Jürgen Stark: The global financial crisis and the role of central banking
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank, at
a meeting hosted by the Institute of Regulation & Risk, North Asia, Hong Kong, 12 April 2011.
* * *
It is a pleasure for me to address this distinguished audience. In my remarks today, I would
like to share some thoughts with you on how the global financial crisis could shape central
banking in the future.
Crises are often associated with deep-seated changes in both the mandates and functions of
central banks - this is a well-established regularity in contemporary economic history. For
example, central bank inaction was widely held responsible for worsening the economic
downturn during the Great Depression of the 1930s. The result was that monetary policy was
placed under the control of fiscal authorities for nearly two decades afterwards.
The Great Inflation of the 1970s had the opposite effect. The failure of weak monetary
regimes to reign in high inflation led to the establishment, in the early 1980s, of monetary
policy frameworks solidly anchored by price stability mandates, and safeguarded by
independent and autonomous central bankers.
Will this crisis - which is still ongoing - have any implications for the tasks of central banks in
the future?
To shed light on this question, I will, first of all, look back on the salient features of the
monetary policy paradigm prevailing before the crisis. Then I will review how central banks
responded in practice to the crisis, focusing on the ECB's policy actions in this regard. And
finally, I will discuss whether certain aspects of the pre-crisis monetary policy paradigm need
to be reassessed on the basis of the recent experience, and outline the likely challenges for
central banks that lie ahead.
***
1. The monetary policy paradigm before the crisis
We do not know yet to what extent the pre-crisis consensus macroeconomic framework has
been de-constructed by the crisis. But we do know that the "hubris" of the intellectual
paradigm on which that framework was erected has completely vanished.
Some aspects of the framework, in my view, will undoubtedly survive the crisis. One is the
great and increasingly shared emphasis on central bank independence. Another is the
centrality of price stability for monetary policy. These were the twin foundations of the
dominant monetary policy paradigm before the crisis, and the crisis has not challenged or
discredited either of them. I will return to the issue of price stability towards the end of my
remarks.
Beyond these considerations, other aspects of the international consensus framework merit
some careful re-evaluation. In particular, I will take this opportunity to share my thoughts on
two salient features of the monetary policy paradigm as described in a number of pre-crisis
studies1.
One was complacency. The "great moderation" of the 1990s appeared to have inflation
permanently under control and conveyed the impression that the monetary policy battles of
yesteryear had been won once and for all. This sense of security was highly consequential.
Some observers thought that monetary policy had a greater freedom to turn to other
purposes, notably short-term demand management.
Policy practitioners of this view referred to this as "fine-tuning"2. The theoretical counterpart
to this was a form of "flexible inflation targeting" with an added emphasis on output
stabilisation beyond inflation stabilisation.
Simplifying, one can express the inflation targeting policy advice in two main precepts. First,
look at inflation and output gap forecasts as summary statistics of the state of the economy.
Second, fine-tune the policy instrument so that inflation forecasts - whatever the nature of
the shocks that might have caused them - are stabilised, and output volatility is minimised, at
a pre-set horizon through a given interest rate path.
It is easy to conceive of economic conditions in which these prescriptions induce
destabilising action on the side of monetary policy. Indeed, limiting the information set to
inflation and output gap forecasts can be highly misleading. One reason for this has been
known for a long time: output gaps are ill-defined objects and are subject to a great deal of
measurement error. An imperfectly understood concept which - in addition - is statistically
very imprecisely measured is not a reliable indicator for guiding policy.
Paradoxically, with its focus on the output gap, pre-crisis consensus macroeconomics ran full
circle back to the intellectual climate of the 1970s, the same climate that had favoured the
Great Inflation. The major policy failures of the 1970s were largely due to policymakers'
exaggerated real-time measures of economic slack.
The second distinctive feature of the pre-crisis monetary policy paradigm stemmed from a
complete under-appreciation of the role of money and credit indicators in the conduct of
monetary policy. Liquidity and money lie at the core of the ECB's second pillar. But they were
at best ignored, at worst "derided", as redundant and unnecessary complications by
mainstream modellers before 2007.
The crisis has shown that liquidity and various definitions of money are critical links in the
transmission mechanism. Far from showing a lack of theoretical foundations in the ECB's
strategy, the crisis has exposed the incompleteness of the transmission mechanism in the
reference model.
But disregard for monetary and financial phenomena had another implication. It found a clear
counterpart and theoretical underpinning in the risk management approach to asset price
trends. The consensus view in pre-crisis times was that the best thing that central banks
could do was to "clean-up" following the bursting of a bubble by loosening the monetary
policy stance.
I do not need to underline how this approach can turn into a formidable multiplier of market
turbulence. The expectation that the central bank will aggressively protect the markets from
"tail events" in bad times can encourage - and did encourage, in my view - markets'
tendency to opt for risky strategies, over-exposures and exuberance.
