Peter Praet: Deleveraging and monetary policy
Speech by Peter Praet, Member of the Executive Board of the European Central Bank, at the
Hyman P Minsky Conference, organised by the Levy Economics Institute and ECLA of Bard
with support from the Ford Foundation, The German Marshall Fund of the United States, and
Deutsche Bank AG, Berlin, 26 November 2012.
* * *
I would like to thank Philippine Cour-Thimann, Federic Holm-Hadulla and Roberto Motto for their contributions to
the preparation of this speech.
It is a great pleasure to join you on the occasion of the Levy Economics Institute's Hyman P.
Minsky Conference. The financial crisis erupted five years ago when the leverage cycle that
had accompanied the "great moderation" abruptly reversed. Since then, the euro area and
large parts of the global economy have been swept by several waves of financial shocks.
And each wave has unleashed strong deleveraging forces throughout the affected
economies.
Deleveraging often reflects a necessary adjustment process. And it does not necessarily
warrant policy intervention. At the same time, it bears the risk of becoming abrupt and
disorderly, thus threatening price stability by dislodging the provision of credit and the
transmission of monetary policy signals to the real economy. In the worst case, it may lead to
a full-blown financial meltdown via self-sustained adverse feedback loops of the kind
envisioned by Hyman P. Minsky.
Central banks have a role in ensuring that the economy does not move towards divergent
dynamics that would be inconsistent with price stability. To this end, they have a range of
policy tools at their command which may be used to control deleveraging pressures.
But, of course, strong accommodative central bank intervention may create moral hazard,
thus discouraging needed adjustment efforts and possibly leading to the accumulation of new
imbalances.
In my remarks today, I will discuss how the ECB navigated through the crisis in view of the
complex "balancing act" between disruptive deleveraging processes and moral hazard. I will
argue that forceful action was needed to fend off acute downward pressures on price
stability. In illustrating this point, I will often come back to the concept of the transmission
mechanism, which is fundamental to a central bank's ability to maintain price stability.
I will also focus on the specificity of the approach adopted by the ECB during the crisis in
order to maintain price stability. And I will relate it to the challenges faced by a single
monetary policy in the multi-country context of the euro area. This may have implications for
the process of deleveraging in the economy.
To contain moral hazard concerns, the ECB has consistently conveyed to market participants
and the general public that it responds symmetrically to upside and downside pressures on
price stability. Moreover, it adopted additional safeguards against moral hazard, such as the
explicit conditionality attached to our recently announced Outright Monetary Transactions.
At the same time, we have used and will continue to use our influence to ensure that the
overall institutional architecture of Economic and Monetary Union (EMU) becomes
incentivecompatible, also beyond monetary policy.
Monetary policy during the global financial crisis
Let me elaborate on the ECB's response in the different phases of the crisis, starting with the
global phase before the crisis became combined with a sovereign debt crisis in some euro
area countries.
The first phase of the financial crisis - with Lehman Brothers' failure being the watershed -
can be described as a bank run on a global scale. In contrast to a classic run, it centred on
wholesale deposits rather than retail deposits. But the dynamics were the same in that they
essentially reflected an evaporation of confidence in banks.
The spark that ignited this crisis was a bout of general uncertainty about the health of
financial-intermediary balance sheets in the context of huge losses made by some obviously
systemic banks. As financial intermediaries no longer trusted each other, they shortened the
maturity of their exposures, charged higher premia or withdrew from the market altogether.
The fuel which fed the flames of the crisis, in a context in which previously much vaunted
hedges had become meaningless, was a large maturity mismatch and high leverage in the
financial sector. This translated perceived vulnerability into actual vulnerability.
Finally, the wind which fanned the flames came from the feedback loop associated with fire
sales.
Despite its dramatic effects, devising a response to this first phase of the crisis might, at first,
seem like a case study in a standard monetary economics curriculum. Bagehot's analysis of
the UK banking panic of 1866 delivered the insight that the central bank has to lend freely
against good collateral at a high rate. Also, Friedman and Schwartz's analysis of the Great
Depression suggested that the central bank has to accommodate liquidity preference shocks.
