Ewald Nowotny: Central banking after the crisis - responsibilities,
strategies, instruments
Opening remarks by Mr Ewald Nowotny, Governor of the Austrian National Bank, at the
38th Economics Conference of the Austrian National Bank, Vienna, 31 May 2010.
* * *
Dear Chancellor Faymann,
Dear President Trichet,
Ladies and Gentlemen,
It is my pleasure to welcome you to this year's Economics Conference on behalf of the
Oesterreichische Nationalbank. We are especially grateful that Chancellor Faymann and
President Trichet are here with us this morning. Let me also use this occasion to publicly
thank the Austrian government under Chancellor Faymann and Vice Chancellor and Finance
Minister Pröll for the excellent and respectful cooperation between the Austrian government
and the Austrian central bank in these very challenging times. I would also like to use this
occasion, President Trichet, to express my full admiration and trust in your leadership of the
ECB during the years of crisis and especially also over the past few weeks. We all had to
navigate, as you always say, in unchartered waters - and it was extremely important in this
situation to have such an experienced captain in command. My own life experience has
taught me that we should never underestimate the human factor, also in big policy issues.
Thus, it is essential for the ECB to have a President who, due to his experience and life-long
achievements, is able to communicate convincingly that the ECB is and remains fiercely
independent and inflexibly attached to its primary mandate, price stability. We are proud
indeed that price stability has been fully maintained in the euro area since the inception of
the euro more than 11 years ago.
Ladies and Gentlemen,
This year's Economics Conference is entitled "Central Banking after the Crisis: Responsibilities,
Strategies, Instruments".
The term "after the crisis" seems somewhat premature and obviously needs some
clarification. It refers to the specific role of central banks and the lessons to be learned from
the experience of the past three years. But we have to keep in mind that crises follow
a typical sequencing, as Professors Reinhardt and Rogoff have shown (again) recently:
A banking crisis tends to evolve into a general crisis of the financial sector, which may then
trigger a crisis of the real sector of the economy via financing channels and wealth effects.
And this, in turn, may lead to a crisis of public finances via automatic stabilizer effects and
additional measures.
The big challenge is to prevent a vicious circle in which a crisis of the public sector again
leads to crisis developments in the financial and real sectors of the economy. Preventing
such a vicious circle was indeed the main motivation for the actions taken by European
governments and by the ECB this month.
At this conference, however, we do not intend to focus on actual crisis management but will
try to gain some insights into - or at least a feel for - underlying longer-term developments.
Those of you who know me from my academic profession know that I am a great believer in
the importance of knowing economic history, and especially understanding economics as
disequilibrium economics - to follow the approach of my academic teacher and friend, Kurt
Rothschild.
So please allow me to use these opening remarks to introduce some historical perspectives.
I will give you two quotes and let you guess who made them and when. Both quotes
comment on the link between monetary policy and financial stability, in particular on how
central banks and monetary policy should deal with financial imbalances and ensuing
financial crises. Here is quote number one:
"[N]othing short of a sharp increase in short-term rates that engenders a
significant economic retrenchment is sufficient to check a nascent bubble. The
notion that a well-timed incremental tightening c[an be] calibrated to prevent [a]
bubble is almost surely an illusion. Instead, we [...] need to focus on policies to
mitigate the fallout when it occurs and, hopefully, ease the transition to the next
expansion."
And number two:
"The idea that central banks can thwart financial crises - in the sense of
preventing their occurrence - is absolutely wrong; however, large and solidly
governed central banks can contribute crucially to a milder resolution as their
strength and unquestioned credibility provides a safe recourse in a climate of
general unsteadiness and eases the return of confidence."1
Now for the solutions:
The first quote - and I am sure many of you have got this one right - is from Alan
Greenspan. He made these remarks in his capacity as Chairman of the Federal Reserve in
2002 during a speech before the annual central bankers' meeting in Jackson Hole.
Greenspan discussed the experience of the sharp increase in the price of technology stocks
- the dot-com boom - that had burst two years earlier in 2000. Greenspan argued that
central banks stand no chance when it comes to preventing bubbles. First, they would have
to be able to recognize a bubble when everyone else was still thinking that prices were
driven up by technological progress or increased future earnings. Second, and this is the
point he makes in the quote I have just given, the central bank's policy tool, the short term
interest rate, is very blunt: An increase in the interest rate is either too small to affect the
targeted asset prices, or so large that it harms the entire economy. So what central banks
should do instead of using the interest rate preemptively is to mop up the mess after the
crisis, which is in fact what the Fed did after 2000/2001 by keeping the interest rate at very
low levels for quite some time.