In summary, there was an inherent contradiction in some of the salient features of the
precrisis monetary policy paradigm. On the one hand, central bank policy "activism" was seen
as justified in order to help with short-term output stabilisation purposes. Yet activism did not
apply to financial risks except in an entirely ex post fashion: proponents of policy "activism"
saw no merit in a central bank's ex ante intervention to stem asset price developments,
arguing that the policy interest rate was too blunt a tool to contain potential bubbles.
2. Central bank response to the crisis and "the new normal"
The central bank response to the crisis, by any metric, has been unprecedented. When
tensions in the interbank market emerged in the euro area and elsewhere in August 2007,
the ECB reacted swiftly by providing de facto unlimited overnight liquidity to limit euro area
banks' liquidity risk.
As the tensions morphed into a large-scale crisis of confidence in October 2008, the ECB
responded with a mix of standard and non-standard monetary policy actions to foster
financing conditions and enhance its credit support to the euro area economy, all with a view
to maintaining price stability.
The standard measures essentially entailed a steep reduction of the main refinancing rate to
a historical low of 1% over a seven-month period (October 2008 - May 2009). This was done
in reaction to the weak economic environment and the associated change in the inflation
outlook.
The non-standard measures included granting banks unlimited access to central bank
liquidity against an extended range of collateral with the possibility for banks to borrow
liquidity at a broader spectrum of maturities, of up to 12 months. The ECB also intervened
directly in some market segments that were dysfunctional, namely the covered bonds
market. This was deemed important for the long-term financing of banks.
In May 2010 the financial crisis took a different direction; markets started to question the
sustainability of public finances in parts of the euro area. In response, the ECB intervened in
some debt securities markets, in order to prevent large and important segments of the
securitised credit market seizing up and obstructing monetary policy transmission. These
interventions have been limited in size, and their impact on liquidity creation has been fully
sterilised.
Overall, the non-standard measures have been adopted with a view to ensuring the
transmission of low policy rates to the euro area economy. They have been tailored to the
specific financial structure of the euro area economy, whose financing to a large extent relies
on banks. These measures are fully in line with the ECB's price stability objective.
In this regard, the approach chosen by the ECB and the Eurosystem differs from that of other
major central banks which embarked on large-scale unconventional measures to replace,
rather than complement, standard actions, after those standard actions - changes in the
policy interest rate - had reached their lower limit. In this respect, the ECB's non-standard
response does not qualify as a form of quantitative easing or credit easing.
Non-standard monetary policy measures are an extraordinary response to exceptional
circumstances. They are, by construction, temporary in nature. Looking ahead, a return to a
more normal liquidity management and to a more moderate scale of central bank
intermediation is warranted to avoid distortions in financial incentives with longer-term
adverse consequences for the economy. The ECB started in fact to phase out a number of
non-standard measures back in late 2009.
The maintenance of price stability over the medium term guides all monetary policy
decisions. In this respect, the macroeconomic and financial landscape has fundamentally
changed and the monetary policy stance has become more accommodative than at the peak
of the crisis.
As with the phasing-in of non-standard measures, there are no pre-defined steps between
phasing them out and exiting from very low policy interest rates. Non-standard measures can
in fact co-exist with any interest rate level. The ECB will adjust its policy interest rates and its
provision of liquidity at a pace and to a degree commensurate with the evolution of risks to
price stability and as appropriate to maintain an orderly and functional monetary policy
transmission.
A number of key principles, which served the ECB well both before and during the crisis, will
continue to underlie the post-crisis "steady state" design of the ECB's operational framework.
These principles are: operational efficiency, a strong market orientation, simplicity and
transparency, and equal treatment of our counterparties.
[In line with these principles, the ECB equipped itself with a broad operational framework
from the outset, including the eligibility of a large number of counterparties and a wide set of
collateral in refinancing operations. At the same time, the post-crisis operational framework
also needs to be designed in a way that contributes to shaping a healthy banking sector,
even if proper incentives should essentially come from sound regulation and supervision].
3. The future of central banking and main challenges ahead
What are the desirable features of a post-crisis "steady state" monetary policy framework?
On this subject, I would like to make a number of points.
As I mentioned already, the "core" elements of the monetary policy paradigm have emerged
from the crisis unscathed. I firmly believe that price stability is the best contribution that
monetary authorities can make to overall economic welfare. Price stability should remain the
primary task and the key "deliverable" for central banks in the period ahead.
If anything, the crisis has reaffirmed the importance of having a clearly defined objective for
price stability, not least by contributing to the anchoring of expectations during periods of
turbulence, when otherwise the private sector would become disoriented.
Central bank independence under a specific mandate together with transparent
communication policies will continue to be instrumental in the pursuit of price stability by
monetary authorities.