However, although these insights may provide inspiration, they do not provide an
off-theshelf recipe. Bagehot did not have in mind a monetary regime of fiat money and had a clear
view of which banks were sound and which were not. Friedman and Schwartz argued that
the Federal Reserve should have stabilised M2, which collapsed in the early 1930s. But only
stated this as a general rule without a detailed prescription. As a result, it remained unclear
how to implement it, starting from a situation in which the soundness of banks was uncertain
and the usual monetary instruments were different.1 There was also no consensus in the
economic literature on how to think about the monetary policy stance when markets are
suddenly unable to perform in the manner which most theorists prefer to assume: would it be
just the overnight market rate - normally controlled by the central bank - or a broader
concept encompassing the whole "risk-free" yield curve, or perhaps even including other
rates and asset prices?
The ECB's response to the crisis was to deepen the policy it adopted in "good" times in order
to also address "bad" times. In simple terms, this policy required us to continue to decide the
appropriate level for the short-term interest rate, while ensuring that the transmission
mechanism works as effectively as possible. The transmission mechanism is the long chain
of reactions that lead from a policy-rate change to its final impact on the real economy and
inflation via the effects on the whole array of interest rates, asset prices and monetary and
financial indicators more generally.
In normal times, the ECB decides on the appropriate level of the short-term interest rate and
provides the necessary liquidity to make such a rate prevail in the overnight market. A
forecast of the necessary amount of liquidity is based on the need for liquidity by banks at the
aggregate level. And the money market fulfils the task of distributing the liquidity across
individual banks in an efficient manner as the banks themselves provide intermediation.
In normal times, the change in the overnight rate is then transmitted to the whole array of
interest rates via arbitrage and somewhat predictable relationships, both along the
intertemporal dimension and the intra-temporal dimension. Trust in the stability of such
relationships led most of the academic literature prior to the crisis to focus on the policy rate
(or equivalently on the overnight market rate) as a summary indicator of financial and
monetary conditions - although this trust often was not shared outside the academic
literature.
Incidentally, I note that the idea that what matters for the transmission mechanism is the
whole array of interest rates and asset prices as well as balance sheets, and not just any
specific short-term interest rate has been a crucial theme in monetarist thinking. And
monetarists argued that monetary aggregates provide a handy summary indicator of the
changes in the various yields and asset prices.2
From the beginning of the financial crisis, the first element of the transmission mechanism
- the money market - ceased to function properly. Liquidity premia soared and arbitrage
transactions became thin.
With the collapse of Lehman Brothers, financial tensions affected almost all asset classes,
leading to a pronounced liquidity preference shock. As a result of the ensuing self-sustained
deleveraging process, interest rates and asset prices can lose contact with or change their
relationship to the central bank policy instruments.
In such circumstances, a central bank needs to regain control of the transmission
mechanism, meaning that it must steer financial and monetary conditions in a way that is
consistent with its price stability mandate.
The ECB responded to these challenges by cutting its policy rate - the main refinancing
operation (MRO) rate - and by switching to a fixed-rate full allotment regime. Under such a
regime, the central bank stands ready to satisfy fully the demand for liquidity - against
collateral - at the prevailing policy rate. In the absence of a functioning interbank market, that
demand for liquidity is in excess of the banks' liquidity needs under normal conditions.
Note that this regime can be maintained at any policy rate level, due to the presence of a
corridor in the ECB's operational framework. It simply implies that excess liquidity pushes the
overnight rate down towards the rate paid on the deposit facility. It also implies that the
corridor can provide for a way to detach the decision to provide liquidity from the decision to
set the interest rate.
Let me illustrate this point with an example. If market interest rates and bank lending rates
move in a manner inconsistent with a change in the policy rate, the central bank's ability to
influence the real economy and inflation may be impaired. The central bank can try to correct
this. Traditional wisdom is based on making an even larger change in the policy rate so that
the impact on financial and monetary conditions is of the originally-desired size. But another
solution is to anchor other rates directly to the central bank policy intentions by the provision
of liquidity.
The fixed-rate full allotment regime can achieve this outcome because, in effect, it squeezes
out the premium at short maturity via the intermediation role taken up by the central bank.
This assumes, however, that the counterparties of the central bank are still fundamentally
sound.
A similar logic can also be applied to longer maturities. The central bank can provide liquidity
at longer maturity at the average policy rate that will prevail in the future over this maturity.
This can be done at any level of policy rate. The existence of the deposit facility provides a
floor to the overnight rate. And the central bank can extend its influence over term credit by
lengthening the maturity of its lending operations.