The point made in the second quote sounds very much like Greenspan's: Again it is argued
that central banks cannot (and should not) prevent bubbles from arising. Instead they should
throw their weight behind a swift restoration of stable conditions after the outbreak of a
financial crisis. However, this quote is not from Greenspan. You might have suspected from
the somewhat archaic wording - like for instance the "strength of the solidly governed central
bank" or the "climate of general unsteadiness" - that it is older. This is true. In fact, it dates
from 1870 and is drawn from a testimony of the then Secretary General of the
AustroHungarian National Bank, Wilhelm von Lucam, to the Hungarian Parliament. Lucam was a
widely regarded expert in economic and monetary matters. In late 1869, the Hungarian
Parliament called for a parliamentary commission on monetary reform. One of the subjects to
be discussed was the Hungarian stock market crash of 1869.
Following the "Ausgleich" - a compromise that saw the creation of a largely autonomous
Hungary within the dual monarchy of Austria-Hungary - the newly gained political
independence and a series of bumper harvests fuelled optimism. New banks, railroads and
other companies sprouted in Budapest, the period was named the famous "Gründerzeit", or
"founder years". And in fact, at the Ringstraße in Vienna and in the center of Budapest, you
can still see the marvellous buildings that give testimony to the optimism of this period.
However, excessive speculation in Budapest led to a crash in 1869. In 1870, the
disappointed members of the Hungarian Parliament were looking for the culprit, and the
Austro-Hungarian National Bank (that issued money for both the Austrian and the Hungarian
parts of the monarchy) was among the natural candidates. It is in this context that Lucam
testified before the parliamentary commission, arguing that the bank had neither been in
there for the creation of the speculative bubble nor was it responsible for its eventual
bursting.
He also maintained that, not only in this specific case but as a matter of principle, a central
bank had no means at its disposal to prevent a bubble from arising but could only do its
utmost in the period following the crash to restore confidence in the financial system and the
economy at large.
Note one last interesting parallel in terms of timing between the statement made by
Greenspan in 2002 and the one by Lucam in 1870: Both came one year after a sharp fall in
the stock markets; in both cases, the much larger financial crisis was only to come a couple
of years later. Greenspan advanced his ideas of "mopping up" after the burst of the dot-com
bubble in 2001, but the true shock hit in 2007/2008. And it was the year 1873, three years
after Lucam's testimony, that saw the infamous May 9 - the Black Friday on the Vienna stock
exchange - that ushered in a prolonged period of economic stagnation.
I hope these two examples have convinced you that the interactions between monetary
policy and financial stability are barely new questions for central bankers. In fact, the debates
were at the center of the process that saw the emergence of modern central banking in
England in the early 19th century.
At that time, monetary stability had a slightly different meaning from today, as it was mainly
understood as a stable price of precious metal (silver, gold, or both) in terms of the domestic
currency. When talking about price stability today, we look at a broader set of goods: in the
euro area, for instance, the basket of goods used for the Harmonised Consumer Price Index
(HCPI). However, both then and now has monetary policy principally aimed at achieving
monetary stability, and the questions about the implications of monetary policy actions and
their interaction with financial stability resemble each other quite a bit.
Is monetary stability a necessary precondition for financial stability? That is, do we need an
environment of stable prices for a healthy financial sector? Or to put it even stronger: Is
monetary stability sufficient for ensuring financial stability? In other words, is a monetary
policy that successfully keeps prices stable by itself already a guarantee for stability in the
financial system?
Or is the contrary true: that monetary stability, instead of ensuring financial stability, could
lead to financial instability (a point made by BIS economists not too long ago)? At first, it
might seem paradoxical that something good (stable prices) could bring about something
bad (financial instability). The idea here is that policies that narrowly focus on price stability
might fail to consider arising imbalances in the financial area or even set in motion processes
that put financial stability at risk. For instance, for the recent crisis, some have argued that
low inflation rates, low interest rates and a general sense of confidence in the central banks'
ability to deal effectively with any shock to the economy that might come - all positive things,
I would argue - have led economic agents to underestimate risks and to take positions that
in the end turned out to be unsustainable.
