Axel A Weber: Reflections on the financial crisis
Text of the Mais Lecture by Professor Axel A Weber, President of the Deutsche Bundesbank,
at the Cass Business School, London, 13 May 2009.
* * *
1 Introduction
Ladies and gentlemen
It is an exceptional honour for me to be invited to give this year's Mais Lecture here at City
University. And it is a very welcome opportunity for me to present my reflections on the
financial crisis.
The events that have been shaking financial markets since the summer of 2007 and which
escalated markedly in September 2008 are occupying the attention of governments and
central banks worldwide on an unprecedented scale.
While it is certainly true that attempts to contain the financial crisis and thereby prevent
financial market tensions from creating a vicious circle for the real economy is a challenge for
monetary policymakers in nearly all areas, I would argue that, for monetary policy in the euro
area, the challenges may be even larger than for other industrial economies.
When we recently celebrated the tenth anniversary of the launch of the single currency, it
was often stated that the first ten years of the euro have been a notable success with regard
to price stability, trade and financial integration in Europe. However, it was also said that the
years ahead are likely to pose an even greater challenge.
2 Challenges for monetary policy
And indeed, as I have argued before, the challenges we are currently facing are, in many
respects, more demanding than anything else in the euro area's first ten years.
To that end, it is my firm belief that the value of monetary union has never been greater than
during this financial crisis. Try to imagine what would have happened without the single
currency. Probably, foreign exchange markets may have been subject to speculative attacks.
Currency fluctuations may have aggravated both the financial crisis and real economic
tensions - and do not forget the political turbulence implied by such currency tensions.
The financial crisis confronts policymakers with a situation of uncertainty in a very profound
sense. Such Knightian uncertainty means that past experience is not of great value when
deciding on appropriate policy measures. In such an environment, policy has to strike a
difficult balance between short-term and long-term needs. More specifically, in the case of
monetary policy, there is, on the one side, a need for resolute action to counter the
consequences of the crisis. On the other side, such actions should not undermine the
longterm foundations of monetary policy, such as the central bank's credibility. Striking that
balance is not only key to monetary policy, but also to other policy areas, such as fiscal
policy and policies that aim to stabilise the financial system. And the appropriate balance is
not independent of the institutional background against which these policies operate.
This is all the more true of EMU, where the institutional setting is still comparatively young,
the political balance between monetary policy and fiscal policy is more complex than in other
mature economies, because it is characterised by the coexistence of a supranational
monetary and autonomous national fiscal policies.
These considerations have to be kept in mind when talking about appropriate policy
responses. The responses may differ among central banks even in the face of common
economic shocks because of the differing institutional frameworks within which monetary and
fiscal policy operate.
Thus, I would like to go on to elaborate somewhat on the challenges for monetary policy, on
the approach we have taken in the Eurosystem, and on lessons to be learnt for monetary
policy in the longer term.
2.1 A brief account of the financial crisis
When looking at the underlying causes of the recent tensions in the global financial system,
numerous culprits have been identified: securitisation, quality of risk management, credit
rating agencies, compensation schemes, accounting standards and even expansionary
monetary policy - to name but a few.
I am extremely sceptical about any monocausal explanation. Instead, I believe that a cocktail
of various ingredients generated the shock waves that have rocked the global financial
system.
A key factor was a combination of new and complex instruments for transferring credit risks,
and the "originate and distribute" business model of credit institutions.
It has now become clear that the "originate and distribute" model can actually improve the
resilience of the financial system if, and only if, a high-quality standard is maintained at all
levels of the transfer process, and no new concentrations of risk arise. Since the outbreak of
the financial crisis, however, we have learned about a series of distorted incentives, which
manifested themselves in lax origination standards for products such as subprime mortgages
and in some investors' excessive reliance on credit ratings. In the end, securitisation, as
Claudio Borio from the BIS aptly put it in 2008, has, ultimately, "distributed fear rather than
risks".
However, while financial innovation has undoubtedly magnified vulnerabilities in the global
financial system, there is more to the present financial market turmoil than the proliferation of
structured finance products. Arguably, the "originate and distribute" model would not have
been possible without the benign macroeconomic and financial setting in the years preceding
the current crisis: Booming global economic growth, low consumer price inflation, low-level
long-term and short-term interest rates, and rising prices of real estate and other assets in
many countries - not just in the USA.
