Lorenzo Bini Smaghi: Presentation of the book entitled "L'acqua e la
spugna" by Franco Bruni
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Center for American Studies, Rome, 24 June 2009.
* * *
Above all, I should like to thank the Center for American Studies for inviting me to present
this book by Franco Bruni; a book which is a real pleasure to present because it actually
shows to be untrue what many have claimed recently, namely that the economists did not
foresee the crisis and that they did not send out the alarm signals. Some economists, such
as Franco Bruni, had been pointing out the imbalances accumulating on the financial
markets for a long time, and, whilst they may not have anticipated the full extent of the crisis,
they did, for sure, signal the risks.
Franco Bruni's book is a book well worth reading, because it helps us understand how the
science of economics, is, at the end of the day, linked to common sense, and also that the
"new paradigms", which are increasingly cited to justify events that cannot be easily
explained, should be questioned. If you base your own judgements on sound analytical
grounds, albeit unsophisticated - and the book has the great advantage of also being
accessible to non-specialists in economics - you can get to grips with the general trends, at
least in the medium term. In this context, the conflicting schools of thought, for example, the
Keynesian and monetarists, serve no purpose. Those who did not understand the crisis were
those who, in some way or another, were trapped in simplified models without understanding
that these models are the starting and not the finishing points of an analytical path aimed at
understanding reality.
On the one hand, those who have made the neo-Keynesian models extreme, excluding
money and the financial markets, have made the search for model elegance an end in itself,
without understanding that it does not actually help to explain reality.
This may seem absurd nowadays, but at a conference organised by the European Central
Bank, in the autumn of 2006, to explain its own monetary policy strategy - a strategy in
which money and the financial markets play an important role - the majority of academics,
above all on the other side of the Atlantic, played down the usefulness of taking money and
financial markets into account in economic models. In the more sophisticated neo-Keynesian
models, they managed to completely get rid of money! Consequently, monetary policy could
also get rid of money, and focus only on the interest rate as the variable representative of the
equilibrium on the money and financial markets.
With such models, it was sufficient to align the interest rate with the equilibrium level, or the
so-called "neutral" level, in order to ensure a monetary policy in line with the general
equilibrium. No one, however, asked, in a world of uncertainty, how to measure the "neutral"
level of the interest rate. That was assumed as a given. This is the theoretical basis of the
so-called Taylor rule.
Nor was the crisis understood by those who continued to assume that financial markets were
perfect, without frictions, in which the inflating and bursting of speculative bubbles is part of a
moving equilibrium condition, in which economic policy should not intervene.
In accordance with this approach, monetary policy, or the prudential supervision system,
should not intervene in order to avert erratic market behaviour, which causes excessive flows
of indebtedness and unstable dynamics in financial activities, but rather intervenes ex post,
in order to reinflate the bubble when it bursts. Doing it that way, by reinflating it, the bubble
has finally burst with detrimental effects on the world economy.
Franco Bruni's book demonstrates that the excessively accommodative monetary policy
following the dot-com bubble and 11 September fuelled the subsequent speculative bubble,
which then burst in the summer of 2007. He himself acknowledges that the main
responsibilities probably do not lie with monetary policy, but rather with the absence of
regulation of new financial instruments, which permitted institutions to increase their leverage
capacity and favoured the indebtedness of households and firms.
However, monetary policy contributed to the build-up of imbalances by keeping interest rates
very low, above all, during the period when the US economy was starting to pick up again. I
believe that by now there is a broad consensus on this theory. Alan Greenspan's
counterargument that US monetary policy was not responsible for low interest rates, but rather the
inflow of capital from China, is not convincing.
Even if there were any truth in Greenspan's theory, the lesson that should have been learnt
was that the short-term interest rates were too low and should have been increased.
It was decided not to do so for fear of the US economy falling into deflation and it was,
therefore, preferable to "err" in the direction of excessive monetary growth, in order to avoid
the risk of deflation, despite the low probability of this occurring, rather than to err in the
opposite direction.
This fear was evidently well founded. And, as such, the mistake developed into an
excessively expansive policy, which led to the subsequent bubble. This experience
demonstrates that the monetary policy approach in terms of "risk management", as defined
by Greenspan, which does not take into account the medium-term probability of events, but
rather the extreme risks, does not account for the errors that the statisticians call "second
type", which is to give too much importance to a hypothesis which does not actually
materialise. This is interesting because, generally, it is academics who underestimate this
type of error and attach greater importance to the first type of error. Empirical research tends
to be taken note of when it demonstrates the significance of a statistical relationship, not its
insignificance. In 2003 heavy emphasis was placed on evaluating the significance of the
hypothesis of deflation, not its absence, nor the probability of future inflation.
