these were the years that saw the emergence of a number of papers trying
to make sense of the so-called "Great Moderation": a phenomenon that started in the mid
1980s. The question then was "why did macroeconomic volatility decline?" Ben Bernanke
(then Governor of the Federal Reserve Board) identified "three types of explanations [in the
existing literature] ... structural change, improved macroeconomic policies, and good luck"
(Bernanke, 2004). Now, of course, the question is: why are those tranquil times over?
Up until the summer of 2007, the relative stability of corporate-bond and sovereign spreads
- interrupted only by mild turbulences during the dot-com crisis at the turn of the millennium -
can be observed against the backdrop of widespread moderation in macroeconomic volatility.
Chart 1 shows a snapshot of the relative calm, before the recent storm, for BBB corporate
spreads for the euro area and the US as well as 10 year sovereign bond spreads (relative to
the Bund) for a number of euro-area countries. To a large extent, the positive trend in
macroeconomic growth and stability and the low and stable credit premia are closely related.
II.2 From US sub-prime turmoil to the global financial crisis
The protracted period of tranquillity was abruptly brought to an end by the collapse of the US
housing bubble and the subsequent implosion of the sub-prime mortgage market. In the early
stages, the financial turmoil was circumscribed so that it was very difficult to assess its
severity. Furthermore there was a widespread belief that the real economy, both in the US
and in the euro area, was sufficiently strong to withstand the financial turbulence (ECB, 2011).
This notwithstanding, the European Central Bank did not fall victim to complacency and
promptly intervened in the money market with an injection of 95 billion euros when severe
strains emerged in that market in August 2007. This was the first of a series of interventions
aimed at securing liquidity in the face of an interbank market paralyzed by fear. Concerning
these interventions, it is particularly worth mentioning the high degree of international
coordination among central banks. Besides the simultaneous liquidity injections in domestic
currencies that took place in many advanced economies, the ECB was able also to rapidly
provide ample liquidity in dollars thanks to swap agreements with the Federal Reserve.2
Despite these unprecedented interventions, and similar measures implemented in the US, in
October 2008 Lehman Brothers collapsed wrecking havoc on international financial markets
and the world economy. The spiralling of the crisis is evident if we look at the Libor-OIS and
Euribor-OIS spreads in Chart 2.
The ECB's response to the crisis was swift and combined a mix of standard and
nonstandard monetary policy measures.
As regards the former, official interest rates were cut in a sequence of steps, bringing the
main refinancing rate from 4.25% to 1% within a span of 6 months. The first of these
reductions - on October 8, 2008 - was part of a concerted move with other major central
banks.
In order to meet banks' increased demand for liquidity and to reduce uncertainty, a number
of non-standard measures, which we have characterised as our "enhanced credit support"
policy, were adopted. The most important of these have been the fixed-rate full-allotment
policy, the introduction of additional and new long-term refinancing operations and the
extension of the list of collateral eligible for monetary policy operations. By allowing banks to
continue rolling-over their short and medium-term financing, the liquidity provision of the ECB
avoided a fire-sale of assets.
Like various other central banks, the Eurosystem has also embarked on outright purchases
of securities, though on a relatively limited scale, in order to support the broader functioning
of euro area financial markets.
The Covered Bond Purchase Programme was initiated in July 2009. This programme was
part of the "enhanced credit support" measures and its objective was to support a financial
market segment that is particularly important for the longer-term funding of banks and the
financing of the real economy in the euro area. The spill-over effects connected with the
intensification of the financial crisis in September 2008 had led to a virtual shut down of the
covered bond market, notwithstanding the high credit quality of this type of asset. In
response, the Eurosystem purchased EUR 60bn of covered bonds between July 2009 and
June 2010. Empirical research conducted by ECB staff suggests that the CBPP has been
successful in achieving its goals (Beirne et al., 2011).
Not least due to strong and timely action by central banks and governments, worldwide signs
of stabilisation in financial markets emerged, with spreads returning to pre-Lehman levels
and positive output growth resuming in the second half of 2009. In this respect, the ECB's
non-standard measures played a non-negligible role in supporting the euro area economy.
