Erkki Liikanen: The economic crisis and the evolving role of central
banks
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland and Chairman of the Highlevel
Expert Group on the structure of the EU banking sector, to the Paasikivi Society, Helsinki,
25 November 2013.
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Introduction
One of the consequences of the most recent international economic crisis has been the more
prominent role of central banks in economic policy. The central banks have played a pivotal
role in crisis management. With the various initiatives currently underway to strengthen
economic governance, the central banks of the euro area, in particular, will be assigned new
responsibilities.
An extreme interpretation of this dynamics was put forward by the American journalist, David
Wessel. In his excellent book on the outbreak of the financial crisis, "In Fed We Trust", the
subtitle on the cover reads "How the Federal Reserve Became the Fourth Branch of
Government", ie alongside Congress, the President and the Supreme Court. Similar thoughts
have also been voiced elsewhere, including in Europe. The central banks have even been
referred to as being "the only game in town". To central bankers, this has been a cause of
concern rather than delight.
The financial crisis brought about changes in the operation of central banks and will continue
to do so. It has forced a rethinking of central banking in terms of both functions and
instruments. The crisis has even raised the question of how central bank independence,
which has become well established in the past couple of decades, can be reconciled with the
new position of heightened influence.
Major financial crises have also in the past had an epochal impact on the perception of the
tasks and capabilities of economic policy and, especially, the role of central banks. The Great
Depression of the 1930s and the great inflation of the 1970s mark significant turning points in
this respect. Each resulted in big changes from which there was to be no return.
The past five years may very well be comparable in significance to the depression of the
1930s or the stagflation of the 1970s. The former governor of the Bank of Israel, professor
Stanley Fischer recently made a remark that this crisis will rewrite economics textbooks. It is
indeed possible that the changes in economic policy practices and institutions initiated in this
period will be assessed as equal to those following in the wake of previous crises.
The shaping of the role of central banks
It is too soon to attempt today a comprehensive assessment of the consequences of the
most recent crisis on economic policy and, in particular, monetary policy doctrines in the
longer term. Certain trends can nevertheless be discerned.
Let me first briefly recount the various stages passed globally on the way to the current
division and definition of economic policy responsibilities.
Following the experiences of the 1930s and the war-time command economy, monetary
policy was, for several decades to come, integrated within the coordinated approach to
general economic policy, and the focus of monetary policy was shifted away from
maintenance of price stability (under the gold standard) towards aggregate demand
management, ie towards a policy aiming at full employment and rapid growth. The theoretical
foundation of this approach was derived from Keynesian macroeconomics. The result was a
significant loss of central bank independence, which in the United States happened as early
as 1933 as a part of Roosevelt's New Deal policies, and in the United Kingdom and France
immediately after the war, when the Bank of England and Banque de France were
nationalised.
New policy instruments emerged as central banks were assigned broad regulatory powers
over foreign capital movements, retail banks' interest rates and the investment of banks'
asset portfolios . Financial market regulation was tightened, but there was little need for
active financial stability policy as understood today, given the high level of stability of banking
systems overall. Occasional balance-of-payment crises still took place, however.
This regime, which had became established after the Second World War, nevertheless hit a
wall in the 1970s. Inflation accelerated to two-digit rates in all leading industrial economies
(except for Germany), while unemployment surged to levels higher than ever recorded since
the 1930s. The situation grew unsustainable to the point of prompting a fundamental
reassessment of economic policy in all Western economies by the early 1980s.
The lesson learnt from the 1970s inflation and the measures to curb it in the following decade
was that monetary policy has its own special role to play in the context of economic policy. Its
most important function is to maintain confidence in the value of money. Failing this,
monetary policy cannot make an effective contribution to any other economic policy
objectives such as sustainable growth and employment.
The redefinition of the functions of monetary policy was, on the one hand, conditioned by the
advances in economic theory and, on the other hand, by German monetary policy
experience. In economics, a greater emphasis was given to the role of expectations in the
inflation process. Germany, whose central bank enjoyed an exceptionally high level of
independence, weathered the storms of the 1970s better than other countries. This was
attributed to the consistent anti-inflationary economic policy of the Bundesbank. This was of
great relevance to the monetary policy of other countries, in general, and to the future
structure of European Monetary Union, in particular.
