Jarle Bergo: Nominal and financial stability in a new economic world
Speech by Mr Jarle Bergo, Deputy Governor of Norges Bank (Central Bank of Norway),
Valutaseminaret, Sanderstølen, 1 February 2008.
* * *
Thank you for inviting me once again to this venerable institution - Valutaseminaret. It is a
pleasure to be here with you. This morning I will discuss with you some issues under the
broad heading of "Nominal and financial stability in a new economic world".
Introduction
The general economic environment has changed dramatically over the past 30-40 years.
When I started my career as an economist in the late 1960s, a belief had evolved that the
economy could and should be controlled and steered in considerable detail. A widespread
view was that markets should be regulated and coordinated by authorities. Furthermore, the
Phillips curve was embraced as proof that a long-run trade-off between inflation and
unemployment existed. By merely accepting somewhat higher inflation, it was thought
possible to reduce unemployment in the medium and long term. The economic policy of the
1970s and 1980s, which was based on these views, led to high and variable inflation and
wide fluctuations in the economy.
In the face of the disappointing experience from this period and advances in economic
theory, put forward by among others the Nobel Prize winners Phelps, Friedman, Kydland and
Prescott, views have now changed. We have learned that low and stable inflation is the best
contribution monetary policy can make to high and stable growth. The absence of a nominal
anchor was one of the main reasons behind the pronounced swings in the real economy in
the 1970s and 1980s. It was demonstrated that a long-run trade-off between inflation and
unemployment does not exist. Today, monetary policy aimed at price stability is the norm,
and in most countries monetary policy has been delegated to independent central banks.
We have also learned that very high policy ambitions are not compatible with the way the
economy really works. Attempts to control all the quirks of the economy will eventually
undermine the intentions. In fact, by scaling back on overly high policy ambitions the overall
outcome will be better. Today the beneficial effects of making full use of markets in resource
allocation are again widely recognised. State ownership and "dirigisme" have been reduced.
Competition has increased in most markets, though lapses do occur from time to time. Trade
barriers have generally been lifted or reduced. Well developed financial markets help move
capital across borders and between industries.
Today's economic environment has in many respects risen from the ashes of failed
paradigms. In a sense, today's regime resembles the one we had 100 years ago. From the
mid-19th century until the outbreak of the First World War, capital markets were integrated
across countries that had adopted the gold standard. Markets were largely deregulated.
Cross-border financial capital movements were subject to little or no regulation. There was
solid confidence in the gold standard as a nominal anchor. Inflation was low and stable,
supporting economic growth.
The links between countries today are even stronger and broader than was the case 100
years ago. The number of countries taking part in the global exchange of goods and capital
has soared. China, India, Russia and many other emerging markets have during the past
twenty years opened their borders and embraced capitalist reforms. The economic world has
become larger. What we have seen is, to use the words of Federal Reserve Chairman Ben
Bernanke, "a wave of worldwide economic integration and increased economic
interdependence".1
Economic developments the past 15 years have been extremely favourable. Inflation has
generally been low and stable. At the same time, compared to the 1970s and 1980s
economic growth has been higher and recessions shallower. Better monetary policy and a
firm nominal anchor are in my view vital factors behind this "great moderation". But
intensified competition and increasingly deeper and more integrated markets for goods,
services, capital and labour have also contributed to containing inflationary pressures and to
making economies more resilient to shocks. Even more importantly, globalisation and a
better economic framework have lifted hundreds of millions out of poverty, an achievement
that far surpasses anything development aid has ever accomplished.
"The age of
In his book turbulence", former Federal Reserve Chairman Alan Greenspan
states that "...we are living in a new world - the world of a global capitalist economy that is
vastly more flexible, resilient, open, self-correcting, and fast-changing than it was even a
quarter century earlier. It's a world that presents us with enormous new possibilities, but also
enormous new challenges."2 In my presentation here today I will, not surprisingly, take a
central banker's view and ponder the challenges this new world might raise for a central bank
trying to achieve both financial and nominal stability.
Financial stability
The last decade or so, we have witnessed increased financial integration and competition
across national borders. The unleashing of international competition in financial markets is a
positive development. By spreading and diversifying risk, financial markets have become
more efficient and stable. Deeper and more mature markets tend to be better equipped to
deal with uncertainty and distress.