II.3 From the financial to the sovereign debt crisis
Chart 1 also shows that sovereign credit spreads (relative to the German Bund) started to
widen already in the early stages of the crisis as the market reassessed risk across the
board. But sizable repercussions on the sovereign bond market are noticeable only after the
collapse of Lehman Brothers, when the spread on Irish and Greek long-term government
bonds soared above 250 basis points. This reflected the fact that, during the initial stages of
the crisis, government guarantees for the financial sector and, more generally, the policy
response to the crisis implied a transfer of risk from the private sector to the government
sector. However, as deficits surged and the Greek government revealed a much larger deficit
than previously thought, the attention focused more on the state of public finance. From then
on, and in particular after the downgrading of Greek bonds by all the major rating agencies,
the financial crisis that originated in the US turned into a sovereign debt crisis with a
European epicentre.
This escalation of events brought the crisis to a new dangerous level. While in the early
phases concerns focused around the risk of a protracted recession the new phase raised
concerns regarding the ability of some euro area countries to honour their debt obligations.
The widening of sovereign bond spreads and the malfunctioning of securities markets in a
number of countries impaired the smooth operation of the monetary policy transmission
mechanism. In order to address this problem the Eurosystem initiated its Securities Markets
Programme (SMP) by means of which private and public securities became eligible for
outright purchase by the Eurosystem.
A key distinguishing feature of asset purchases made under the SMP is that their liquidity
impact has been sterilised through the conduct of weekly liquidity absorbing operations.
Overall, there has been no net injection of central bank liquidity to the market as a
consequence of these operations. These measures and their objectives are therefore
fundamentally different from quantitative easing. For the ECB, non-standard measures have
always been seen as a means of coping with abnormal functioning of some key markets,
which, if unaddressed, would have posed problems for the effective transmission of
monetary policy. This implies that, standard and non-standard measures are seen as
complements, not substitutes. We have never chosen non-standard measures as
alternatives or substitutes for changes in official interest rates. Indeed our standard and
nonstandard measures were implemented in parallel. This so-called separation principle is
illustrated by the rate increases in the first half of 2011 in a context of stable or reinforced
liquidity measures.
These measures seemed to produce positive effects in the early stages, when spreads
stabilized and the market gave signs of increased confidence. Yet a slower than expected
recovery and overstretched public finances have made investors and consumers retrench in
the second and third quarters of 2011, with spreads widening again and for an even larger
group of countries in the euro area, reaching over 2000 basis points for Greece. In order to
diffuse tensions in the euro area secondary sovereign bond market, the ECB, in its 7 August
statement, indicated that it would resume its Securities Markets Programme. Importantly, this
statement was made following the announcement of new fiscal and structural policy
measures by the Italian and Spanish governments.
III. Lessons to be learned
Against this background, it is clear that what needs to be explained is how we went from
historically tranquil times to the worst financial crisis since World War II and, eventually, to an
equally severe sovereign debt crisis. Was it sheer bad luck? Or can we detect the seeds of
the crisis in policies and structural changes that had taken place before? And if so, what
needs to be changed?
It would be foolish to argue that what we have experienced in the last four years is the sole
result of an exceptionally large adverse shock. Major structural changes in financial markets
gave life to a gigantic securitization market which allowed financial intermediaries to diversify
their portfolios and, hence, to reduce their exposure to risk. Or so market participants liked to
believe. As in the case of collateralized mortgage obligations (CMOs) and credit default
swaps on CMOs and CDOs, many securitised products had an unknown or very uncertain
risk profile due to the novelty of the financial products and the lack of data. The systemic risk
associated with these assets was naively underpriced, and the consequence was an
excessive exposure to risk.
Such mechanism has been captured in a recent model by Boz and Mendoza (2011). They
show that if investors have imperfect information on the risk profile of assets, and have to
learn over time these characteristics, boom-bust cycles can easily emerge. In particular, after
a positive shock that increases the availability of credit (e.g. financial innovation), financially
constrained investors must assess the riskiness of the new environment: i.e. whether they
are short lived or sufficiently persistent to warrant an increase in leverage. Given the limited
information available on the new environment, mis-pricing of risk is very likely. The
materialization of the underlying, yet mis-priced risk (like the widespread losses in the
subprime mortgage market) in an environment of over-leveraged investors could have negative
consequences via the sudden deterioration of investors' balance sheets, and hence of their
collateral.