The possibility of a mis-pricing of risks and the attendant dangers were perceived by some
commentators even before the crisis began. Indeed, central banks, in particular, pointed to
such a development. Once the vulnerabilities in the global financial system were revealed in
August 2007 and intensified in autumn last year, we all witnessed financial imbalances
starting to unwind. Especially after the collapse of Lehman Brothers in September 2008, the
process of unwinding of financial imbalances escalated. Frictions spilled over from the core
segment of structured products to other asset classes, spreads on credit and bond markets
rose dramatically and interbank markets froze.
2.2 Banking stabilisation measures
As solvency risks in the banking system mounted, on both sides of the Atlantic governments
in close cooperation with central banks set up rescue schemes that moved away from a
case-by-case approach in dealing with troubled banks to broad-based schemes.
The rescue schemes focused primarily on improving the banks' capital position when the
ability to raise private capital became virtually non-existent. Moreover, stabilising banks'
access to medium-term funding through public guarantee schemes served as an additional
tool.
This sketchy characterisation also holds true for Germany. Measures taken in Germany so
far by the Financial Market Stabilisation Fund (SoFFin) have focused on the liability side of
banks' balance sheets, because it has been recognised that the financial market problems
and, not least, the recessionary economic environment ultimately have a dramatic impact on
the banks' capital position.
The capital-injection and guarantee programmes have contributed to a stabilisation, but have
not been able to entirely eliminate uncertainty about banks' soundness. Hence, the ongoing
risk of balance sheet strains as a result of continuing write-downs on problematic assets led
to a drying-up of private equity capital issuance and aggravated the issuance of debt (without
a government guarantee).
This, together with the fear that these problems could lead to a significantly reduced bank
loan supply is likely to be the main reason why governments have recently augmented their
previous approaches with plans to provide relief to the asset side of banks' balance sheets.
In that regard, in Germany the establishment of a scheme to deal with problem assets is
currently in the legislative making.
I do not want to elaborate in detail on the various proposals that have already been adopted
or scheduled to be implemented on both sides of the Atlantic. Instead, I would rather discuss
some basic requirements which - as I see it - should be fulfilled by such asset-side
measures:
• Banks must be restructured in a way which makes them attractive for new capital.
More specifically, new equity as well as new debt capital should not be burdened by
risks from the time prior to the stabilisation measure.
•
Government intervention should stabilise banks, not subsidise the former owners.
Measures should provide guarantees for the continuity of the financial system in the
form of insolvency protection for systemically relevant institutions. At the same time,
investors who provided risk capital prior to the stabilisation measure are fully liable
for any extant risks up to the amount of their capital. This is important not just from a
fiscal standpoint, but also for creating an adequate incentive structure for the future.
•
Given the uncertainty it currently entails, intervention through the stabilisation of
asset positions should, as far as possible, avoid the need to value the assets. Or, to
be more specific, approaches in which asset valuation plays a major role in the
distribution of risks and losses should be complemented by elements which ensure
that existing shareholders - not the banks - fully bear the consequences from
possible re-valuations of these assets at a later stage.
2.3 Monetary policy measures taken
I would now like to return to the monetary policy responses of the Eurosystem.
Since the financial market turmoil began in August 2007, the Eurosystem has stabilised the
European money market by generously providing liquidity above and beyond the benchmark
allotment. This has enabled banks to fulfil their minimum reserve requirements early in the
reserve period (frontloading). In the early stages, these measures were accompanied by the
use of liquidity-absorbing fine-tuning operations at the end of the maintenance period. At the
same time, the Governing Council also tried to stabilise the longer-term maturity segments of
the money market by introducing refinancing operations with a maturity of up to six months
owing to the continued weakness of interbank trading activities in these segments.
From mid-September 2008, however, as the crisis intensified, the yield spread between
secured and unsecured quarterly liquidity in the interbank market peaked at more than 1.8
percentage points. Owing to the renewed sharp increase in banks' mistrust, the overnight
money market also suffered heavily. Further adjustments to liquidity policy were unavoidable
under such circumstances. The transition to fixed-rate tenders with full allotment of all bids
decided upon in October 2008, together with a widening of the collateral framework in our
refinancing operations, ensured that all banks received the liquidity they needed at the
interest rate deemed appropriate from a monetary policy perspective.
The escalation of the financial market turmoil from mid-September onwards and the global
shock to confidence led to a considerable change in the outlook for the real economy and
price stability changed. Against this background, the Governing Council of the ECB has
lowered its main policy rate decisively since October 2008 from 4.25% to 1%.
