Lars Nyberg: Monetary policy and financial crises - some reflections
Speech by Mr Lars Nyberg, Deputy Governor of the Sveriges Riksbank, at Danske Bank,
Stockholm, 21 December 2011.
* * *
On the first of January 1999, thirteen years ago, Sweden gained a new central bank act. Six
people were given the privilege of independently deciding on something that interests almost
everyone in Sweden, namely the interest rate. These six people were forbidden to take
instructions from anyone - that is, politicians - and it was also forbidden for outsiders to give
them instructions. I had the privilege of being one of the six who started in 1999, and I have
thus been here ever since. This means that I have been a member of the Executive Board
more than twice as long as any of the other current members and more than four years
longer than any other person who has been on the Board. Whether this longer experience is
then reflected in a correspondingly greater wisdom on central bank-related matters is of
course less certain. In any case, I shall leave this to others to decide.
An eventful period
But there is no doubt that these thirteen years have been eventful. There have been the
usual cyclical ups and downs, but also a number of crises in various parts of the world and,
of course, the global financial crisis and the ensuring sovereign debt crisis that we are
currently in the midst of.
The way we conduct monetary policy has also changed over the past thirteen years. The
inflation-targeting policy introduced in 1993 has of course always been the nucleus, but it has
developed in various ways. Work in my particular field of interest, financial stability, has also
been refined in many ways. For obvious reasons, this is an area that has come under
particular focus in recent years. One might say that if the task of maintaining financial stability
had previously tended to be overshadowed by the usually more attention-grabbing task of
maintaining price stability, the situation has almost been reversed during the crisis. The
financial stability work has in any case gained a more prominent position and become more
on a par with monetary policy.
Now I do not intend to devote my last speech as member of the Executive Board to outlining
my central bank memoirs. I have always been more interested in looking ahead than looking
back, and I intend to do so today. More specifically, I intend to take up some areas that I
believe will feature in the discussions on central banks and their activities in the coming
years. They are all connected with the financial crisis in one way or another; it is difficult to
avoid it in this context. In brief, I will talk about two themes: The importance of indebtedness
not becoming too high and the importance of having crisis management mechanisms in
place before the event.
The most important lesson: Don't allow too much debt to build up!
Of course, the financial crisis was due to many factors acting together. But one of the most
important lessons was that one should beware of allowing debts to grow too much. This
applies equally to households, companies and governments. This is neither a particularly
surprising nor especially new lesson; over several hundred years, financial crises have often
been preceded by periods when the attitude to credit granting and lending has been too
carefree. But it seems as though this is a lesson that we must experience again and again -
at least once a generation, and perhaps even more often.
A rapid and substantial credit expansion can cause many different problems. If the expansion
is characterised by an exaggerated optimism and an underestimation and underpricing of
risk, large loan losses may arise in the banks when the sentiment changes. This can lead to
banks failing and ultimately to a financial crisis. We experienced this in the 1990s, and Spain
and Ireland are experiencing it now.
Once the economy has entered a recession after a period of rapidly-increasing indebtedness
and rising asset prices, the recovery from this level may be very slow. The reason is that the
economy then often enters what is known as a balance sheet recession.1 Put briefly, what
this means is that the economic agents need time to adjust their balance sheets if, for
example, property prices have fallen. Their incomes will for some time to come be used for
amortisation rather than consumption and investment. Monetary policy stimulation has less
effect than normal and developments in the economy as a whole are weak. Studies show
that this type of mechanism largely explains why the recovery in the United States has been,
and still is, so slow.2
A financial crisis may also have other consequences. For instance, one can claim that the
sovereign debt crisis we are currently in the midst of is in many ways a consequence of the
financial crisis, and thus of the credit expansion that preceded it. Bank crises and sovereign
debt crises are often connected. Public finances in many countries have weakened
substantially because demand has fallen and in some cases also because they have needed
to support a precarious banking system. Moreover, in many countries the credit expansion
concealed the need for structural reforms in the labour market and in public administration,
which meant they were ill-equipped when the recession came. So, all in all, there are many
good reasons to try to avoid a situation where credit and lending accelerate out of control.