Franco Bruni does not assign to the ECB the same level of responsibility, given that it kept its
rates higher than those in the United States. He is not one of the many who belatedly
reconverted to monetary rigour ex post, forgetting what was written at the time. On 2
December 2005, Franco Bruni wrote: "The small ECB rate increase was announced. It is a
logical increase (which in fact comes a little late) for various reasons. The starting point is
very low...".1 And yet Bruni seems ungenerous. First of all, the European economy grew at a
rate of 1.5% over the three-year period 2003-05, below potential and even lower than the US
rate (3%). Moreover, in this period, the effective exchange rate of the euro appreciated, by
slightly less than 10%, signalling a relative tightening of monetary conditions. I would like to
recall that at the time there were many, both in academia and in politics, who argued that the
ECB should tie its monetary policy to that of the United States and fix the exchange rate to
the dollar. Just imagine how much more liquidity would have been provided to the market in
those years and how much more devastating the effects of the bursting of the bubble would
have been now!
Indeed, at that time, the ECB was subject above all to criticism contrary to that levelled by
Franco Bruni. At least three European heads of state, and many ministries of finance, not to
mention business people, trade unionists, journalists, politicians and commentators, exerted
public pressure on the ECB to finally cut rates. And when, at the end of 2005, the ECB
decided (rather late, in Bruni's opinion) to increase them, many of those persons lined up,
together with renowned international institutions, to severely censure the decision, because
they felt it would have cut off the legs of the recovery. The ECB is independent, fortunately,
and cannot dump on others the responsibilities of its own choices. But what we should not
forget is the context in which it operates, largely influenced, also in the countries of
continental Europe, by an "activist" vision of monetary policy with an Anglo-Saxon inspiration.
It is also surprising how the teachings taken from that period of monetary policy are quickly
put aside when you go from the historical analysis to that of the economic juncture, in
particular the current economic situation. If the experience of the first half of this decade
teaches us that monetary policy should have a medium-term orientation, should take into due
consideration the developments in the financial markets and should avoid focusing on
extreme events that are unlikely to take place, and should be put into effect by an
independent central bank, with a clear mandate that favours price stability - in line with the
analysis contained in Franco Bruni's book - the assessments of the present frequently
continue to be contingent on opposed preconceptions. In the current circumstances, the
actions of the central bank, especially those of the ECB, continue to be assessed in terms of
a comparison with the United States and in terms of quantity rather than results. There's a
tendency to look above all at the number of rate cuts and points cuts and the scale of the
refinancing operations, rather than looking at the results in terms of the sustainability of a
certain policy over time. As I have had an opportunity to explain, a policy that quickly brings
rates down to zero but cannot generate expectations of stable rates at those levels, can end
up being less effective than a policy which maintains rates slightly higher but has stable
expectations, allowing a flatter yield curve to be maintained.2 If you look today at the results
obtained in terms of the yield curve and inflation expectations, you can appreciate the
strategy followed by the ECB in the rate-cutting phase.
One point on which I don't agree with Franco Bruni's analysis concerns his judgement on
changing the objective of monetary policy after the failure of Lehman Brothers on 15
September 2008. Bruni writes: "...the objective became only that of saving the credit system
from the collapse. This last change of objective is of great conceptual and political
importance, it has a significance that could prove to be, so to speak, historic. And yet it has
never been officially declared, particularly by the ECB". The proof that he provides for the
above remarks is the decision to reduce interest rates from 2% to 1.5% in March this year, a
step which, in his opinion, was not justified by the trend of the economy, but by the problems
facing Europe's banking system.
There is a misunderstanding here that needs to be quickly clarified, also in view of the
ensuing discussion on macro-prudential supervision and on the powers of the central banks
in question. From the outset of the crisis in August 2007, the ECB has pursued a policy of
separation between, on the one hand, the interest rate decisions, based solely on the priority
objective of price stability and, on the other hand, the decisions concerning the instruments
used to pump liquidity into the system in order to tackle the difficulties being encountered by
the market.
The most obvious example of the separation is precisely the one which occurred on 9 August
2007, when amid market tensions, it was decided both to maintain the rates unchanged and
to intervene on a substantial scale to satisfy the banks' demand for liquidity, with a €90 billion
operation. And the same separation has been continued in all the months since then.
