Lars Nyberg: In the wake of the financial crisis
Speech by Mr Lars Nyberg, Deputy Governor of Sveriges Riksbank, at the HQ Bank,
Stockholm, 18 November 2009.
* * *
I would like to start by expressing my gratitude for having been invited to discuss a few of my
thoughts about what may follow in the wake of the financial crisis. Make no mistake, the
crisis is not behind us yet. Many balance sheets in many countries must be adjusted before
the world's banking system can be given a clean bill of health. But the acute phase is
hopefully over, giving us reason to reflect not just over why developments took the turn that
they did - many others have already written volumes about this - but also over what should
be done to prevent these mistakes from being repeated. Much of this discussion deals with
regulation and supervision and, just like after every crisis, many political initiatives are being
proposed, some better than others. This is what I intend to talk about today. But there is also
reason to reflect over the interplay between financial stability and monetary policy. The
current crisis has indisputably demonstrated that monetary policy and financial stability
overlap in many important ways that we in the central banks previously may not have entirely
considered. I intend to devote the main part of my speech to this issue.
Bubbles and dangerous imbalances
Rising asset prices are currently the subject of intense discussion - in Sweden, because
house prices have started to rise again in the middle of a recession, internationally because
prices of financial assets in many newly industrialised countries in Asia and South America
are rising far more rapidly than expected. Is this a problem? Have bubbles already arisen on
the asset markets? And, if so, what should we do about it?
Now, to start with, remember that asset prices can rise, and rise quite far, without necessarily
becoming what is known as a bubble. Even if these assets become overvalued for a period
of time, reality usually catches up eventually and prices are adjusted without there being any
serious macroeconomic effects.1
A bubble is something else. A bubble always includes an element of speculation, based on a
belief that this development will continue and provide continuously increasing prices. This
belief leads to increasing investments and, consequently, further price increases. Of course,
the term bubble also suggests the image of something that will eventually burst, be it with a
loud bang or with a quieter one.
Financial bubbles are normally built up during good times when growth is high, investment
opportunities are plentiful, household incomes are developing favourably and the banks' loan
losses are minor. For example, the global economy saw record growth in the years
immediately prior to the current crisis. Strong economic development can, to a certain extent,
justify increasing asset prices and higher-than-normal credit growth. However, experience
tells us that this development often spills over into an exaggerated optimism about future
economic prospects, at the same time as awareness of various risks decreases. Investors
become increasingly willing to take increased risks, without receiving the compensation for
this that would be reasonable over the long term. The price of risk has never been as low as
in the years prior to the start of the financial crisis in the summer of 2007.
There are both dangerous bubbles and less dangerous bubbles. One bubble that did not
have such serious consequences when it burst was the IT bubble at the start of the year
2000. While it was building up, it is true that a number of investments were made that did not
turn out to be viable, and many investors watched their wealth shrink as the bubble burst.
However, the macroeconomic consequences were not so major. Growth in Sweden flattened
out for a few years, but never declined. The IT bubble never formed a major problem from a
monetary policy point of view.
Dangerous bubbles are those in which a market experiences not only rising prices, but also
the use of the underlying assets as collateral. This leads to the unsustainable long-term
development of the price of these assets, parallel to unsustainable long-term credit growth.
As these prices increase, so too does the value of the underlying assets, enabling them to be
used as collateral for further loans. At the same time, increased credits provide increased
purchasing power, allowing prices to rise even more. This can turn into a feedback loop that
is hard to break. The development of housing markets in the United States and a number of
other countries in the period leading up to the present crisis are examples of such bubbles.
The Swedish commercial property market at the start of our crisis in the 1990s is another
illustrative example.
A current illustration was provided in last week's Financial Times by the well-known
economist Frederic Mishkin, who, among other research, carried out an assessment of
Swedish monetary policy a couple of years ago. Mishkin emphasised the importance of
making a distinction between different types of bubble. Bubbles are dangerous when the
underlying assets are used as collateral and fuel an excessive credit boom. However, this is
not the situation in the world today. On the contrary, the banks are shrinking their balance
sheets and tightening their credit conditions. Thus the asset price increases that we are
currently seeing in a number of countries hardly constitute a serious problem.