Other aspects of the pre-crisis monetary policy paradigm need to be carefully re-examined.
The crisis should mark a clean break with short-termism and "fine-tuning" demand
management by monetary authorities. An insufficient medium-term orientation and a
systematic asymmetry in responding to shocks - with downside risks to the economy always
receiving a greater weight in central bankers' "policy preferences" than upside risks to price
stability - all of this contributed to the build-up of financial imbalances in some advanced
economies.
The sudden unwinding of these imbalances set in motion the chain of events which we now
call "the crisis". Greater medium-term orientation in monetary policy frameworks would have
made the events which followed less severe.
Monetary data are critical as indicators of risks that are slow to appear elsewhere, for
example, in inflation forecasts or in measures of output gaps. Monetary analysis at the ECB
has consistently sent early signals that risk was broadly under-priced, when inflation was
quiescent and measures of slack were moderate.
Incorporating monetary phenomena in the policy framework inspires a sort of
"leaningagainst-the wind" stance which can help smooth financial cycles and stabilise the economy in
the medium term. Coupled with the inescapable fact that inflation is a monetary phenomenon
in the long term, this is a powerful reason to redress the under-appreciation of monetary and
credit variables in policy frameworks characteristic of the policy paradigm in the run-up to the
crisis.
The crisis has shown that central banks have powerful instruments at their disposal to
effectively respond to extraordinary situations without compromising their ultimate objective.
However, this does not mean that monetary policy is liable to be subordinated to financial
stability concerns. The ECB is well aware of the possibility of monetary policy being
"contaminated" by financial stability considerations. Monetary policy - even in crises and, I
would say, particularly in crises - is about lending temporarily to solvent institutions. Lending
to institutions which have long-lasting, structural funding and equity problems is the
responsibility of the fiscal authority.
The limits to what monetary policy could and should credibly do are both conceptual and
practical: monetary authorities cannot be expected to solve issues which lie well outside their
official remit.
There are two sides to this simple truth, one concerning financial regulation and one broad
economic management.
On the financial side, the ECB has a major stake in the quest for financial stability - but the
authority lies elsewhere. Basel III is a very important step in the right direction, as it should
provide for higher minimum capital requirements and better risk capture by financial
institutions. But in addition to the progressive roll-out of this framework and its incorporation
into domestic law, the treatment of systemically important financial institutions and risk
capture by the shadow banking sector remains to be addressed. It is important to achieve a
level playing field in these areas and that bodies such as the Financial Stability Board
continue to work to accomplish such an objective. Market regulation on, for example,
overthe-counter instruments, alternative investment vehicles and ratings agencies is also an
issue in this context.
On the economic side, at the European level, the key challenge is to bring the "economic"
part of E-M-U up to speed with the "monetary" part. The crisis has shown that the overall
system of economic governance was in need of fundamental reform.
Pro-cyclicality was not confined to monetary policy before the crisis. Actually, too many
economies in the euro area entered the acute phase of the financial crisis with insufficient
room for manoeuvre, because they had not behaved counter-cyclically before. Policy
hyperactivism was another feature of fiscal policy management before the crisis, and the crisis
exposed it in a spectacular way.
European leaders have responded by taking a number of important steps to remedy the
situation, including measures to improve economic policy coordination in budgetary
decisions, such as the so-called "European Semester". A new macroeconomic surveillance
framework will be established in order to check deviant behaviour at an early stage. The
Stability and Growth Pact (SGP) will also be reformed to enhance the surveillance of fiscal
policies and apply enforcement measures at an early stage.
In addition to these EU-wide proposals at the legislative level, a separate pact (the Euro Plus
Pact) has been drawn up by the euro area countries and several other EU Member States in
order to redress competitiveness differences, thereby further strengthening the economic
pillar of EMU.
These measures, once fully operational, would certainly improve the economic governance
of the euro area. But strict implementation is key, so that the concept of "effective peer
review" in the Union regains credibility among market participants and the public.
The ECB regards the reforms made to the macroeconomic and budgetary surveillance
framework as not ambitious enough: they appear to leave room for discretion by Member
States to escape sanctions in the event of non-compliance. More automaticity in this regard
would be preferable.
4. Conclusion
In conclusion, I believe that the crisis has exposed a couple of shortcomings in the monetary
policy paradigm: policy frameworks are insufficiently medium term-oriented, and the role of
monetary variables in this context is underappreciated.
But the core elements of the paradigm, including central bank independence and policies
decisively oriented towards the maintenance of price stability, remain pertinent for the period
ahead.
Central banks have taken unprecedented steps to safeguard this overriding objective during
the crisis. Looking ahead, it is up to other key stakeholders in the global financial and
economic system to live up to their collective responsibilities and mandates in order to avoid
any repetition of past mistakes.