Various perceptions of the link between monetary policy and financial stability policy
So what should we do to prevent, or at least reduce the risk of, this type of development in
the future? Opinion is currently divided on this question. The role central banks should play
has been debated a lot, and in particular whether rate-setting should be used to subdue
credit expansion.
At one end of the spectrum are those who say that the crisis has meant that the dividing line
between monetary policy and financial stability policy has in many ways been erased, or at
least become less evident. If the central bank does not already have the clear and express
task of maintaining financial stability, it should be given this - in addition to the natural task of
acting as "lender of last resort" in a crisis. Monetary policy should be regarded as a legitimate
tool in the financial stability toolbox.3
At the other end of the spectrum we find those who say that monetary policy and financial
stability policy are distinct policies that should not be confused with one another. They claim
that monetary policy and financial stability policy differ in the same way that monetary policy
and fiscal policy differ, and they have different targets and methods. The policy rate should
therefore not be regarded as an instrument for financial stability policy. Both types of policy
should react to one another, but they should not be coordinated and conducted together as
there is then a risk that both will become unclear. The outcome may also be poorer and it
may be more difficult to hold policymakers accountable.4
The problems are exaggerated by those who believe that both types of policy must be
coordinated...
I can understand both points of view, but I believe that both have exaggerated their
arguments somewhat. Those who say that monetary policy and financial stability policy
should be integrated to a greater extent sometimes give the impression that they believe the
central bank should at every monetary policy meeting both determine the policy rate and
activate a number of macroprudential supervisory levers to find a policy mix that is
appropriate for both monetary policy and financial stability.
I do not believe that this is the way things will be done - I believe that this way of thinking is
too coloured by recent events. After all, it is not as though problems arise from
overgenerous credit granting during every economic cycle. Most cycles are "normal", with no
financial imbalances or balance-sheet problems. Of course, one must remain vigilant and
constantly assess the risks - and try to reduce them when necessary. But it is probably quite
rare that one will actually need to use macroprudential tools, or the policy rate, to subdue a
credit boom and thus reduce the risk of a crisis. Growth in lending is normally something
positive. It is, of course, difficult to say how often problems may arise, but one can conclude,
for instance, that we in Sweden have experienced two financial crises with not quite twenty
years between them, and this is regarded as unusually often. For the great majority of the
time the central bank will thus be able to conduct its monetary policy in a normal way.
Monetary policy and financial stability policy have, so to say, slightly different time
dimensions.
...and by those who say they should be entirely separate
But I also believe that the problems are exaggerated by those who warn against integrating
monetary policy and financial stability policy. For example, I believe that one can decide on
both the policy rate and macroprudential supervisory measures at the same time and in a
coordinated way, without either monetary policy or financial stability policy being perceived
as less clear. I believe, for instance, that it would be fully possible for the Riksbank to explain,
together with Finansinspektionen (the Swedish Financial Supervisory Authority), that the
mortgage ceiling is being lowered to counteract excessive credit expansion and rising prices
in the housing market, at the same time as the Riksbank holds the policy rate unchanged
because this is justified by events in the economy as a whole. Of course, this makes
considerable demands on the authorities' communication, but I believe that it is fully possible
to put this message across and gain understanding.
I can also imagine that under certain circumstances it might be difficult in a purely practical
manner to avoid some amount of coordination between monetary policy and financial stability
policy. Some countries have chosen to place the main responsibility for maintaining financial
stability with the central bank. Other countries have created some form of cooperation
between the central bank and the supervisory authority and I believe that this would be a
good model for Sweden, too. Macroprudential supervision entails to a large extent using
traditional supervision instruments with the focus on the entire financial system instead of
individual financial institutions.
In any case, the central bank becomes deeply involved also in macroprudential supervision. I
believe that it may be difficult in practice to make the monetary policy decisions on the
assumption that the financial stability policy is regarded as given, and vice versa.5
Let me also say, in this context, a few words in general about whether monetary policy and
financial stability policy should be regarded as different types of policy with different goals
and means. When regarded as principles and concepts it is of course the case that financial
stability is quite different from stability in the inflation rate and the real economy, that is, what
central banks with flexible inflation targeting strive to achieve. Logically, one could thus argue
that monetary policy and financial stability policy are two different types of policy that should
be conducted quite separately.