Sooner or later, bubbles burst and, sooner or later, financial imbalances are corrected. The
problem is that it is very difficult to predict exactly when this will happen. As we know, asset
prices can increase relatively rapidly for many years, perhaps as long as a decade, before a
bubble arises and bursts. Individuals expressing concern over the build-up of worrying
financial imbalances are often regarded as whining pessimists who have failed to realise that
times have changed and that there is no danger this time. I'm sure we all remember the
"New Economy" that everybody was talking about during the build-up of the IT bubble.
Technological developments had boosted long-term global growth to higher levels, which
was reflected in asset prices. Has anybody forgotten what happened next? However, as has
been said, no serious macroeconomic problem ever arose from the IT bubble, as it was not
funded by loans.
When the correction of a bubble finally takes place, it generally has extensive real economic
effects, particularly, of course, if it has been funded by loans. The stock exchange drops
sharply, even if no great over-valuation has initially been present on the stock market itself.
Economic uncertainty and the drop in asset prices mean that consumption and investments
become heavily subdued. Risk aversion among financial investors increases and the price of
risk, credit spreads, increases. The banks suffer increasing loan losses as the value of
collateral falls and more and more borrowers find that they cannot make repayments. In the
worst case, the negative interaction between the financial markets and the macroeconomy
escalates into a financial crisis in which loan losses become so comprehensive that parts of
the banking sector face problems surviving.
When a bubble bursts, prices can fall by up to 50 per cent or even more, depending on the
asset involved and the degree to which this asset has been used as collateral. This fall in
prices means that the value of collateral decreases and, consequently, the banks start trying
to get their money back. This may compel the sale of assets, further forcing prices
downwards. The same feedback loop that acted to increase prices during the build-up can
thus act to push them down during the decline. During the present crisis, we have seen this
happen to a number of different securities in the balance sheets of many international banks
and investors.
Monetary policy consequences
So what does a bubble imply for monetary policy? Increases in credit growth and asset
prices stimulate consumption and investments and increase aggregated demand in the
economy. The economic overheating arising as financial imbalances are built up thus often
leads to real imbalances in the form of strains on resource utilisation, which, in turn, lead to
increasing inflation. In such a situation, it is natural for monetary policy to be tightened. A
tighter monetary policy in the form of higher interest rates naturally serves to counteract the
build-up of bubbles, as lending becomes more expensive. However, experience tells us that
increased interest rates are seldom enough to break the trend. Optimism can be such that
investors are glad to pay the extra interest costs or to accept a correspondingly lower return
on assets, as they are convinced that prices will continue to rise. For example, in Sweden in
1989, the direct yield requirement on the commercial property market lay at around 4 per
cent, while a risk-free five-year government bond had a return of up to 12 per cent. So the
market preferred an unsecured property asset to a covered bond with a return of 8 per cent
more! No monetary policy can defeat that kind of optimism.
Furthermore, it could be the case that inflation is low despite the strong economic
development. If this is the case, monetary policy may need to become more expansionary to
attain the inflation target, which, in turn, may fuel financial imbalances. During the years
preceding the current crisis, increasing globalisation resulted in a heavy dampening of import
prices, which pushed inflation down and contributed to an expansionary monetary policy in
many countries. Monetary policy thus fuelled the bubble, rather than counteracting it.
If a crisis becomes really serious, as is the case with the present crisis, the conditions for
conducting monetary policy become very difficult. The situation became exacerbated when
rising risk premiums increased the interest rates affecting households and companies.
Falling inflation and inflationary expectations led real interest rates to increase even more.
Although many central banks have cut their policy rates to almost zero, the expansionary
effect of this has consequently not been as strong as could have been desired.
In addition, the more serious the financial crisis becomes, the more poorly the financial
markets function. This, in turn, means that monetary policy becomes less effective, that is to
say that changes in the policy rate have less effect on the economy than is normally the
case. Developments in the present crisis provide a good illustration of this phenomenon.
Many central banks have experienced that changes in the policy rate have not at all had the
same effect on demand that they have normally. In other words, the transmission mechanism
between policy rate and the real economy has ceased to function normally.