We have also witnessed the forging of new and ever more complex financial instruments.
Increasing the set of available financial instruments creates more complete markets. It
enhances the opportunities for households and enterprises to decouple consumption and
investment from current income. Investors can take on or load off risks in a more tailored
fashion than before and actively manage their exposures and relocate risks to those best
equipped to bear them.
Yet, the flip side of increased financial integration and diversification is the potential for more
widespread contagion if something goes wrong. Furthermore, rapid innovation and increased
complexity can make it difficult to assess the real underlying risks of the new instruments. It
takes time for borrowers and lenders to learn the true characteristics of new instruments.
This increases the possibility that some investors - and issuers, for that matter -
misunderstand the riskiness of an instrument. As a consequence, expected return may not
appropriately reflect the true risk. When the true risk of an instrument starts to reveal itself,
sharp corrections in the market may follow.
The recent subprime crisis is one example of how new and complex instruments can give
rise to global financial turmoil. Problems stemming from over-optimistic price expectations for
the US housing market have spread to investors and financial institutions all over the world.
The wide dispersion of the financial turmoil took many of us by surprise. Not to mention
where problems turned up; in German Landesbanken, in large investment banks and in
Norwegian hydro-electricity-rich municipalities, to name but a few.
One lesson from the current financial turmoil is that the expected advantages of
securitisation have been somewhat exaggerated. Securitisation was believed to make
markets deeper and more liquid and - most importantly - to provide continuous pricing.
Recent events have shown that this is not necessarily true for all markets at all times. In
times of distress and uncertainty, some financial market segments can cease to function.
When no trading takes place, no updated prices are quoted. This represents a challenge for
institutions, auditors and regulators trying to mark assets and liabilities to the market.
This has amplified the impact on the financial sector of the defaults on subprime mortgages.
In the absence of pricing, the balance sheets of financial institutions holding such
instruments became opaque. Uncertainty about the potential loss of other banks and about
their own future liquidity needs has made banks reluctant to lend to each other. To the
surprise and dismay of many, the extremely efficient and well-functioning money market
ground to halt. Central banks had to step in and provide liquidity to the banking system.
When money markets go into gridlock, it is appropriate for central banks to ease banks'
liquidity problems, but they should do so at a price that maintains the incentive to restore the
smooth functioning of the market.
Losses and evaporating liquidity then hit the capital base of many financial institutions. So
far, the most severe problems have been local or national, like the British bank Northern
Rock and the Norwegian brokerage house Terra Securities. These problems were resolved
by means of national remedies. But with increased integration and the emergence of
crossborder banks, sooner or later we are bound to encounter a problem in a bank or financial
institution that may be systemically important in several countries (but not necessarily in the
home country). The existence of cross-border institutions makes crisis management more
challenging, as it necessitates close cooperation between central banks, supervisory
authorities and finance ministries in different countries. With one global financial market, one
could wish there were one supervisory authority, one liquidity provider and one public
treasury with a common script for handling crisis situations. We are far from this point. At the
recent Davos World Economic Forum the head of the BIS, Malcolm Knight, stated that the
"major challenge" "the Balkanisation of regulation - fragmented across
for regulators was
market segments, across national jurisdictions and yet we want to have a global financial
3
system."
A single financial market is one of the EU's objectives. Against the background of growing
integration, crisis management has been moved up on the agenda within the EU. Norway is
participating in extensive discussions on this topic under the auspices of the EEA agreement
and in separate talks with the other Nordic countries. As an example, the Nordic central
banks have agreed on a Memorandum of Understanding on crisis management that provides
guidelines for information sharing and gathering, coordination of decision-making and so on.
The surprisingly wide dispersion of the subprime crisis has led to calls for an international
overseer charged with keeping a complete account of the financial flows and pipelines that
transfer contagion across borders in order to provide an early warning system to identify
emerging crises. In a speech two weeks ago, British Prime Minister Gordon Brown proposed
a new role for the IMF: "...its role should be to prevent crises and not simply manage or
resolve them as in the past. And in a wider role the IMF, working with the global financial
stability forum, should be at the heart of what we need - an early warning system involving
regulators and supervisors in all countries for financial turbulence affecting the global
economy."4
Obviously, there are pipelines that are not on our present maps. Also, our knowledge of what
flows through the known ones is scarce. But would it help us if we knew? Would we be able
to predict a looming crisis and thus prevent it? I do not have the answer to this, but I think it is
fair to raise the question.