In a similar spirit Brunnermeier and Sannikov (2010) and Brunnermeier, Eisenbach and
Sannikov (2011) emphasize the role of occasionally binding credit constraints in generating
sudden contractions. They argue that in normal times (under moderate risk) borrowers are
not limited by the value of their collateral. Only when risk increases and, hence, also the
likelihood of hitting the borrowing constraint, borrowers will start liquidating their assets in
order to increase their safety buffer. This can lead to fire-sales of assets, which will in turn
lead to a deterioration of collateral values and set in motion a vicious spiral. Most
interestingly their analysis emphasizes the role of liquidity risk (as opposed to credit risk): the
more illiquid is the asset the larger is the price effect of fire-sales. An initial increase of risk,
that generates margin calls or increased haircuts, will lead to larger asset-price falls the more
illiquid are these assets. For these reasons, financial intermediaries play a key role in this
environment. On the one hand they increase stability by providing liquidity-transformation
services. On the other hand, when their net-worth deteriorates, their ability to provide liquidity
(inside money) is impaired increasing the value of outside (central-bank) money. As the
money multiplier shrinks, "Fisherian deflation" sets in worsening the debt burden of
borrowers and, hence, further amplifying the contraction.
Regrettably, the diversification delusion discussed in Boz and Mendoza and the
liquidity-risk
understatement of the channel in Brunnermeier et al. affected investors as well
as policymakers and regulators. Indeed this same literature tells us that there can be ample
scope for welfare improvements through economic policy. The fundamental reason for this
public role is that private agents, typically, are not large enough players to internalize the
general equilibrium - or even market specific - consequences of their portfolio decisions (as
in the case of fire sales). These results warrant ample liquidity injections by central banks
and underpin the current wave of regulatory reforms undertaken in the European Union as
well as in other major economies. Among these reforms, it is important to mention in
particular the new Basel Accord (Basel III) on banks' capital adequacy which is consistent
with the idea of Brunnermeier et al. that critical reductions in banks' capital can generate
dangerous liquidity shortages. Equally important is the establishment of the European
Systemic Risk Board (ESRB) with macro-prudential oversight responsibilities over the
financial system in the European Union, which directly relates to the limited ability of financial
markets to internalize systemic risk.
Another important lesson that has been learned, admittedly the hard way, is that it is very
difficult, if at all possible, for the market to correctly price sovereign risk. Charts 1 and 3 offer
a clear example of what I mean. In particular consider two of the most troubled economies,
i.e. Greece and Ireland. The evolution of their public finances in the recent history leading up
to the crisis is dramatically different (as Chart 3 shows), in large part reflecting the deep
differences in their growth experiences. Up to the start of the crisis Ireland experienced a
rapid fall in the debt-to-GDP ratio, while Greek public debt had been hovering around 100%
of GDP for the whole period (even considering older un-revised figures). Yet both economies
were paying virtually the same rate on their debt as Germany did, the main reason being that
the exchange rate risk had been removed by the single currency. Furthermore the market
might have also made the assumption that by being in a monetary union each member
country now benefited from a collective euro area wide implicit guarantee over its
government's liabilities. But were those debt levels equally sustainable?
Up to the crisis, the "Celtic Tiger" was seen as an example of good public finances, having
reached a debt-to-GDP ratio of about 25% in 2007 from more than 80% in the mid 1990s.
The seemingly healthy picture of the Irish economy concealed deep imbalances that
constituted implicit liabilities for the government. The real estate and banking sectors swelled
to disproportionate levels compared to the ability of the government to intervene in case of
major disruptions. A similar picture is offered by Spain, although in a less dramatic way,
where the housing boom was the main driver of growth. It is obviously extremely difficult for
the market to be able to assess these implicit liabilities. This is a further reason why
macroprudential oversight by public institutions is crucial in order to mitigate the risks of systemic
crises.
With hindsight, we can say that the excessive compression of sovereign risk premia has
been unfortunate as it removed an important disciplinary device for issuing countries. There
is widespread agreement that a new set of rules for fiscal discipline must be introduced. As
the ECB already pointed out at the time, it was regrettable that France and Germany
breached the Stability and Growth Pact (SGP) in November 2003 and that the European
Council failed to initiate the Excessive Deficit Procedures. The reform of the SGP undertaken
in 2005 has addressed a number of weaknesses of the of the original design, in particular by
enhancing its economic rationale and by calling more effectively on member states to
undertake fiscal adjustments. Nevertheless, as I have pointed out in 2005
(GonzálezPáramo, 2005), the reform had serious shortcomings, as it introduced more explicit flexibility
and room for economic judgement. In this way, in order to guarantee sustainability, the new
pact required even more commitment by the member states to consolidate their public
finances and to rigorously and consistently apply the new rules. In light of the current crisis,
the next major challenge for the European Union will be to design rules that are at the same
time credible, effective and enforceable.