Moreover, given that very short-term rates are now at an appropriate level, the Governing
Council decided at its meeting last week to implement further measures in order to fulfil its
primary goal - that is, safeguarding medium-term price stability. These measures include the
introduction of tender operations with a maturity of 12 months and outright purchases of
covered bonds up to a maximum amount of €60 billion. The Governing Council will provide
detailed information on the covered bond programme after its next meeting.
Such "non-standard" monetary policy measures extend the traditional monetary policy
toolbox of the Eurosystem. They reflect the bank-based nature of the financial system in the
euro area - which implies that monetary policy impulses are predominantly transmitted
through the banking system - by aiming to improve funding conditions for banks.
All in all, the monetary policy actions and the rescue schemes for banks in stress have
helped to stabilise the financial system at a time when systemic stability was at risk. Thus,
they have put a floor under the tail risk of a self-enforcing uncontrolled downward-spiral from
feedback effects between the financial and the real spheres.
However, monetary policy has created an enormous expansionary stimulus - not just in the
euro area but also worldwide. While this stimulus is currently warranted, we have to keep in
mind that it has to be reduced or even inverted very quickly as soon as the overall situation
improves. The need for such a quick retraction of the expansionary stance stems from at
least two factors. The first is that part of the monetary stimulus will remain in the pipeline for
some time due to the usual lags of monetary transmission. The second is that there is a
possibility of the recovery taking place in a more dynamic way than currently expected (if the
factors that caused the non-linearity in the downswing work favourably in the upswing as
well). Both factors could lead to inflationary risks making a rapid and powerful comeback,
and we should all be aware of this.
All policy responses, especially the monetary policy actions, cannot - and should not -
prevent the necessary adjustment processes in the financial system. Above all, the
excessive leverage in the financial system needs to be corrected. Short-term policy
measures should do no more than try to manage this deleveraging-process in an orderly
way, that is, it should prevent unnecessary collateral damage to the rest of the economy.
Moreover, monetary and fiscal policies are unable to provide shelter for the domestic
economy against the global symmetric confidence shock that hit the global economy after the
collapse of Lehman Brothers. They can only attempt to dampen some of the second-round
effects on the domestic economy by trying to stabilise domestic demand.
Public finances in Germany indeed are contributing noticeably to macroeconomic
stabilisation. The German government has implemented discretionary measures in a
magnitude of over 2% of GDP for the years 2009 and 2010. Most of the effects of these
measures have still come into effect. With regard to fiscal stabilisation it is also necessary to
keep in mind that its effects should not only be evaluated by discretionary measures alone.
Built-in adjustments in public budgets - so-called automatic stabilisers - provide stimulus
through a rule-based fiscal framework. These automatic stabilisers are more important in
countries with larger social security systems and progressive tax systems. For example, in
Germany the contribution of automatic stabilisers in 2009 and 2010 will be nearly 3% of GDP
(including developments in profit-related taxes).
Thus, for a thorough assessment of public finances in its stabilisation role the swing in the
overall public deficits is the most adequate measure. According to the latest forecast by the
European Commission - which is plausible in our view - the overall public deficit will
deteriorate by 6% of GDP over 2009 and 2010. This is somewhat less than in the UK, but it
makes clear that - contrary to some popular misperceptions - Germany's fiscal policy is
markedly contributing to stabilising the economy.
There is not only a structural adjustment need in the international financial system. In
addition to a marked cyclical shock, some real imbalances in the global division of labour are
being corrected through the current global downturn. Stabilisation policies should not try to
prevent these processes; returning to a status quo ante is not a sensible option.
Given the recent encouraging signs from financial markets and a number of leading
economic indicators, I believe there are some grounds for being optimistic that the pace of
decline in economic activity will decelerate markedly in the months ahead. However, it is
certainly not advisable to be overly optimistic that the recovery process is safely on track.
This will most likely be a gradual process with growth rates - notwithstanding some volatility
in quarterly figures - lying below potential for a considerable period of time. This means that
economic slack measured by very low rates of capacity utilisation will not diminish rapidly.
And we should take into account that, even if in many countries - including Germany - the
worst may be over in terms of negative growth rates, the labour market situation will visibly
deteriorate in the quarters ahead.