But I am not sure how meaningful this distinction is in practice. Personally, I have not
regarded financial stability as merely a goal, but just as much a means, or a condition, for
attaining a stable real economy and stable inflation. Assessments of developments in the
financial sector must, as far as possible, be included in the macroeconomic assessments.
Financial unrest and instability often lead to demand in the economy being too low and
inflation undershooting the target. If one considers that there are both "normal" economic
cycles and less frequent credit and debt cycles, the upturns in both cycles are not
necessarily synchronised. However, it is often the case that a rapid fall in a credit and debt
cycle entails a corresponding fall in the normal economic cycle - and not uncommonly a
balance-sheet recession.6 Monitoring the credit and debt cycle thus becomes a way of
stabilising the normal economic cycle. With this view, it is less obvious that financial stability
policy and monetary policy should be conducted separately. But, once again, it is probably
quite rare that there will be reasons to coordinate them.
The policy rate will probably need to support financial stability policy
With regard to the question of the role of the policy rate in financial stability policy, it is my
personal opinion that one must always be prepared to use it to slow down an excessive
expansion in credit, or to "lean against the wind" as it is usually called. Hopefully, it will be
possible to find a set of macroprudential tools that are efficient enough so we do not need to
use the policy rate for this purpose. Hopefully it will also be possible to find appropriate forms
as to when they shall be used and by whom.
But my feeling is that even when we have a proper framework for macroprudential
supervision, situations may arise where support is needed from monetary policy "leaning
against the wind". One reason is that experience shows that it is difficult to construct
regulations that can never be circumvented. The policy rate is a blunt instrument, as it has a
broad impact on the economy. But at the same time, this may be a strength compared with
the macroprudential tools, simply because it is difficult to "avoid" a policy rate increase.
I am also convinced that quite regardless of what formal responsibility the central bank bears
for financial stability, it will always receive a large share of the blame if a financial crisis
arises. When all is said and done, the interest rate is the price of credit and as the central
bank controls this price, at least regarding shorter maturities, I believe that the general public
will hardly absolve the central bank of blame if a financial crisis arises after a period of
cheaper credit. It will probably therefore be difficult in practice to conduct a monetary policy
that does not take into account financial stability.
We should continue to develop flexible inflation targeting
So, what conclusions should one draw from developments in recent years? How much do we
need to reconsider and how much must we modify the monetary policy framework? I would
reply: Somewhat, but perhaps less than one sometimes might think. I am fairly convinced
that the flexible inflation-targeting policy conducted in many parts of the world has essentially
been the right path to take, although it has not solved all of the problems. It appears to solve
the problems it is intended to solve, without any serious side effects.
I think that it is difficult, particularly with regard to Sweden, to overestimate the role played by
inflation targeting in attaining better macroeconomic stability - together, of course, with
farreaching changes especially in the fiscal policy area. Economic policy is now more
disciplined and we were able to benefit from the stability and credibility this has provided in
the most recent crisis.
But it is also clear that the financial crisis highlighted some weaknesses and that the work on
further developing the inflation-targeting policy must continue, both in the academic field and
in central banks. For example, it is evident that there is reason to try to get to grips with and
model the interaction between financial markets and the macro economy in a better way than
before. Financial factors, and in particular credits and indebtedness, should play a larger role
than before in our models and our thinking.
Given the impressive amount of studies produced every month in these areas since the
financial crisis broke out, I am fairly hopeful that it will be possible to gradually incorporate
these aspects in a fruitful manner into practical inflation-targeting policy.7 But there clearly
remains a lot to do.
But what is important is that this is all about continuing to develop the inflation-targeting
policy. The financial crisis should not be regarded, as some would appear to claim, as a sign
that the inflation-targeting policy has been an unsuccessful monetary policy "experiment" and
a blind alley - this is not the case.