During the crisis, parts of the world were affected by an acute credit crunch, entailing that
fully creditworthy companies encountered difficulty in obtaining credit due to a lack of capital
in the bank sector. This, if anything, has been characteristic for this crisis, having clear
consequences for the real economy, including the heavy decline in world trade. The credit
crunch came to be and to remain a monetary policy problem in many countries as the supply
of credits frequently became more or less insensitive to interest rate changes.
In Sweden, we only saw the merest hint of such a credit crunch. For a period during the
winter, major Swedish companies encountered difficulty in obtaining funding on the
international credit markets and so turned to the Swedish banks, with the result that they
squeezed out smaller companies, to a certain degree. The Swedish economy, which is
strongly dependent on exports, was also hit hard by the collapse of world trade. Many foreign
companies reduced their investment levels in order to deal with their liquidity problems,
which subdued demand for Swedish export goods.
Some lessons from the crisis
What lessons can be learned and what do these lessons mean in terms of economic policy
and the actions of the central banks in the future? Here are a few thoughts, although the list
is far from exhaustive.
There are serious shortcomings in regulation and supervision. This is entirely evident,
forming the subject of intensive discussions among politicians and in the media. It is beyond
the scope of this speech to provide a comprehensive account, so I will make do with pointing
out a couple of the overall problems.
One main problem has been that banks and other financial institutions have had too little
capital in relation to the risks they have taken in their balance sheets, whether these risks
consisted of traditional lending, the holding of various hard-to-value securities or large
shortterm positions taken when trading. This meant that many financial companies, for many
years, were able to provide high returns on equity, higher than in most other industries. But
when the crisis came, capital was insufficient, forcing a number of governments to contribute
tax revenues to prevent a collapse of the financial system.
At present, intensive work is underway in various international forums, above all in the Basel
Committee, to develop new regulations covering the amount of capital a bank must hold in
relation to its commitments. Capital adequacy requirements will be placed on liquidity risks,
which previously lay outside such regulations, but this is only one of many areas in which
capital requirements will be strengthened. New forms for equity are also being discussed, for
example bond loans that, in the event of a crisis - but without requiring the bank to cancel
payments - can automatically be converted into contingent capital.
Another problem has been that the supervisory structure, which has generally been
concentrated around the individual banks, missed the risks building up in the financial system
as a whole. One example of this has been the tremendous growth of credit derivatives over
the last decade, which, together with the emergence of complicated and hard-to-value
structured products, have been given much of the blame for causing the crisis to develop in
such a serious direction. An immediate example for us is the lending in euro in the Baltic
countries, whose exchange rates are tied to the euro, but where the fiscal policy framework,
at least in a couple of countries, has turned out to be weak.
This problem is also being discussed intensively in many places around the world. In terms
of European cooperation, supervision will be given a new structure, based on proposals
presented by the European Commission last summer. One element of this proposal is the
creation of a European risk board, the European Systemic Risk Board (ESRB), in which
central banks and supervisory authorities will meet to discuss exactly the kind of overall
systemic risks that were overlooked in the run-up to the present crisis. Another element is the
upgrading of the three supervisory committees in which all European supervisory authorities
collaborate into European authorities with somewhat greater independence and more
widespread authority than previously. All of this will hopefully be agreed upon by the finance
ministers in December of this year, while Sweden still holds the Presidency of the EU.2
The costs of financial crises are greater than was previously believed.
The present crisis has
shown that the world's financial markets are more strongly interlinked than there has
previously been reason to believe. Who would have thought that the collapse of a US
investment bank would cause the entire world's credit systems to break down? A national
financial crisis can rapidly spread across the entire world if, for example, the value of certain
assets starts to be brought into question and it is not known in which balance sheet these
assets have been hidden. The difficulties monetary policy is faced with when markets cease
functioning normally has also been underestimated, despite previous experiences from, for
instance, Japan.
Monetary policy and financial stability overlap in several areas. Following the past year's
dramatic economic developments, it should be evident that insufficient financial stability
leading to a major financial crisis seriously impairs the preconditions for monetary policy.
Strategically important markets must be made to function in order to avoid a total collapse.
