Hermann Remsperger: Monetary stability - institutions matter
Speech by Professor Hermann Remsperger, Member of the Executive Board of the Deutsche
Bundesbank and Chairman of the Supervisory Board of the Monetary Stability Foundation, at the first
conference of the Monetary Stability Foundation, Frankfurt, 5 December 2002.
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The first conference of the Monetary Stability Foundation is dealing with the role of institutions for
monetary stability. This is certainly not a new topic. Economists have thought about this for centuries
and have come up with a wide range of answers. While the questions remain the same, the answers
change as the monetary and financial system evolves.
Rather than going into the details of each of the sessions, let me start the conference off by referring
to two issues. The first concerns the involvement of central banks in safeguarding the stability of the
financial system. The second is the relationship between fiscal and monetary policy in a monetary
union.
In my view, a good opportunity to start thinking about price and financial stability is a paper by
Friedrich A. Lutz on "The Basic Problem of the Monetary Constitution", first published as early as
1936. Its starting point is the observation that money and credit are essentially two sides of the same
coin as money results from bank lending.
On the credit side, competition between banks should ensure an optimal allocation of resources. On
the money side, however, this competition could lead to an excessive creation of money and hence to
inflation and instability of the financial system. As a consequence, money is best controlled by a
monopolist, while credit is best granted by competing banks.
The key idea of the Lutz paper is still interesting today, because it explicitly recognizes the link
between price stability and financial stability. As Lutz himself emphasized, having two very different
principles of order for each side of the balance sheet in the banking system does not appear to be a
problem in normal times.
In periods of crisis, however, a problem appears. To quote Lutz once more: State guarantees for
deposits and bailouts nationalize bank liabilities, while keeping the asset side in competition. To put it
in today's words: The result is a considerable moral hazard.
Lutz's insight may not be surprising given that he wrote in the aftermath of the severe banking crises in
Germany and the US of the early 1930s. It is perhaps more of a surprise that his discussion seems to
have been somewhat forgotten afterwards. As recently as in the early 1990s, conventional wisdom
appears to have been "keep prices stable and you will minimize the danger of a financial crisis".
After several financial crises, and in particular with the Japanese experience in mind, few would
subscribe to this view. We have learned that it is not only movements in the general price level that
matter, but also movements in a specific class of prices, namely asset prices.
The example of Japan shows that the price stability of the late 1980s was not sufficient to ensure
financial stability in the decade that followed. Conversely, financial instability can lead to price
instability, in particular deflation.
Financial stability is therefore an essential condition for a successful monetary policy. Any central bank
that wants to take its price stability mandate seriously also needs to have a direct interest in financial
stability. We are therefore interested in developing tools that help us to ensure the stability of financial
markets and financial institutions. Without financial stability, price stability cannot be guaranteed.
Still focussing on banks' balance sheets I would like to add that the money creation process through
the asset side of the banks can be dampened or even endangered by a high volume of
nonperforming loans. That's what we have learned from the Japanese experience.
And the experience in the Eurosystem has made clear that a strong expansion in monetary
aggregates is not necessarily the result of a high increase in bank lending. A large increase in money
supply may reflect a low monetary capital formation, which is heavily dependent on the expectations in
the financial markets.
Thus we have to take account of the fact that the financial system has become much more complex. In
Germany, this has had essentially two effects. First, the role and size of financial markets have grown
dramatically, providing both new sources of finance and investment opportunities. Although banks
remain at the centre of the financial system, they are much more dependent on financial market
conditions than in the past.
Second, our financial system is far more closely integrated with the rest of the world than it used to be.
On the one hand, this provides both profit opportunities and permits a more ample diversification of
risk. On the other hand, it makes us more sensitive to shocks from abroad.
Against this background, I believe it is worthwhile expanding the basic problem of the monetary
constitution as described by Lutz. Whereas he concentrated on bank balance sheets we have to pay
special regard to the ever increasing importance of financial markets. There might be a conflict
between the interplay of market forces in the financial markets on the one hand, and financial stability
on the other, just as there could be a clash between competition in bank lending and monetary
stability.