Important to plan crisis management in advance, but this is rarely the case
I have so far mainly talked about preventing crises and in particular what role monetary policy
should play. Let me now go on to focus on the challenges with regard to managing the
situation once a crisis has occurred. How one manages cross-border financial crises - or not -
is a question that is very topical right now and will probably remain so for a long time to come.
My first thesis here is that when one allows a financial system to grow and the dependence
between the financial agents in different countries increases, one should carefully consider
what regulations and institutions are needed to manage different crisis situations. As well as
making it easier to resolve the crisis itself, clarity in this respect also affects how banks and
other financial institutions develop their operations and also how supervision of them can
best be shaped. Instead of thinking in terms of the sequence integration - supervision -
crisis management, one should see it in the other direction, that is, crisis management -
supervision - integration (Figure 1). My second thesis is that it is unfortunately very rare that
this is done in practice.
Bank regulation should be based on reverse induction
Timing
Crisis
of
Integration Supervision
management
events
Logic of
incentive
Crisis
Supervision Integration
analysis
management
Inadequate planning for crisis management in the monetary union
This reasoning can also be applied to nations, not just to their financial systems. During the
autumn, we have seen yields on government bonds soar in a number of euro area countries,
particularly those with sovereign debt problems. It is quite clear that the euro area lacks the
necessary institutions to manage such a crisis situation. In the United Kingdom, on the other
hand, yields have not risen in the same way, despite weak public finances there too
(Figure 2). There may be several explanations for this, for instance, that investors have
confidence that the United Kingdom will manage to consolidate its budget successfully. But I
believe that it is mainly because the euro area countries lack the defence mechanism that
the United Kingdom has.8
The reasoning is as follows: When investors in, for instance, Italian government bonds are
concerned over Italy's creditworthiness they sell their bonds and buy something else, such
as German government bonds. Then the Italian bond yields rise at the same time as liquidity
leaves the country. Other investors become worried that the yields will rise further - which is
the same as the value of their bonds falling - and therefore sell their holdings, which means
that yields continue to rise. This becomes a spiral of falling liquidity and rising yields, which is
difficult to stop. The Italian central bank is unable to do very much, as it cannot create
liquidity in euro. Only the European Central Bank, ECB, in Frankfurt can do this. The Italians
can ask for help, but they cannot do very much themselves - at least not in the short term.
And the investors are aware of this, of course.
Government bond yields, 10-year maturity
Per cent
8 8
Italy UK
7 7
6 6
5 5
4 4
3 3
2 2
1 1
0 0
08 09 10 11
Source: Reuters EcoWin.
This situation is very similar to the one experienced by Argentina, for instance, when they
had a "currency board" that firmly tied their domestic currency to the US dollar. In the event
of a crisis there has been no central bank that could create currency - in other countries with
similar problems the physical currency has run out and the only solution has been to fly in
dollar bills from the Federal Reserve.
Now, of course, the fundamental problem is that Italy, like Argentina, has lost
competitiveness, had a deficit on its current account and built up debt until the market has
gradually lost confidence and demanded higher and higher interest rates. Competiveness
then needs to be restored through some form of internal devaluation. This is unavoidable, but
it takes a long time and does not help the acute liquidity crisis.
The situation is different in the United Kingdom. If investors are concerned over the British
credit worthiness they will sell their government bonds as in the example above. They will
then receive British pounds and they may also sell these too if they wish to get rid of the
British credit risk. But liquidity in the UK is not affected in the same way as in Italy - there are
just as many pounds in the UK as there were before. What happens is that the pound
declines in value in relation to other currencies until the UK government bonds are once
again regarded as worth their price. Moreover, the Bank of England can create liquidity by
buying UK government bonds if this should prove necessary. There is no risk of a spiral of
falling liquidity and rising interest rates in the same way as in the Italian example. In addition,
British competitiveness will be helped by the weaker pound. And investors know this too. So
UK bond yields will not rise in the same way as the Italian ones.
On the basis of these examples, one might conclude that it is easier to manage a financial
crisis if one is not involved in a monetary union. This is true, but fairly trivial and one should
beware of making the related conclusion that currency unions are harmful. The euro
cooperation has offered major benefits to its members, although these are not mentioned so
much now. However, when it comes to crisis management in a currency union there are
some important conclusions to draw.