One notable application of this logic was the 12-month refinancing operation enacted in
December 2009. In this operation, the ECB stood ready to satisfy fully the demand for
liquidity at one-year maturity. The interest rate charged on this liquidity was the average
MRO rate that would prevail over the life of the operation.
This type of measure is distinct from attempts to flatten the "risk-free" yield curve via forward
guidance which is often discussed in the literature. The reason is that it is aimed at
squeezing out the premium faced by banks over and above the current and expected policy
rate.
Let me recall that, in the euro area, about three-quarters of corporate finance comes from
banks. Hence, anchoring banks' funding conditions to the desired level can help ensure that
lending rates faced by households and firms continue to reflect policy intentions. This was
indeed the case during the first phase of the crisis, with lending rates declining in tandem
with policy rates according to standard regularities.3
Central banks' willingness to accommodate the increased demand for liquidity may, however,
be ineffective in preventing a destructive deleveraging process, unless two additional
elements are addressed.
First, there is a need to remove the stigma associated with accessing central bank liquidity.
The ECB did so by providing liquidity at an attractive price via monetary policy operations in
which a broad number of counterparties have access.
Second, deleveraging forces and fire sales have a direct impact on the value of collateral. To
address this situation, the ECB broadened its collateral rules, thereby also enabling banks to
take full advantage of central bank liquidity. At the same time, the ECB tightened its own
risk-control measures to mitigate the risk it absorbed.
Monetary policy in the period of the sovereign debt crisis
As we all know, the crisis did not remain restricted to the banking sector. In fact, from 2010
onwards, several euro area countries have experienced a severe sovereign debt crisis.
The driving forces of this evolution varied across countries. Some countries had already built
up weak fiscal positions before the crisis, which emerged as a major vulnerability in the
downturn. Others were overburdened by the fiscal costs of domestic banking crises. But
irrespective of its origins, in all cases an adverse feedback loop between bank and
government balance sheets emerged, which then spilled over national borders.
This adverse sovereign-bank nexus was nurtured by the large holdings of sovereign debt on
bank balance sheets. When market scrutiny of public finances and investors' risk aversion
suddenly increased, sovereign yields started rising. The implied, actual or potential, losses
for overly exposed banks raised the spectre of additional public support. As a consequence,
the credit standings of sovereigns and banks have moved in tandem and both have found it
increasingly difficult to maintain market access.
In several jurisdictions, the access of the banking sector to funding markets was heavily
impaired. There was a real threat of a second wave of disruptive deleveraging. And as banks
had already shed parts of their external and other non-core assets in the first wave, less
room was left for banks to protect domestic credit.
The propensity for banks to pass on the ECB's monetary policy signals to the real economy
fell markedly. In other words, there were renewed risks that the monetary policy transmission
channel could become severely impaired. But this time the ECB faced a new challenge: the
dislocation had taken on a distinctly national dimension. Financial market fragmentation
along national borders had become the new reality.
The ECB's response to this second phase of the crisis has been guided by the same
principle as in the first phase: decide on the appropriate level of the policy rate to maintain
price stability and preserve, to the extent possible, the proper working of the transmission
mechanism. Moreover, the experience we accumulated during the first phase helped us in
designing measures aimed at providing abundant liquidity, while avoiding stigma effects.
The ECB conducted two three-year lending operations indexed to the MRO (in December
2011 and February 2012). The operations were aimed at alleviating adverse funding
conditions for banks by allowing them to satisfy their additional liquidity needs. The net
liquidity injection amounted to around €520 billion - taking into account the shifting of liquidity
out of other operations. One key result was that the longer-term refinancing operations
(LTROs) provided banks with a more certain medium-term funding situation, in line with the
longer maturity of the operations.
The months following these operations saw a broad stabilisation of financial conditions.
Money and credit figures indicated that an abrupt and disorderly adjustment in the balance
sheets of credit institutions had been avoided. Funding conditions for banks generally
improved, and increased issuance activity and a re-opening of some segments of funding
markets could be observed.
However, the root-problems of the sovereign debt crisis were only partly addressed by
Members States. Hence, tensions in sovereign debt markets did not take long to resurface.