The past has taught us that it is important to adopt a fairly broad approach when developing tools to
protect the stability of the financial system. In particular, we cannot discuss this topic without looking at
the institutional framework. Institutions matter. Any discussion that ignores this is of little use to the
real world. Two issues are important. The first is, the design of the individual institution, and the
second is the relationship between different institutions.
Let me focus on the second of these issues. The classical view of the relationship between institutions
is to let each institution concentrate on its own task. For example, price stability would fall into the
responsibility of the central bank, while the stability of the financial system would be the task of
another government agency. Separating tasks, it is argued, makes institutions more accountable and
helps to limit agency problems. While there is much merit in this view, we have become aware that
tasks often cannot be separated so clearly.
Let us recall the example of the central bank and financial supervision. Under certain circumstances,
there may be a short-term conflict of interest between price stability and financial stability. In some
cases, low inflation may call for a cut in interest rates, while financial imbalances may warrant a rate
hike. What should the central bank do?
If you take the idea of separating responsibilities to the extreme, the central bank should simply cut
interest rates and forget about the impact on the financial system, the protection of which would be the
regulator's job. Few would consider such a policy optimal.
The reason for this is that a conflict between price stability and financial stability is not necessarily an
agency problem. Instead, we may be faced with a short-term trade-off between price stability and
financial stability. Strictly separating these two tasks could thus lead to worse outcomes than
coordinating the tasks between institutions.
Most non-Europeans would stop here. In Europe, we have to consider an additional factor: the
geographical dimension. Different institutions are subject to different jurisdictions. For example,
prudential supervision is at the national level, monetary policy at the EMU-12 level, and the regulatory
framework within which both supervision and monetary policy take place at the EU-15 level.
Let me turn now to the relationship between monetary and fiscal policy. It is not too long ago that
interest rates in many countries were set by the finance ministry. One of the reasons behind combining
monetary and fiscal policy decisions in a single institution was the idea that this would result in a better
policy mix.
Today, in contrast, virtually all central banks in the developed world are independent, and it is hard to
think of a country were the treasury decides on the level of interest rates. The last two decades have
witnessed an enormous paradigm change on the role of central banks in monetary policy.
What are the reasons behind this paradigm shift? A key insight was the expectation-augmented
Phillips curve. It said that monetary authorities may have an incentive to trigger off a boom by relaxing
monetary policy. However, you cannot surprise agents too often. They soon will learn to anticipate this
expansionary bias and adjust their behaviour accordingly. The result is high inflation and no
expansion. The way out of this time-inconsistency trap is to install a "conservative" central banker who
sets interest rates independently.
Central bank independence reduces the time-consistency problem, but it cannot prevent the possibility
that monetary policy may be dominated by an unsustainable fiscal policy and thus be ineffective. This
was first shown by the "unpleasant monetarist arithmetic" of Sargent and Wallace in the 1970s and,
more recently, by the "fiscal theory of the price level".
At the EMU-level, the relationship between monetary policy and fiscal policy becomes even more
complex. There is only one monetary policy for the whole euro area, yet there are as many fiscal
policies as there are countries. As a consequence, in addition to the problem of a possible fiscal
dominance, there is a free-rider problem as it is possible for countries to reap all of the benefits while
bearing only some of the costs of an unsustainable fiscal expansion. This shows how quickly the
geographical dimension turns into a political dimension, with important implications for sovereignty.
The Stability and Growth Pact is the mechanism designed to mitigate this problem and thus an
important part of our monetary constitution.
Let me conclude by saying that monetary stability consists of both price stability and financial stability.
From this perspective the two-pillar approach of the ECB provides an excellent analytical framework. It
does not only allow the ECB to integrate asset prices as an indicator of other variables in the second
pillar. The ECB's approach also allows it to analyse some aspects of financial stability within the broad
framework of the first pillar.
As financial instability is very often created by a credit expansion that is too rapid, we have to pay
particular attention to the counterparts of money supply. That is what Lutz told us many years ago.
And that's one of the reasons why I support the first pillar. In my view, the macro prudential element in
the first pillar should be emphasized more than has been the case in the past.