The first is that one must of course have regulations in a monetary union that enable one to
avoid a crisis of the proportions we are seeing now. This was what the creators of the union
were thinking when they initiated the Stability and Growth Pact. However, the pact did not
work very well and intensive discussions are therefore underway as to how it can be
supplemented with new regulations that will guarantee that no members have excessive
budget deficits or can build up excessive debt burdens. Hopefully these discussions will bear
fruit. However, it is far from certain that the developments we are seeing now could have
been avoided even if the Stability and Growth Pact had been upheld. Low interest rates have
meant that not only governments, but also companies and households have built up their
debt. But an efficient regulatory system would probably have made the crisis more
manageable.
A second conclusion is that when one refrains from the crisis resolution mechanism inherent
in a national currency, one must replace it with something else. Because crises that entail
concern over a member state's creditworthiness are always a risk. One must have an
institutional framework to manage the investors' concerns regarding rising bond yields in, for
instance, Italy now that there is no Italian currency that can depreciate and the Banca d'Italia
cannot create the necessary liquidity. If there is an institutional framework that is credible
from the start, it will not need to be used in most cases. It is to some extent this type of
framework that the European Financial Stability Facility, EFSF, is meant to become. It will be
able to buy government securities issued by euro area countries. However, it is difficult to
restore market confidence when it is already seriously damaged. The institutional framework
must be in place and have credibility before the crisis breaks out. This makes the crisis
easier to manage and one might even prevent it arising at all.
It is probably the case here that politicians in the EU have helped increase market distrust
because of the way they have handled the crisis. For example, it is understandable from a
political point of view that they have wanted to force private lenders to write off their loans to
Greece. But from an economic perspective - and in the longer run also political - this is not
such a good idea. This has meant that Italy and Spain have had to pay much higher interest
rates than before - not primarily because one perceives a risk that Italy and Spain will be
unable to service their debts, but because the market has become uncertain as to whether
the politicians intend to take similar coercive measures here.
If one suffers an acute crisis, whether one has created it oneself or not, one must consider
carefully how it should be managed. If one has not created a credible crisis resolution
mechanism in good time and does not manage to do so during the crisis, there is finally only
one last resort, and that is the ECB. The ECB is the monetary union's central bank and can
do in a crisis what the union's national central banks are unable to do. It can always create
liquidity and buy securities as needed and therefore in principle it can also attain the same
credibility as the Bank of England has in the United Kingdom. The problem is that the ECB
does not have an indisputable mandate to do this, and that the EU member states have
differing views as to whether it should be given such a mandate. The ECB should not save
countries from making necessary adjustments in legislation and public finances, many quite
rightly point out. But this also risks having the consequence that one refrains from the only
remaining mechanism that can manage an acute crisis.
Obstacles to setting up crisis management mechanisms
One reason why it appears difficult to set up clear frameworks for managing a crisis in
advance is, as I mentioned earlier, that crises occur so rarely. "There will be no more crises
during my mandate period," a politician said to me after the Swedish crisis in the early 1990s,
when we were to discuss new crisis legislation. And he was right, of course. It took almost
20 years until the next crisis occurred, and by then he had left politics long ago.
There is another important reason, particularly when several countries are involved. If one is
to create a framework to manage crises, one will unavoidably face the question of how the
costs are to be divided, and it is almost, if not completely, impossible to agree on this in
advance. All crises are different. It may be possible to agree on how to act when the problem
arises, for instance, who should negotiate and how. One can thus decide on "ex ante
preparations for ex post burden-sharing", but not on "ex ante burden-sharing".
Given this, it is interesting to note that with regard to the ECB there is actually a crisis
resolution mechanism in the form of an implied agreement on "ex ante burden-sharing". It is
written into the Treaty on European Union exactly how the national central banks should
recapitalise the ECB if this were necessary. If the securities the ECB purchased were to fall
in value so that the ECB needed more capital, it is thus clearly stipulated to what extent the
different countries shall contribute. It may be because of this that some countries do not want
to allow the ECB to buy government bonds, while others think it is an excellent idea. So,
paradoxically, it may be the actual crisis resolution mechanism that in this case leads to a
deadlock that risks aggravating the crisis.