The recent Euro Plus Pact of March 2011 is an important step in the right direction. The ECB
strongly supports the objectives of the pact, i.e. to foster competitiveness and employment,
to contribute to the sustainability of public finances and to reinforce financial stability. The
pact has been reinforced by the statement made by the Heads of State or Government of the
euro area on 21 July 2011 (see also Trichet, 2011). In particular, it has been reaffirmed that
fiscal consolidation is a primary goal of member states. In this regard all countries not under
a programme will have to achieve a deficit below 3% by 2013 at the latest. Indeed countries
that have experienced turmoil in their sovereign debt market have already taken
unprecedented measures to ensure sustainability of public finances. The ECB will monitor
these developments very closely, as sound public finances are a fundamental prerequisite
for a credible and effective monetary policy.
IV. Fiscal and monetary policy in the euro area: need for tighter governance
Allow me to dwell a little bit more on the sovereign debt crises and the challenges it poses to
monetary policy. As mentioned earlier, the economic literature has long emphasized the
intimate connection between fiscal and monetary policy. The relationship between monetary
and fiscal authorities can be of two alternative types. The first is one of "dependence"
- typically of the monetary authority on the fiscal authority. The second type is a relation of
"mutual independence" with a well defined monetary policy mandate. The literature has
shown that countries displaying more independent central banks also enjoyed lower average
inflation rates (e.g. Cukierman, 1992 and Walsh, 2003, Chapter 8). As argued earlier, this
set-up can deliver price stability and growth only if accompanied by clear and enforceable
rules for the fiscal authorities. Ensuring this, as we know too well, is not a minor challenge.
In the case of a monetary union among sovereign countries with independent fiscal
authorities, the challenge is much bigger. In a monetary union the misbehaviour of one fiscal
authority can be offset, at least partially, by the virtuous behaviour of other countries, and the
more so the smaller is the economy that misbehaves. In the face of these free-riding
incentives, the non-cooperative behaviour of the member states can generate unsustainable
fiscal policies.
A large number of papers have highlighted the challenges that come with the establishment of
a monetary union among countries with independent fiscal authorities. We know, for example,
that if there are no limits to non-monetary policies (e.g. fiscal policy), governments might have
the incentive to pursue lax policies in the national interest, putting pressure on the central
bank to increase inflation (Chari and Kehoe, 2008). This literature has long called for a
strengthening of fiscal rules, but also for euro-area wide bank supervisory bodies in order to
bypass dangerous incentives at the national level to tolerate imbalances in the domestic
banking sector, with associated risks of contagion and systemic crises (Uhlig, 2002).
Indeed, the current dire situation is the result of the lack of effective and enforceable rules,
i.e. of the lack of a credible fiscal commitment. Before the crisis, after initial efforts to
consolidate public finances, some governments have enjoyed increasingly feeble external
pressures to put their own house in order, thanks mainly to favourable global economic
conditions, and have reverted to unsustainable fiscal stances. Others have turned a blind eye
on the domestic economic imbalances that were building up, mainly as a consequence of
abundant credit, and enjoyed the delusion of sustainable growth. As the crisis unfolded, all
those vulnerabilities materialised calling for supranational interventions. As I have mentioned
earlier, some of these interventions involved the ECB, as in the case of (sterilized) purchases
of sovereign bonds in the secondary market. These type of unconventional interventions can
only be seen as exceptional measures which would not have been necessary in the
presence of appropriate institutional arrangements and credible rules for fiscal authorities. In
designing these rules and institutions, European legislators will find vast insights in the
existing economic literature.
V. Priorities for the academic research agenda
Let me conclude with a "wish list" for economic research.
As I have alluded to before, current generation economic models used at central banks were
ill equipped to signal the mounting risks of a global recession. The two sides of the current
crisis - credit markets and sovereign debt crises - originate from the excessive leverage of
private and public agents and by the extreme under-pricing of risk by investors.
The DSGE literature has made considerable progress in this direction in the last 10 years.
Most of this literature builds on the idea of asymmetric information and agency problems in
financial markets.3 These models appeared at central banks quite some time before the crisis
and their development has intensified since 2007.4 The main lesson that we have learned
from this literature is that financial frictions can generate considerable amplification and
enhance persistence of aggregate shocks. They may also be a source of sizeable
international spillovers. Unfortunately, though, all these models are solved using linear
methods and completely lack the non-linearity that is crucial to explaining disproportionate
effects of seemingly small shocks. Linearized models can explain the crisis, only ex-post, by
hitting the economy with exceptionally large shocks.