These tensions took a form that was specific to the institutional features of the euro area:
markets started questioning the irreversibility of the common currency, thus pricing in
redenomination risk in sovereign bond yields of vulnerable countries. The ensuing disruptive
dynamics risked undermining one of the key motivations for introducing the euro, namely to
provide a lasting safeguard against currency crises, such as the one experienced in Europe
in the years 1992-93.
The main symptom of these problems was a pronounced movement towards financial market
fragmentation. For example, the cuts we made in the MRO rate over the period had very
heterogeneous effects on funding conditions in different countries. In some countries, retail
lending rates declined, but in others they hardly moved or even increased. As a
consequence, the singleness of monetary policy in the euro area was no longer guaranteed.
And the countries in greatest need of a further expansionary impulse were the ones that
were impacted least by cuts in the policy rates. This drags down their domestic economies
and further weakens their fiscal positions.
To mitigate the dynamics of such self-sustaining fragmentation, the ECB decided to adopt
Outright Monetary Transactions (OMTs). OMTs provide for interventions in government bond
markets, with no ex ante limits, for countries that are subject to effective conditionality of a
programme under the European Stability Mechanism (ESM).
The aim of OMTs is to directly address excessive risk premia in government bond markets
that reflect in particular unwarranted perceptions of redenomination risk and are a key source
of impairment in monetary policy transmission.
By imposing conditionality, OMTs aim to strike a balance between counteracting adverse tail
risk and preserving incentives. Specifically, OMT conditionality ensures that countries commit
themselves to a path of ambitious fiscal consolidation and structural reform, thereby
preserving fiscal sustainability. This has two functions: first, it mitigates the balance sheet risk
associated with outright purchases; second, it preserves the monetary policy rationale for
OMTs. If countries were to reduce their adjustment efforts in response to ECB intervention,
the beneficial effects of OMTs on the monetary policy transmission would be undermined by
weaker fiscal and macroeconomic fundamentals. Therefore, conditionality is an inherent
feature of OMTs.
Specific challenges facing the single monetary policy for the euro area
The twin banking and sovereign debt crises, with heterogeneous manifestations across the
single currency area, has put a premium on deleveraging - or at least a curb on leveraging -
both in the banking sector and government sector. This contrasts with the greater emphasis
on household sector deleveraging as driver of the US "balance sheet recession" in the wake
of the financial crisis, to take the words of Koo.4 It also contrasts with the greater emphasis
on corporate sector deleveraging in the Japanese case over the past two decades.
In part reflecting these circumstances, the ECB's approach during the crisis has also been
different to that of other major central banks. The ECB's main focus has been on
collateralised lending, whereas the focus of other major central banks has been on
largescale asset purchases. This has had, in turn, implications for the pace and size of
deleveraging in the euro area economy.5
In this respect, the ECB's approach can be seen as more indirect than the approach based
on large-scale asset purchases. Both approaches, by supporting the capacity of the
monetary and financial sector at large to acquire assets, can support asset prices and
lending, which is conducive to a smooth deleveraging process in the economy.
Asset purchases directly create scarcity in the instrument being purchased. This exerts an
upward pressure on prices, and, through portfolio rebalancing effects, may also affect the
prices of other assets. However, direct asset purchases involve a difficult choice for the
central bank: it must take a decision on which assets to buy, necessarily interfering with
relative asset prices and income distribution.
Collateralised lending involves such decision only at the level of the definition of the collateral
and its eligibility conditions. This can also influence the prices of collateral, but the role of
selecting which assets to buy or sell is essentially "outsourced" to the banking system, that
is, to many private agents. Hence, collateralised lending leaves the price discovery process
and the allocation of savings to market mechanisms.
The specificity of the ECB's approach must be seen against the background of the
bank-based financing structure of the euro area economy which I mentioned earlier - in
contrast to the more market-based financing in the United States for instance. It must also be
seen against the specific institutional environment in which the ECB operates - characterised
by a multi-country context.
Some commentators suggest that governments should always take on leverage when there
is excessive deleveraging in the private sector. But this option rapidly reaches its limits in the
presence of debt sustainability concerns. And it has done so more quickly in the euro area
than in other economies where the institutional framework is different.
In a context of macroeconomic imbalances across the euro area countries and financial
market fragmentation, the Eurosystem balance sheet has expanded in size, with an
increased concentration of liquidity provision to banking systems in countries under strain.