We must expect turmoil in financial markets to occur from time to time. There will always be
stupidity and greed, fear and euphoria (and some scoundrels). Accidents will happen.
Authorities should strive to establish regulatory frameworks that give the right incentives for
prudent behaviour. It is important to avoid overregulation that severely restricts markets and
stifles innovation. We must of course make sure that obvious shortcomings in existing
regulations are corrected. One such loophole was the possibility for banks to provide
shortterm guarantees without having to set aside regulatory capital. The new capital adequacy
framework, Basel II, rectifies this situation. It is also important to encourage market discipline
and counterparty surveillance, crucial elements to the well functioning of financial markets.
Basel II is enhanced through the so-called Pillar III, which requires banks to publish
information on key parameters of their business profile, risk exposure and risk management.
The recent episodes have also reminded us of the importance of vigilance and competence
in supervision.
In general, the markets themselves are the best regulators as long as economic agents
follow the advice of Sir John Gieve, Deputy Governor of the Bank of England: "Financial
markets ... can only work well if investors and firms expect to live or die by their own
decisions and do not come to rely on a safety net to mitigate their losses."5 That is a good
advice also with respect to safeguarding financial stability in a rapidly changing world. We
might not be there quite yet. With reference to the banking industry, as Martin Wolf so
eloquently put it in the Financial Times: "No industry has a comparable talent for privatising
gains and socialising losses. Participants in no other industry get as self-righteously angry
when public officials - particularly, central bankers - fail to come at once to their rescue
when they get into (well-deserved) trouble."6
Nominal stability
Let me now turn to challenges to nominal stability.
The entrance of new, large emerging economies into the world trading system has strongly
influenced relative prices and the prospects for nominal stability. The potential labour supply
available for the global economy has doubled7 and increased relative to the supply of capital.
Wage shares have fallen and profit shares have risen, both globally and in Norway. Firms in
high-cost countries increasingly offshore activities to low-cost countries. Imports of goods in
industrialised countries have shifted from high-cost to low-cost countries. Furthermore, the
collapse of the Soviet Union and the accession of Central and East European countries to
the European Union have played a significant role for the labour market in Europe. Labour
migration has increased. Off-shoring and outsourcing - or merely the threat of it - may have,
at least temporarily, reduced the bargaining power of trade unions and employees. Increased
competition, both in product and labour markets, has probably motivated
productivityenhancing measures. Productivity growth has been unusually high.
Lower import prices, intensified competition and high productivity growth have been
important disinflationary forces both in Norway and elsewhere. As a result, many countries
have been able to bring down inflation at virtually no cost. In this respect, we can probably
talk about some degree of endogeneity in inflation. However, it is still the non-trivial task of
monetary policy to ensure that inflation remains low and stable on a more permanent basis.
In a country with its own national currency, inflation is not something that just drifts in with the
wind from abroad. It is the monetary policy choices we make that determine price
developments over time. As Ken Rogoff, professor of economics at Harvard University, has
"...any central bank, no matter how small or open its economy, can
so aptly phrased it:
always stabilise domestic prices at medium- to long-term horizons, should it choose to do
so...Globalisation may affect the parameters of central bank models, but independent central
banks still control their own inflation
destinies...".8
For some years now, the short-run trade-off between inflation and economic growth has
been extraordinarily favourable. Inflation has been low and economic growth high. We have
been hit by massive and long-lasting positive supply shocks thanks to the globalisation
process. To accommodate a higher growth potential and to maintain the nominal anchor,
central banks worldwide for a long period held short-term interest rates well below what can
be regarded as a normal level.
Furthermore, long-term real interest rates have declined markedly since the 1980s and the
beginning of the 1990s and have been especially low in recent years. A fall would seem
reasonable since expectations concerning future inflation in our economy and the world
economy have become far more stable, thus reducing the inflation risk premium.9 But it
seems unlikely that this is the whole explanation. Two theories are often invoked to explain
the low real interest rates in recent years: The saving glut theory and the liquidity glut theory.