The model of Brunnermeier et al. that I have mentioned earlier is also based on the same
type of financial frictions. Yet, by preserving the model's non-linearity, it is able to generate
endogenous time-varying risk and feedback-loops that can bring about boom-bust cycles
from even modest shocks. Indeed we know that the nonlinearity implied by financial
constraints can generate multiple equilibria, with the further possibility that non-fundamental
shocks (so-called sunspots) can generate large economic fluctuations. In this regard, further
research on non-linear solution techniques should have high priority in the economic
profession's research agenda.
The current financial crisis has certainly offered strong arguments to convince the sceptics
that financial markets must not be neglected. The crisis has also taught us that another
usually neglected market, the money market, is claiming its right to belong in business cycle
models. In order to assess the fragility of the financial market and the risk of a systemic
crisis, we need models where the liquidity-transformation role of financial intermediaries
plays an explicit part. Some of the models that I have referred to include financially
constrained banks. Yet most of them abstract from liquidity issues. On the other hand, quite
some progress has been made in the banking and finance literature - typically in partial
equilibrium or highly stylized models - in characterizing the interbank market. For example
Heider, Herova and Holthausen (2009) show that private information in the interbank market,
where liquidity plays a central role, can generate different regimes, including turmoil and
market breakdowns. Here too there is a high premium on incorporating these ideas into
quantitative policy models.
Some progress in this direction can be seen in recent work by Gertler et al. (2010), who
show in a DSGE model how the monetary policy stance can influence portfolio decisions of
financial intermediaries and, hence, their exposure to risk. This model has important policy
implications as it incorporates the moral-hazard consequences of policy decisions and of
regulatory reforms, like new capital requirements and other macro-prudential regulations.
Another deficiency in standard models is the absence of a meaningful role for the fiscal
authority. As argued above, modelling the interconnection between public finances and the
economy is a very difficult task, as the sudden deterioration of public finances can often be
ascribed to the materialization of implicit commitments, something which is very hard to
quantify ex-ante. Yet we know that in order to design appropriate policy responses to crisis
events we need to have accurate predictions of their likely macroeconomic impact, which in
turn crucially depends on the state of public finances. An early description of the deep
interdependence of monetary and fiscal policy was provided by Sargent and Wallace (1981).
More than a decade later the debate centred around the so called "Fiscal Theory of the Price
Level" (FTPL, see Sims, 1994). Most of the DSGE models used for monetary policy analysis
either disregard completely the fiscal side or assume a "passive" fiscal policy and an "active"
monetary policy (as Leeper would put it). This constellation is certainly of interest but, in light
of the recent events and issues that I have described earlier, quite remote from reality. In
improving our policy models we will certainly benefit from Leeper's research agenda (see
e.g. Leeper, 2010). We may also benefit from the same inescapable logic of the FTPL as far
as the interconnection between monetary policy, fiscal policy and the risk of sovereign
default is concerned (as pointed out recently by Uribe, 2006). This is a further example of
how non-linear dynamics can play a crucial role.
The literature on self fulfilling debt crises mentioned at the beginning of my speech and the
related developments in the literature on exchange rate crises (Obstfeld, 1996) emphasize
the importance of economic policy in determining the conditions under which self-fulfilling
crises can occur. The level of public debt is often a key determinant of these conditions, as
high levels of debt increase the cost of interest rate hikes and heighten the sensitivity of
public finances to risk premia. Embedding these concepts in our policy models would allow
us to assess changes in the risk of self-fulfilling crises and would give some quantitative
guidance in designing the appropriate policy responses.
Finally, the standard model is based on the assumption of perfectly and equally informed
rational agents. As argued above, in the case of asset-backed securities, a decisive role was
played by the limited knowledge of their risk profile (Boz and Mendoza, 2010). Many have
described the origin of the financial crisis as the result of second-moment shocks. In
particular market agents realized that their guesses on asset price correlations were wrong.
The very evolution of the crisis has been characterized by enormous uncertainty. The
increase in uncertainty froze markets and paralyzed consumers and investors (e.g. Bloom,
2009). Policy models displaying these features would be close to a holy grail for central
bank's policy analysis.
All in all, there seems to be quite some ground to cover in macroeconomic modelling. Yet,
the programme of this conference gives me further reasons to believe that it won't be long
before these wishes will be realized.
Thank you for your attention.
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