How were these questions answered in 19th century England? In the 1820s and 1830s, the
English economy was rocked by several financial crises. In 1844, the Bank of England
received new statutes, the famous Peel's Act, that put severe constraints on the Bank of
England's ability to issue banknotes.
In particular, all notes issued in excess of a fixed amount had to be backed 1:1 in gold.
Compared to earlier practice, this rule was extremely strict. The authors of the law were
hoping that the monetary stability brought about by strict limits on the amount of banknotes in
circulation would also prevent speculation in financial assets. This hope was disappointed
only four years after the Peel's Act was signed into law, when the severe financial crisis of
1848 triggered a run on the Bank of England and forced the suspension of the convertibility
of bank notes in metallic coin. The episode forced central bankers to recognize that the
monetary target in itself was not enough to keep financial crises at bay. Instead, financial
emergencies created a need for the central bank to take action over and beyond the simple
and automatic rules of a metallic currency. In the second half of the 19th century, the Bank of
England implicitly assumed this responsibility and became the de facto "lender of last resort"
for the financial system, a concept explicitly spelled out by Walter Bagehot in his 1873 book
"Lombard Street".
Central bankers today are therefore in good company with their predecessors. Does this
mean that nothing has been learned since Lucam's testimony in 1870?
I would strongly disagree. What it means is that there are some constants in the basic
challenges that monetary policymakers face. However, the possibilities we have today are
quite different from those 150 years ago. The financial system has evolved significantly since
then, and so have the resources available to policymakers.
Lucam himself did not argue that speculative bubbles were benign and could be ignored. In
his view, the inaction of monetary policy is rather grounded in helplessness.
Central banks cannot prevent speculative bubbles from arising because - I quote again from
the testimony before the Hungarian parliamentary commission - "the only means [to prevent
the emergence of crises] would be to curtail the entrepreneurial spirit and we cannot count
on such moderation, as the pursuit of quickly gained wealth will always be one of the prime
moving forces of mankind".2 You would probably agree that "the pursuit of quickly gained
moving forces of
wealth" is still one of the "prime mankind" today and the hope for
"moderation" is as elusive these days as it was as back in the 19th century.
However, as economic policymakers today we do dispose of a set of tools that can be used
entrepreneurial
to moderate or guide "the spirit" in a way that prevents the emergence of
financial imbalances and ultimately financial crises. The regulation and supervision of
financial institutions and financial markets are powerful instruments that were unavailable to
my predecessors 150 years ago.
This brings me to what is a sort of leitmotif of this conference. The need for reform and a
significant strengthening of financial regulation and supervision are generally considered as
the prime lesson from the crisis experience of the past two years. Before the crisis, we had
trusted in the discipline of financial markets combined with microprudential regulation, i.e. the
regulation of individual financial institutions. Both failed to address the risks arising at the
systemic level, risks that could not be seen by looking at individual institutions and individual
markets alone.
There is broad agreement now that regulation needs to focus on the stability of the financial
system as a whole, which is termed "macroprudential regulation".
Macroprudential policy is the use of prudential tools (often the same tools as in
microprudential regulation, like capital requirements) with the explicit objective of promoting
the stability of the financial system as a whole and not necessarily of the individual
institutions within it. To be able to do so, macroprudential regulation explicitly takes into
account the interlinkages between financial institutions and financial markets as well as the
procyclicality of the financial system.
There is also broad agreement that central banks will play a crucial role within the new
regulatory framework, which is already evidenced in the central position that the ECB and the
EU central banks will take in the European Systemic Risk Board (ESRB), a newly created
body set up to assess and prevent potential risks to financial stability in a wide range of
areas, ranging from the banks' financial situation to the potential existence of asset bubbles
or the smooth functioning of market infrastructures.
But as we all know, the devil is in the details. What exactly should central banks be in charge
of and how are they expected to fulfil their tasks? These issues are still very much open. In
the next two days of the conference, we will have the occasion to look at the intersections of
monetary policy and financial stability from various angles. As the title of the conference
indicates, we will do so at three different levels: responsibilities, strategies and instruments.
The most general level is the question of
responsibility.
Clearly, central banks are - if not by intention then at least by necessity - also responsible
for financial stability. Yet, unlike in the domain of price stability (where central banks are
solely in charge), the duty of ensuring financial stability is divided up among a larger number
of agencies. This immediately raises the question how to delimit the central bank's
responsibility from the responsibilities of other public bodies, like regulatory agencies. How
can we ensure the free flow of necessary information?