The saving glut theory posits that some countries for various reasons have very high
propensities to save10 and lack sufficient domestic investment opportunities. Current account
surpluses, particularly in Asian countries and oil-exporting countries, have increased the
world's total savings, thereby exerting downward pressure on long-term interest rates to
bring capital markets back into balance.11 In this case, low real interest rates globally can be
understood as a natural response to the preferences of welfare-maximising economic
agents. For a given country, these interest rates might seem uncomfortably low, but
monetary policy-makers' scope for influencing this is limited.
Alternatively, or additionally, low long-term real interest rates can be seen as a consequence
of excessive liquidity creation. Central banks may have fuelled the markets with low
shortterm rates and very generous supplies of liquidity to prop up growth or to keep inflation from
falling below target. But financial intermediaries also create liquidity.12 As financial markets in
8
Kenneth S. Rogoff (2006): "Impact of globalisation on monetary policy", A symposium sponsored by Federal
Reserve Bank of Kansas City, Jackson Hole, Wyoming. Uncertainty about future inflation generates
uncertainty as to the real value of investments and investors may require an extra compensation - a risk
premium - for this.
9
Uncertainty about future inflation generates uncertainty as to the real value of investments and investors may
require an extra compensation - a risk premium - for this.
10
E.g. because of inadequate public pensions and safety nets or the desire to make inter-generational transfers
of proceeds from non-renewable resources.
11
The saving glut theory has been emphasised by Ben Bernanke (2005), now Chairman of the Federal Reserve,
in the speech "The Global Saving Glut and the U.S. Current Account Deficit", see www.federalreserve.gov.
Since then the list of references discussing this issue is unlimited, but the IMF World Economic Outlook
September 2005, "Global Imbalances: A saving and investment perspective" offers a discussion.
12
One proponent of the liquidity glut theory is Richard Duncan "The Dollar Crisis", John Wile & Sons, 2005. See
also the survey of the world economy in The Economist September 16TH - 22ND 2006 (Unnatural Causes of
Debt) for a discussion.
BIS Review 14/2008
different countries have become more integrated and new financial instruments have been
introduced, liquidity and credit flow more easily between borrowers and lenders across
borders. More than ever before financial intermediaries are driving the global credit- and
liquidity creating process, and today, financial intermediaries have a substantial impact on
global monetary conditions. In a recent article in the Financial Times, Mohamed El-Erian
"Central bankers now operate in a world where monetary policy influences
observes that:
only a small part of the fluctuations in overall liquidity in the economy. Endogenous liquidity,
or the extent to which the market itself expands and contracts liquidity, has taken over as the
main driver."13
This may well be so but it is far from obvious why abundant liquidity, which is necessarily
short-term, and low short-term interest rates should keep long-term rates very low over
protracted periods of time. There might have been elements of both a saving glut and a
liquidity glut in recent years. It seems fair to conclude, however, that in the global economy
there is limited scope for the individual central bank to influence long-term real interest rates.
In a Wicksellian sense this might be awkward. In a way we can argue that the root cause of
these challenges to monetary policy is the global macroeconomic imbalances.
While improved monetary policy and the globalisation process have contributed to lower
inflation and lower output volatility, asset price and exchange rate volatility seem to have
been unaffected.14 In fact, some argue that with a credible nominal anchor and stable
inflation expectations, low interest rates and hence higher liquidity first and foremost translate
into higher asset prices - not higher inflation as measured in the conventional way.15 Rapidly
rising property prices and debt over long periods can be a source of future instability in the
real economy. This has fuelled a debate as to whether monetary policy should give weight to
developments in property and credit markets beyond their impact on consumer price
inflation, and react in a precautionary manner to prevent an excessive surge in asset prices.
Surely, expansionary monetary policies have contributed to the rise in property prices and
debt accumulation. Asset prices generally will react to changes in short-term interest rates,
but one would expect such movements to more or less even out over the cycle. But more
fundamental forces have also been at play. First, the neutral real interest rate has probably
fallen substantially over the past 5-10 years, maybe as much as 2 percentage points. Such a
fall in the discount factor should have a large impact on asset prices like property and land.
Second, Norway has recently experienced very strong, positive income shocks. For capital
and labour that flow freely across borders, prices primarily reflect global growth and
competitive conditions. The price of fixed capital, such as land, however, will be influenced
by expected future income in a country. In periods with sharp increases in income and
income expectations we would therefore expect land prices to rise at a faster pace than other
prices. This is a real economic effect, which monetary policy over time cannot eliminate.