The asymmetric distribution of the ECB's action across the euro area has attracted attention,
also from a political viewpoint. What is insufficiently reflected in this debate is that this
asymmetry is endogenous and is a result of the single monetary policy.
This asymmetric action across the euro area is also reflected in increased Target2 balances
on the balance sheets of Eurosystem central banks. Such an endogenous shift in
composition has acted as an internal adjustment mechanism, whereby the fallout of funding
pressures in the banking system has been directed into the Eurosystem and away from the
real economy.6 This has buffered the adjustment of the real economy and kept trade and
financial flows flowing across euro area countries, thereby preventing disorderly
deleveraging. It has provided time for governments individually and collectively to address
the adjustment needs and undertake the appropriate reforms. But this time needs to be used
effectively.
The ECB's non-standard measures have been ensuring that solvent banks are not
liquidityconstrained so that they continue lending to the real economy without a disorderly
deleveraging process. However, there are limits to what monetary policy can and should
credibly do: monetary authorities cannot be expected to solve problems which lie well outside
their current official remit.
The delicate balancing act
More generally, a central bank should be aware that it is constantly required to exercise a
delicate balancing act. On one hand, it may need to provide backstops to remove tail risks
that could otherwise result in severe downward pressure on price stability. On the other
hand, by mitigating a crisis which largely reflects shortcomings in other policy areas and
excesses in the financial sector, the central bank may alter incentives for different actors to
correct imbalances.
If domestic policy-makers and other economic actors delay necessary reforms because they
can count on the central bank to provide support whenever market conditions deteriorate,
monetary policy may become insufficiently effective, as well as biased towards the short
term. In the words of Hervé Hannoun, the Deputy General Manager of the Bank for
International Settlements, a central bank has to constantly guard not only against the risk of
"fiscal dominance" but also "financial dominance".
I would like to give one example. A central bank can commit itself to engaging in
extraordinary monetary policy interventions and to swiftly reversing them as conditions
improve. But would this commitment be sufficient to align the incentives of all the actors
involved? In the economic jargon, is this promise "time consistent"? Or will other economic
agents expect the policy-maker to deviate from its stated intention and adjust their actions
accordingly?
Economic literature stresses two elements that add credibility to such commitments: strong
institutional frameworks setting out clearly defined objectives; and the adoption of "rule-type
behaviour" that consistently and predictably determines the response of policy-makers to
specific circumstances. These elements allow a policy-maker to steer the expectations of
other actors in line with its long-term intentions, thereby mitigating the time inconsistency
problem.
As regards monetary policy, the institutional framework set up for EMU - central bank
independence and price stability objective being the key elements - has proved to be strong
and effective.
The crisis has shown, in my view, that the "rule-type behaviour" has to be provided by a
symmetric reaction of central banks to financial forces. In particular, a strong reaction to
financial distress in the downturn has to be matched by a strong reaction to financial
imbalances during the building-up phase.
What is the best way to do this? I believe that a more symmetric reaction to financial forces
can be best ensured by according a prominent role to the analysis of money and credit
developments in monetary policy decisions, especially if this is complemented by appropriate
macro-prudential measures.
But it should be recognised that monetary policy is only one element of the overall
institutional framework.
The current sovereign crisis is largely the outcome of severe shortcomings in the institutional
architecture of EMU, which was not capable of fostering prudent fiscal, structural and
financial policies. But policy-makers have reacted to these shortcomings and have set in
motion ambitious reforms to strengthen economic governance in Europe.
Earlier today, my colleague Vítor Constâncio discussed the rationale of this reform agenda in
great detail. I will therefore not elaborate on this. But I would like to echo his assessment.
The repair of the institutional architecture of EMU will contribute to addressing the underlying
causes of the crisis, thereby also supporting the smooth functioning of EMU in the future.
Conclusions
Let me conclude.
The crisis brought about several waves of financial turmoil that threatened to spiral out of
control. In line with its price stability mandate, the ECB intervened in each of these episodes
so as to tackle the specific threats to the monetary policy transmission that arose with each
incarnation of the crisis.
The policy actions of the ECB, and of all other major central banks, have been able to
repeatedly ward off self-sustaining feedback loops characterised by disorderly deleveraging.
The challenge ahead for central banks consists, in my view, of combining such a backstop
role during a crisis with a credible commitment to adopting symmetric behaviour in the run-up
phase of financial imbalances.