That the decision to reduce interest rates in March to 1.5% was justified is, I believe, evident
from the growth and inflation estimates published at that time. I remember the ECB staff
projections were pointing to euro area GDP growth for 2009 and 2010 being equal to -2.7%
and 0.0% and inflation of 0.5% and 1.1% respectively. Also taking into account the relevant
horizon for monetary policy, between one and two years ahead, an interest rate of 2%
seemed excessive, also considering the downside risks to growth that the ECB's Governing
Council had signalled and that they duly manifested themselves. Indeed, the projections
were again revised in early June, and the cut in the official interest rate to 1% decided in May
is consistent with that revision.
The objective of the decisions to supply liquidity to the banking system was not to "rescue the
banks" but to ensure the continued functioning of the financial market, starting with its base,
i.e. the money market. The ECB's entire range of instruments, characterised by a wide
corridor between the interest rate on the marginal lending facility and the rate on the deposit
facility, weekly repurchase agreements, the acceptance of a large number of counterparties
and a wide range of collateral, is based on the money market functioning. If the money
market doesn't work, the mechanism for transmitting monetary policy doesn't work. The only
solution remaining for a central bank at this point is to stand in for the market and perform the
role of the banks, even by lending directly to the private sector. Maybe this solution is the
most preferable? I don't believe so. In my opinion, the functioning of the market is a statutory
objective for a central bank. It should therefore intervene to guarantee the liquidity of the
market. It should be remembered that every injection of liquidity is guaranteed by the
collateral deposited by the counterparty banks. This means that banks' assets are made
liquid. It's obvious that without such a liquidity intervention, the market would collapse, taking
the banking system with it. This is always true for last-resort interventions whose objective is
to keep a solvent but illiquid system alive. It is at the heart of the role of central banking,
particularly in times of systemic crisis. There can be no doubt that the ECB had to take on
this role and I believe it has done so in an appropriate way.
However, the point is not to intervene to remedy problems of solvency resulting from wrong
decisions regarding investment or resulting from insufficient capital. In this regard, a central
bank is not in a position to deal with these problems, nor is it its job to. This is the
responsibility of the political authorities. Following the collapse of Lehman Brothers, this has
become clear in Europe. Only the heads of state and government, in their meeting in Paris
prompted by President Sarkozy, were able to commit public funds to avoid several banks
going under. The programme aimed at supporting banks' capital and at guaranteeing bonds
was a government initiative, even if the ECB made a technical contribution. And this is
exactly how it should be.
If something can be said to have gone wrong, it was with the implementation of the
measures, not with the decision itself. The ECB has repeated its invitation to financial
institutions many times to make full use of the state measures for increasing capitalisation in
the banking system.
If this doesn't happen, there is a risk that the retroactive effect of the current recession on
banks' accounts will cause the banks ultimately to reduce their financing of the real sector,
thereby further exacerbating the economic crisis. Evidently, there is not enough incentive for
bank shareholders and bank managers to make use of such instruments, the shareholders
out of fear that their shares will drop in value, and the managers for fear of operational and
pay structure constraints. This poses a problem in terms of coordinating behaviour, which
has to be resolved by policy-makers. However, time constraints prevent us from exploring
this matter any further today.
I would like to conclude by looking to the future. I agree with Franco Bruni's analysis and
recommendations.
This crisis affirms the need for fully independent central banks in which the appointment of
Executive Board members is not linked to electoral cycles, and where such members have
long-term mandates. It also confirms how important it is for price stability to be the primary
objective of monetary policy. This experience has shown that having more objectives than
this does not make the task any easier, neither in terms of preventing a crisis, nor resolving
it. Given the objective of price stability, central banks should also aim to contribute to
financial stability but they should also have instruments at their disposal to achieve this.
Finally, whenever central banks are given specific powers, they are also expected - and
rightly so - to exercise accountability. Franco Bruni is no exception, but in this regard he
cannot be distinguished from a certain trend which erroneously considers the ECB to be less
accountable than the Federal Reserve, particularly with regard to parliament. The appendix
gives details about the methods of reporting to the respective parliaments, in terms of
reporting, hearings and responses to questions posed by the parliament. It can be confirmed
from this that the ECB reports with the same intensity and frequency as the US central bank.
This does not mean that the quality of interaction cannot be improved, but this depends, to a
large extent, on the European Parliament.