It is very difficult to establish whether rapidly increasing asset and house prices are bubbles,
or whether the price increases are driven primarily by economic fundamentals. If we were
convinced of the existence of a bubble and had the necessary instruments available, we
should act. But it is not our conviction that monetary policy can in any meaningful way control
asset price developments. Low and stable consumer price inflation is the operational target
of monetary policy. There is, however, an ongoing discussion on how best to capture the
cost of housing in the CPI. It might very well be that our present methods could be improved.
While monetary policies aimed at nominal stability have stood us in good stead, and can
continue to be pursued also in a world where markets are truly global, the sailing might very
"...the greatest challenge ahead for central
well be less smooth ahead. As Ken Rogoff puts it
banks is to make sure that their institutional mechanisms for preserving low-trend inflation
are robust to possible setbacks in the future course of globalisation..."16
As I pointed to earlier we have been greatly helped by positive supply-side shocks in recent
years. Fighting inflation has been almost costless. This may change in future.
One could argue that the process of disinflation will ebb, and downward price pressures from
cheap imported goods abate. What initiated the process of disinflation in the first place was
the integration of labour-abundant developing countries into the world economy. In the
course of time these countries will "catch up" and achieve a production and income level per
capita more similar to that of industrialised economies. They will experience a real
appreciation. This can happen through a nominal appreciation of local currencies, or by
higher wage- and price inflation. Either way, it will have inflationary consequences for the rest
of the world.
With easing disinflation pressures, and if prices for energy, other raw materials and food
remain high, the positive supply shocks we have faced during the last decade may fade
away, posing new challenges to monetary policy. Our dismal economic history from the
1970s and 1980s clearly shows that maintaining nominal stability is of the utmost
importance. So inflation must be fought, also if it should rear its head in periods of low
growth. Real interest rates may need to be higher than what we have seen in the period of
"great moderation". The costs will certainly be felt, but compared with the situation 30-40
years ago, the macroeconomic framework is now well established and central banks have
accumulated credibility over a number of years as witnessed by fairly stable long-term
inflation expectations. In this sense, the economy is now more robust to shocks and costs
should be smaller.
There is reason for us all to be braced for a negative supply shock of considerable
magnitude in the years to come. If global warming is a threat to mankind - and much
evidence suggest it is - then carbon dioxide (and other) emissions must be reduced. That
will entail costs, real costs. Our future consumption path will be lowered, perhaps sharply.
But as compensation we should have improved prospects for mankind.
We have a choice however in how we go about reducing emissions: The efficient way, taxing
emissions (or auctioning permits) and using the markets; or the truly costly one of trying to
subsidise away the problems with highly uncertain results. The debate and actual efforts so
far give only moderate hope of a good outcome. But let us be optimists - at least for the time
being.
To combat climate change, the relative price of fossil fuels must increase. This can be
regarded as a negative cost-push shock. Is there a role for monetary policy here? Yes, as in
the case of other negative supply shocks: Keeping inflation low and stable must be the
overriding objective. And with regard to reducing emissions, keeping inflation low and stable is
perhaps even more important, as this will help make changes in relative prices more visible.
Concluding remarks
Globalisation has so far given us the best of two worlds, high growth and low inflation. But
looking ahead there might be challenges to both nominal and financial stability.
We must preserve a nominal anchor, even when times may become more difficult. History
has shown us that low and stable inflation is the best contribution monetary policy can make
to growth and macroeconomic stability. A new, globalised world does not change this
paradigm.
Financial stability is enhanced by "smart" regulations that provide the right incentives. It is
important to encourage innovation and to avoid overregulation. We must expect losses to
occur and the losses should be borne by investors and financial institutions themselves to
the fullest extent possible.
Some might argue that I am behind the curve and that I should rather be discussing the
breakdown of the global financial system. George Soros has argued that "This is not a
normal crisis, but an end of an era."17 I do not subscribe to this view, though I admit I might
be proven wrong. I would rather regard the present turmoil as evidence of the self-correcting
properties of our system. Yes, corrections can be costly. Thus, we should aim at organising
the system to be even more resilient and well-functioning. I remain convinced, however, that
we would be wise to continue to base our economic system on open borders, competition
and increasingly deeper and more integrated markets for goods, services, capital and labour.
Thank you for your attention!