How can we ensure that if there is a problem, someone will be responsible for solving it and
also in a position to act effectively? The issue of delimiting responsibilities between central
bank, supervisors, regulation agencies and the government at the national level reappears
on the international level. The crisis has clearly demonstrated the limits of national responses
in dealing with cross-border, systemically important financial institutions, markets and
instruments. This is particularly evident in the European Union, where financial markets have
integrated rapidly and cross-border entities have become much more important since the
introduction of the euro, while at the same time the EU's supervisory framework has not kept
pace and remained fragmented along national lines.
The flipside of responsibility is accountability. Given their responsibilities for financial stability,
what will be the criteria by which we judge the performance of central banks? This is very
important for a public agency, in particular an agency that enjoys a high degree of
independence from daily political influence and can therefore not be held accountable at the
ballot box. Accountability is relatively straightforward for the price stability target, even though
we might debate whether we should focus on headline inflation or core inflation or
mediumterm inflation: A quick glance at the official statistics is enough to assess the success of
monetary policy. Such an assessment becomes much trickier with financial stability, and
even more so because the responsibility for financial stability - by its nature a much larger
area than price stability - rests with several agents at once.
Independence is a crucial ingredient to monetary stability, as the success of the Eurosystem
in keeping inflation low and stable since the introduction the euro has well demonstrated. I would
argue that independence is equally important in the area of financial stability, in particular
macroprudential regulation (as has been argued by some authors e.g. at the IMF for quite
some time). Like in monetary policymaking, there will be occasions when it is necessary to
take determined action that might in the short term hurt one or the other special interest in
the economy.
In order for central banks to hold firm in this situation, independence is indispensable.
Underpinning the independence of central banks is crucial for their success in achieving the
objectives conferred upon them by law. And conversely, if central banks fail to achieve their
objectives, their independence will be in question. And rightly so: Independence is not an end
in itself; it is a political mechanism to make sure that common political objectives such as
price stability are attained. Central banks have to earn their independence every day. The
introduction of new objectives for central banks therefore creates a host of issues in terms of
central bank credibility. What if an objective, and thus the benchmark of success, are not
clearly defined? What if two objectives are in conflict? What if failure in one objective
contaminates the credibility concerning another objective?
We will surely do our best to avoid failure, yet the question remains what to do if - despite
our best efforts - results are not what we had hoped for. We will discuss central bank
independence this morning, and the issue is sure to reappear time and again throughout the
conference.
In light of the central banks' responsibility for maintaining price stability and financial stability,
what should be the strategies we employed and what are the instruments we need?
Let us start with the traditional tool of monetary policy, the short-term interest rate. The
Tinbergen principle states that one tool cannot serve two purposes; that is, interest rate
policy cannot deal with both macroeconomic and financial stability issues at the same time.
Still, events over the past few years have implicitly revived the discussion about the
interaction between monetary policy and asset prices. For many years, the "mainstream
view" was that monetary policy should not "lean against the wind" and/or should not include
asset prices in the monetary policy objective function. This was also mainstream thinking in
Austria in the 1870s.
However, there are strong indications that monetary policy does - at least indirectly - play an
important role for financial stability by affecting the measurement of risk, risk perception and
risk tolerance and has done so in the run-up to the current crisis.
Does that mean that financial imbalances should be considered when deciding on the
appropriate interest rate level? Or can we alternatively try to weaken the link between
interest rates on the one hand and risk perception and risk taking on the other, for instance
through technical improvements in the way risk is measured for regulatory purposes and
constrained through regulatory rules?
According to the Tinbergen principle, we need two tools to accomplish our two objectives of
price stability and financial stability. Macroprudential regulation is this second tool. In the
past, central banks shaped interest rate policy to achieve stable prices. When we decided on
the appropriate level of the policy rate, we took the regulatory environment as a given.
For instance, we had to assess the impact of a policy rate hike or cut by a quarter
percentage point, given certain regulation on capital requirements for banks and on the
working of securities markets. The mechanism through which a change in the policy rate
influences the development of prices and the real economy - the so called transmission
mechanism - was seen as exogenous from the central bank's point of view. This is in fact a
sensible approach to microprudential regulation, which is concerned with the health of
individual institutions. Microprudential rules, once agreed upon, are not altered frequently
and certainly not in reaction to macroeconomic developments.