Central banks have thus been compelled to undertake a series of unconventional measures,
partly aimed at maintaining a functioning payments system and partly aimed at improving the
functioning of the financial markets, thereby contributing towards the desired effect of the
expansionary monetary policy. At the same time, there exists greater awareness of the fact
that a monetary policy that does not adequately consider financial factors can lead to the
accumulation of serious financial imbalances. Financial stability has been demonstrated to
form an important restriction to the manner in which monetary policy can be applied in crisis
situations.3
Monetary policy models must become better at capturing the functioning of financial markets.
In my opinion, the present monetary policy framework, in which monetary policy is aimed at
stabilising both inflation and real development, still works well. However, monetary policy
analysis needs to be developed, in certain respects, to enable us to make better forecasts
within this framework. Above all, the monetary policy models used must better capture the
roles in the economy of credit markets and asset prices, so that the consequences of
financial imbalances can be analysed. Not only the price, but also the availability of credit
has been discovered to be relevant. However, these assertions do not mean that the present
models need to be scrapped. They serve us well in periods in which financial imbalances are
not a major problem and intensive work is currently under way around the world to develop
these models to better incorporate financial factors. Neither can it be required that the
models capture serious financial crises. This would probably require the development of
special analytical tools and models.
The role of monetary policy must be developed and clarified.
Even if improved supervision
and regulation enable us to reduce the risk of serious financial imbalances accumulating,
monetary policy will still face difficult dilemmas. The financial markets have a remarkable
capacity to develop continually and to find ways past regulation. Consequently, we cannot
rely on supervision and regulation always succeeding in preventing financial imbalances from
arising. In the future, we will certainly continue to see various forms of bubbles, in which
asset prices increase in a manner that is not sustainable over the long term, together with a
rapid growth in credit. In such cases, the central banks must take a position regarding
whether and to which extent monetary policy should consider this phenomenon.
The debate regarding the extent to which monetary policy should attempt to counteract the
unsustainable development of credit growth and asset prices - a policy often called "leaning
against the wind" - has been spurred by the current crisis. Those who have doubts about
such a policy maintain that it may entail an unnecessarily tight monetary policy, with costs in
the form of a low utilisation of resources and low inflation, at the same time as monetary
policy is deemed to be a blunt instrument to use against financial imbalances. According to
this assessment, it would require excessively large and costly interest rate increases to
prevent these imbalances from arising. Such imbalances, of course, frequently build up in
times of great optimism and excessive future confidence, and, in such a situation, increased
interest rates may have a limited effect on lending and asset prices.
It is entirely possible - and, in my opinion, perhaps even likely - that this assessment is
correct, but I would like to emphasise that there exists a significant degree of uncertainty at
this point in time. So far, research has not had much to say about the ability of monetary
policy to counteract financial imbalances. Naturally, this observation also implies an
argument against any policy that strongly advocates a monetary policy actively aimed at
preventing financial imbalances.
However, my view is that, in certain situations, it can be appropriate to attempt to counteract
financial imbalances with a limited tightening of monetary policy. A tightening of monetary
policy would be likely to have a restraining effect on credit growth and asset prices. Even if
monetary policy does not succeed in entirely preventing financial imbalances from arising, it
can limit their extent. The expected macroeconomic consequences following the correction of
imbalances should then be less serious, particularly if the risk of a serious financial crisis is
reduced. The clear communication of the reasons for increased interest rates should raise
public awareness of the risks of financial imbalances, which, in my opinion, may have a
stabilising effect.
In this example, monetary policy contributes to more stable inflation and resource utilisation
over the slightly longer term, which should be balanced against the short-term costs of
conducting a somewhat tighter monetary policy. This form of monetary policy thus does not
entail a deviation from flexible inflation targeting, that is to say a monetary policy aimed at
stabilising both inflation and the real development. Neither is it an issue of turning house
prices or any other asset price into a target variable for monetary policy. On the contrary, it is
an illustration of flexible inflation targeting in which the destabilising effect of financial
imbalances on inflation and resource utilisation are incorporated into the monetary policy
assessment.
The above reasoning is of a highly principle nature and it would require further analysis and
better models before anything more concrete can be said regarding the manner in which
monetary policy should be formulated when financial imbalances are present. However, I am
prepared to make a few observations on the subject.