Crisis management mechanisms equally important in the banking system
Let me now change focus from countries to banking systems. But both of the theses I
mentioned earlier are the same: When cross-border integration progresses it is important -
and profitable from society's point of view - to create credible crisis resolution mechanisms in
advance. But this is rarely or never done.
One sometimes talks of Europe's "financial trilemma".9 We in Europe want to achieve a
continued financial integration and increased financial stability, but at the same time we want
to retain each country's national sovereignty. The problem is that it is possible to attain two of
the goals, but very difficult to attain all three. If we want to combine financial integration with
continued national sovereignty over, for instance, supervision and crisis management, as we
have done so far, it will be difficult to achieve meaningful financial stability - the crisis we are
currently going through provides a good example of this (Figure 3).
Figure 3
Financial stability
National sovereignty
Financial integration
If, on the other hand, we want to prevent cross-border crises and at the same time maintain
national sovereignty, we must accept reduced financial integration - for example, stricter
regulations as to how banks can move financial assets between countries (Figure 4). One
can see clear tendencies in this direction in the current discussions. If one wishes, as a third
alternative, to retain integration but at the same time reduce the risk of crises spreading
across national borders, one must consider letting go of national sovereignty and allowing
more supervision and crisis management at European level (Figure 5). However, this is not a
path that is considered politically viable at present.
Figure 4 Figure 5
Financial stability Financial stability
Financial integration National sovereignty National sovereignty
Financial integration
The Larosière group, which was given the task after the financial crisis of proposing how the
financial system in Europe should be managed, tried to suggest a compromise: Continued
integration, but slightly less national sovereignty and slightly more joint responsibility for
supervision work. This led to the earlier "level 3" committees on banking, insurance and
market supervision being transformed into authorities. The idea was to give them as much
power as possible without changing the Treaty on European Union. At the same time, the
European Systemic Risk Board, ESRB, was created. This can give warnings or
recommendations when members - central bank governors and supervisory heads - assess
that financial risks are building up in Europe. It is possible in both to vote in the authorities
and the ESRB and the majority opinion applies.10 This has proved important in preventing the
deadlocks that the otherwise common method of a consensus decision can entail. Both the
force and speed of action has increased substantially. But all of this concerns how one can
avoid crises, not how they should be managed once they occur.
Nor did the Larosière group discuss, other than marginally, crisis management or winding up
insolvent banks. However, the European Commission's newly-published proposal does deal
with this, and so do new UK and US legislation that have arisen since the crisis. This is, of
course, an important step in the right direction. Greater clarity with regard to how banks
should be wound up will to a great extent affect both how the supervision is designed and
how the banks act. As I said, it is wise to begin at the other end.11
...but difficult with cross-border agreements
However, the focus in the legislation, naturally enough in the UK and US legislation, but also
the European proposal, is on how to manage national banks in distress. The cross-border
problems are avoided to a great extent, even in the Commission's report. The fact that an
integrated financial system in Europe also requires methods to resolve cross-border crises
remains to be discussed. And of course this is connected to what I mentioned earlier, namely
that it is much too sensitive an issue to discuss how the costs should be divided.
But if one is unable to manage even the preparations and procedures surrounding the
distribution of costs in a crisis - what is known as ex ante preparations for ex post burden
sharing - this will also have consequences. If nothing is discussed in advance, the natural
consequence - what is known as the default option - will be that a cross-border bank in
distress will be divided along national boundaries, regardless of how it is organised. The
branch network in one country may, for instance, suddenly find itself entirely without IT
systems and other central administrative functions, which are very costly to build up. The fact
that this becomes irrational and can substantially increase the total cost of winding up the
bank becomes a problem that cannot be resolved. Fortis and Dexia, at the most recent
reconstruction in the autumn, can be said to be good examples of this from the recent crisis.
They were both divided up according to national boundaries, and at least with regard to
Fortis most appear to be agreed that this was not a good solution. In any case, it was a