Hence, in the aftermath of the 1970s inflation, maintenance of confidence in the value of
money, in other words stabilisation of inflation expectations at a low level, surfaced as the
key function of monetary policy. This is commonly referred to as the "anchoring" of inflation
expectations. It was appreciated that this is the very objective that defines the role of the
central bank in the division of economic policy responsibilities. In the 1980s and 1990s, more
and more countries modelled their monetary policy institutions and practices upon this
approach.
The new central bank doctrine has perhaps best been recapitulated by Stanley Fischer in his
famous paper "Modern Central Banking", delivered in London in 1994 at the Tercentenary
Symposium of the Bank of England. The then professor at MIT later served as First Deputy
Managing Director of the IMF and Governor of the Bank of Israel.
Fischer outlines the following principles of modern central banking.
Central banks must have a clearly defined mandate, which is to maintain price stability, and
they must make a public commitment to honouring this objective.
Central banks must enjoy operational independence in the deployment of monetary policy
instruments, such as interest rates, to achieve their objective. Independence also requires
that central banks must not be obliged to finance the government fiscal deficit.
As a counter-balance to central bank independence, Fischer underscored the accountability
of central banks, ie their responsibility to achieve their objective.
While these principles were gaining ground in monetary policy, the advanced economies
entered a highly favourable period of economic development, now referred to as the Great
Moderation. This period of low inflation and stable economic growth persisted for more than
ten years, until the emergence of the financial crisis.
The seemingly favourable developments, nevertheless, masked mounting risks, such as
global economic imbalances, as well as the huge expansion of banks' balance sheets and
risks, which was partly facilitated by the weaknesses in the regulatory framework for banks.
The emergence of the international financial crisis in 2007 and its escalation in 2008
revealed the fragility of the world economy and the credit system as never before.
It may come as a surprise that, despite its gravity, the economic crisis of recent years has not
undermined the foundations of monetary policy. The principles of "modern central banking"
formulated by Fischer remain unchallenged. Indeed, it is astonishing that central banks have
been so successful in achieving their primary objective of price stability and solid anchoring
of inflation expectations amidst these highly extreme circumstances. This is probably in
essence attributable to central bank independence and the confidence that this builds.
At the same time, the central banks have had to actively step up to safeguard financial
stability in a way not necessary since the early 1930s, when catastrophic banking crises
wrecked the economies of both the USA and Germany, then triggering a steep global
deflationary spiral.
Although a traditional function of central banks, ensuring financial stability has not been to
the forefront in normal times. With the severity of the crisis and the moderation of inflationary
pressures, financial stability and the related policy choices have now entered the very centre
stage in the practice of central banking.
Phase one of the crisis: from subprime crisis to systemic crisis
It is useful to briefly discuss how central banks have responded to the various phases of the
crisis and how each phase has affected the role of central banks in economic policy.
Phase one of the crisis, which can be called the subprime crisis, began in the United States
in summer 2007 and landed in Europe on 9 August. Money market turnover virtually came to
a halt and risk premia rose drastically. At the time this seemed dramatic, although, compared
to later developments, this was merely the overture.
This phase was characterised by a collapse in the value of investments in mortgage-backed
securities and their liquidity. Housing prices began to decline in the United States, which
affected the value of packaged and structured securities based on residential mortgages. At
the same time, this created widespread and harmful uncertainty about the real value of the
structured loans. The turbulence spread in summer 2007 to Europe, because by then it had
become evident that many financial institutions had purchased structured loans on their
balance sheets or these loans had been purchased by special purpose vehicles owned by
them.