To start with, there are probably many asset bubbles that monetary policy should not directly
attempt to counteract, particularly those not associated with strong credit growth.
Furthermore, Swedish monetary policy can hardly prevent stock market bubbles as these are
primarily affected by international factors, in particular international stock market
developments. If, on the other hand, credit growth were to develop in an unsustainable
manner at the same time as housing prices were increasing rapidly, in my opinion, it would
be reasonable for monetary policy to take this into consideration, even if short-term inflation
may be low.
Such considerations characterised the formulation of monetary policy during the years 2005-
2007, when the development of housing prices and loans to households restrained the
Riksbank from cutting the repo rate as much as would have been the case if monetary policy
had only been guided by inflationary assessments for the next two years. It is, of course,
difficult to determine which role this played in counteracting the development of the housing
market. At any rate, prices undeniably rose rapidly. However, the fact that the Riksbank
clearly indicated that the development of household indebtedness and housing prices were
not sustainable in the long term and that monetary policy considered this circumstance may
have played an important role in curbing this development. In that case, this is exactly what
is meant by leaning against the wind.
The housing market today
Housing prices have recently started to rise again, which has aroused some attention, not
without reason. It is undeniably remarkable that housing prices are rising and that the rate of
increase of the banks' lending to households has started to grow again, at the same time as
GDP is very weak and unemployment is rising. However, it seems reasonable to believe that
this is because it is inexpensive to borrow money due to the low interest rates prevailing.
Rising stock market rates and steadily-growing consumer confidence are certainly also
significant.
Household borrowing to invest in housing is also an effect we actually hoped to achieve by
implementing a low interest rate. It is contributing to supporting demand and employment.
Even so, household saving has risen rapidly since 2007, from approximately eight to around
13 per cent of disposable income.
Over the short term, I do not consider the development of the housing market to be a
problem. Housing prices in Sweden have certainly risen rather rapidly in real terms too, but
there are good explanations for this. One such explanation is the low rate of housing
construction in recent years, while another is provided by migration to metropolitan areas.
The greatest price rises, without comparison, are found precisely in Stockholm, Göteborg
and, above all, Malmö. Due to the taxation system and other regulations, we have not
experienced the type of market in which households purchase homes as financial
investments to then rent them out. It is easier for such markets to develop imbalances and
become subject to rapid and heavy price adjustments.
However, in the slightly longer term, there is reason to be vigilant. The increase in housing
prices and in household debt in relation to income that we have seen over the most recent
ten year period is not sustainable in the long term. There is thus a risk that an imbalance of
the type I discussed previously will accumulate.
At present, we cannot do much about this with monetary policy. We need to have a low
interest rate for a longer period of time in order to stimulate the growth needed to help
Sweden out of the crisis. At present, it is not the time to counteract imbalances by leaning
against the wind. However, should this development become cause for concern, there are
other means for making mortgages more expensive for households and thus reducing
demand for housing and subduing price development. One such method would be to require
greater mortgage repayments. This would increase households' monthly expenses directly
and would thus be an effective means of subduing demand. Another method would be to
lower the loan-to-value ratio of each property. Both of these possibilities will be open to the
banks themselves when they consider that there exists due cause. But they are also
measures that Finansinspektionen can prescribe if it is deemed that developments are
beginning to be cause for concern. In its recently-published risk report, Finansinspektionen
discussed these possibilities. We at the Riksbank will make an announcement when we feel
that a serious imbalance risks accumulating.
As regards the housing market, I do not believe that the greatest risk is a matter of either
monetary policy or financial stability. The greatest risk is that more and more households
forget that interest rates will be back at normal levels quite soon, which will entail mortgage
interest expenditure of possibly three to four times current levels for those with variable
interest rates. And most households in Sweden have variable interest rates. We occasionally
hear from analysts or the press that the Riksbank is not making it sufficiently clear that
interest rates will eventually rise. So let me repeat this once again in clear language, just to
be on the safe side. When the economic upswing gathers speed - and the recovery has
already started - interest rates and, accordingly, households' loan costs will rise very rapidly.
This should be considered very carefully by those borrowing, just as it should be considered
very carefully by bank staff handling lending to households.