Macroprudential regulation, i.e. the use of prudential tools with the explicit objective of
promoting the stability of the financial system as a whole, however, is by definition concerned
with macroeconomic outcomes and much closer to the core monetary policy objective of the
central bank.
The introduction of macroprudential tools is a game changer that raises very complex
questions of interaction between, and coordination of, monetary policy and macroprudential
use of (regulatory) instruments. I have already touched upon this interplay in terms of central
bank responsibilities and accountability.
In the daily handling of interest rate policy and macroprudential tools, the existence of two
tools raises tricky issues. Let me give an example: Since monetary policy decisions may also
affect financial stability, should central banks take into account the possible implications of
their decisions on financial stability when making decisions targeted at future inflation risks?
What would take precedence when both goals conflict?
The ECB, as I mentioned at the beginning, has a clear priority for the statutory commitment
to price stability. Therefore, the adequate strategy would be to avoid conflicts from arising by
preemptive action. This involves having a strict regulatory regime that ex ante prevents the
emergence of a financial crisis and that contains credible resolution mechanisms in case of
need.
More fundamental changes will be needed, however, to prevent the crisis patterns I
mentioned before. Austria fortunately has a rather conservative banking system (although
there were some unfortunate exceptions with which we had to deal in the past). But on a
global scale it is obvious that the financial sector has over time become dramatically bigger
and riskier. A striking example is the UK, with banking assets jumping from 50% of GDP to
more than 550% over the past four decades - the main drivers being excessive leverage and
often dubious financial innovations.
The introduction of new macroprudential tools also raises the question of how these tools
should be employed in practice. In particular, is it better to have fixed rules, for instance a
formula linking capital requirements to loan growth, or should regulators be allowed to
exercise discretion when setting capital requirements or leverage ratios?
Rules simplify life and resolve some of the problems of responsibility and accountability
alluded to before: It is the rule that is responsible, not the regulator. On the other hand, we
cannot predict nor determine the future. This is why the prevention of future financial crises
might necessitate different policies and thus significant discretion on the part of regulators
and policy makers.
Ladies and Gentlemen,
I am afraid we have many open points here. But I believe it is the purpose of an event like
the annual Economics Conference of the Oesterreichische Nationalbank to provide the time
and intellectual space to step back from the demands of everyday life and look at the more
fundamental questions behind policymaking. This year we have slightly changed the format
of the conference. All sessions and panels combine people from different backgrounds,
which will give us even more occasions for what I hope will be fruitful debates between
academics, central bankers, commentators, practitioners and the public. I am looking forward
to very productive discussions of these and other issues related to the future of central
banking over the next couple of days.
Let me conclude:
Over the last months, the dramatic events around the situation in Greece have reminded us
that the crisis that began in 2007 is still far from over. Public finances in the entire euro area
face significant challenges from unexpectedly strong declines in GDP, leading to lower
revenues while demanding higher public expenditures, coupled with structural problems in
public finances that predate 2007. When the turmoil in government debt markets reached
unacceptable levels in early May, the ECB together with the national central banks of the
Eurosystem intervened forcefully to stabilize markets, just as it did in August 2007 and in
September 2008.
Providing liquidity in a moment of general uncertainty is a key role of central banks. We are
the lenders of last resort. When banks stopped trusting each other in the wake of the
collapse of Lehman Brothers, central banks stepped in to provide funds as long as it took to
sort out the problems. We have acted similarly in the last month, though this time less in the
interbank market but principally in the market for sovereign debt.
liquidity
In both cases, however, the important point is that while central banks can calm
crises, they cannot resolve solvency crises. For the banks after September 2008, this implied
writing off bad loans and raising capital, either in private markets or with the help of the public
authorities. The central banks did provide crucial temporary relief; the long-run adjustments
had to be made by the banking sector itself. In the current situation this means that the
Eurosystem can and will ensure that short-term volatility and speculation in financial markets
do not derail the fiscal consolidation efforts in the euro area. Again, however, it is the
governments that have to ensure that their public finances become sustainable again in the
long run.
Within this context of uncertainty, the key ingredient to successful stabilization of the
European economy is that the roles in economic policy remain clearly defined. The primary
objective of the Eurosystem is price stability. The Treaty of Lisbon is very clear on that.
Confidence in the long-run stability of the euro is a crucial precondition of economic stability
and growth and thus sustainable public finances. Be assured that the Eurosystem will stay
the course. I wish you all a productive and successful conference.
Thank you very much for your attention.