The German economy has been hit hard by the global downturn. Germany as an open and
export-oriented economy has its comparative advantage in investment goods. And it has
specialised by increasing its degree of openness markedly over the past decade. By doing
so, the German economy has benefited from the dynamic global environment of the past few
years. Currently, the sharp contraction in the German manufacturing sector makes clear that
this kind of specialisation also means a more cyclical overall economy, at least in the face of
rare massive common global shocks. An open economy like Germany's cannot insure itself
against truly global shocks regardless of how diversified its export portfolio is in regional or
product terms.
With regard to measures stabilising the global economy, one aspect that is too often
overlooked is the fact that due to the sharp contraction in net exports since summer 2008 the
German economy is de facto stabilising the global economy. A decline in net exports means
that less income from global trade flows is absorbed by Germany. Then, by definition, in
some other countries net exports must rise, de facto stabilising production in those
economies.
2.4 Longer-term lessons for monetary policy
Let me turn finally to what are more longer-term lessons for monetary policy to be drawn
from the current crisis. In doing so, I shall take a step back from the sort of crisis
management I have just described to the more general issue of conducting monetary policy
in the face of procyclical behaviour by financial market participants.
As I have already mentioned, in the first half of this decade, monetary policy was
expansionary in most industrial countries. This is indicated by interest-rate based measures
of the monetary policy stance as well as by indicators based on money and credit
aggregates. At the same time, risk premiums on financial markets have been too low
compared with traditional economic models based on macroeconomic factors.
There is an ongoing debate on whether low interest rates may have increased financial
market participants' risk appetite and played a part the dynamic growth of credit aggregates
worldwide via a so-called risk-taking channel of monetary policy. Given this debate, the
events of the past few months pose some fundamental questions about the role of monetary
policy in the financial cycle.
At this point, I think that some commentators take too narrow a perspective by concentrating
solely on the role played by monetary policy during the crisis.
In my view, monetary policymakers should not view boom and bust episodes on the financial
markets as unrelated events. Monetary policymakers' responses to upturns as well as to
downturns on the asset markets influence the risk perception of the market participants.
Therefore, an (expansionary) monetary policy response which is stronger in the downswing
than the (restrictive) response in the upswing creates adverse incentives for investors which
could increase the amplitudes of the financial cycle.
A more symmetric approach by monetary policymakers would treat boom and bust episodes
not as isolated events but would try to look through the financial cycle in order to steady
policy. To be more specific, a more symmetric policy would also consider implicit risks in
times when money and credit growth is dynamic, asset prices go up and risk perceptions
decline, possibly weighing the need to act despite low current consumer price inflation rates.
This, however, does not mean that monetary policy should downgrade the price stability
objective for the sake of other objectives. Indeed, financial crises heighten the volatility of
macroeconomic variables such as inflation and growth. Rather, it means that central banks
should take a longer-term perspective which takes into account the future inflationary
consequences of such unfavourable developments. Given the macroeconomic relevance of
financial crises, we have good reason to enlarge our monetary policy time horizon and give
low-frequency movements in credit and monetary aggregates more weight in our analytical
frameworks and our monetary policy decision-making processes.
That is not to say that such an approach would eliminate financial cycles altogether.
However, in the medium to long term, a monetary policy that followed a more symmetric
course would do more to dampen damaging financial cycles than a monetary policy that
merely tries to limit damage after the event using aggressive interest rate measures.
Here, the Eurosystem's monetary policy strategy already possesses such a stabilising
element in the shape of its monetary analysis. This is especially suited to the analysis of
long-term developments.
The recent financial turmoil has shown that the often-criticised monetary and credit analysis
has a valuable role to play in monetary policy analysis.
3 Conclusion
The financial crisis means the greatest challenge for monetary policy in decades. Policy
responses have to take into account the specific institutional environment under which it
operates. Thus, policy responses might somewhat differ among countries even when the
underlying shocks are similar.
The Eurosystem has responded in a decisive way to the emerging financial tensions. These
measures have reflected the specific circumstances of the euro area - and will continue to
do so.
In the euro area fiscal policy is also contributing to dampen the economic downswing. This is
also true for Germany, where automatic stabilisers and discretionary measures cause a
massive swing in deficit figures in this year and next year. The fiscal policy in Germany
contributes visibly to the stabilisation of the macroeconomy. Automatic stabilisers play an
important role in that regard.
In a longer-term perspective one lessons from the current crisis and its causes is that
monetary policy should treat financial cycles in a more symmetric way. This means taking
account of the financial cycle in the upswing as well as in the downturn. In an operational
sense it means enhancing the time horizon for monetary policy and paying paying close
attention to money and credit aggregates.