The crisis was not entirely unexpected, as the under-pricing of risk on the global markets,
which was one factor that triggered the crisis, had been noticed. For example the then
President of the ECB, Jean-Claude Trichet, had already before the onset of the crises
pointed out in public that some investors did not take full account of the possible risks at a
time of general asset price increases. Central banks discussed the dangers of a possible
uncontrolled correction, but they were unable to predict the timing and scale of the problems
that they were about to face.
Already in September 2007, the British bank Northern Rock, which specialised in mortgage
lending and was dependent on short-term market funding, faced a liquidity crisis, which
triggered the first bank run in Britain in 150 years. The Bank of England had to grant massive
liquidity support to Northern Rock, which was subsequently nationalised. The euro area
interbank money market also froze, due to the growing uncertainty, and the ECB had to
increase the amount of central bank money on the market by conducting a series of
nonstandard refinancing operations.
In the United States, the most famous victim of this phase of the crisis was the investment
bank Bear Stearns, whose bankruptcy the US Federal Reserve (Fed) prevented with the help
of large refinancing operations in March 2008. Bear Stearns was subsequently merged with
another investment bank (JP Morgan).
The financial crisis entered phase two, the systemic phase in autumn 2008. The milestone
in this phase was the collapse of the investment bank Lehman Brothers on 15 September.
The message of the Lehman collapse was that even a large financial institution can collapse.
This immediately raised financial market uncertainty and the lack of confidence to completely
new levels globally. The interbank money market, on which banking liquidity was largely
based on, came to a virtual standstill.
Many banks that were dependent on short-term market funding ran into difficulties and had to
resort to central bank financing. Particularly vulnerable was the banking system of Iceland,
whose entire business model hit the buffers. The Icelandic financial system collapsed in
October 2008.
It was clear that the drying up of the credit market would cause great damage. One way that
central banks responded to the situation was, of course, by using their main instrument, the
policy rate. In early November, the ECB began to lower its key interest rates drastically. The
interest rate cuts began from a level of 4.25%, but within six months the policy rate had
already been lowered to 1.0%. The United States reacted even more rapidly and drastically -
by the end of 2008, the Fed had cut the federal funds rate to 0.25%.
The crisis awareness that arose following the failure of Lehman is characterised by the
unprecedentedly swift and smooth international cooperation at the point when the crisis
escalated. Cooperation between central banks, in particular, was very efficient. In Europe,
banks were hit by the drying up of dollar-denominated funding, and therefore the ECB and
the Federal Reserve agreed on large swap lines, as a result of which the ECB obtained
dollars in exchange for euro, to be lent on to euro area banks. The ECB, the Fed and four
other major central banks also conducted an unprecedented coordinated interest rate cut in
October 2008.
In terms of the topic of this presentation, ie the changes in the role of the central banks
during the crisis, even more significant were the measures that the central banks took in
addition to the interest rate cuts.
It was clear that central banks had to focus not only on interest rates but also on
safeguarding banks' liquidity. In October 2008, the ECB launched its full-allotment policy,
under which it has since then provided to banks as much refinancing as they want, at the
prevailing key interest rate, as long as they have the necessary collateral, approved by the
ECB. The list of such eligible collateral has also been extended during the crisis.
Moreover, the ECB began to provide banks with credit with longer maturities than before.
Before the crisis, the ECB's refinancing operations usually had a maturity of one week. To
alleviate banks' uncertainties about their liquidity positions, the ECB has during the crisis
increased the provision of credit against collateral to banks on longer maturities, too. At
times, credit has been provided with a maturity of as long as 36 months.
The longer-term refinancing operations have played an important role in increasing the
liquidity of the banking system, and particularly in decreasing the uncertainty involved. But
now, as the situation has calmed down somewhat, a large part of the excess liquidity
provided has returned to the central bank.
Central banks' actions to safeguard the operation of the markets would hardly have been
possible without the support of governments. In November 2008, the G20 committed to
supporting the liquidity of the banking system, but, at the same time, they also committed to
reinforcing the regulation and supervision of the financial markets. This has triggered very
significant processes, regulatory initiatives, that go further than crisis management and that
aim to reinforce financial market structures in order to prevent a recurrence of the crisis of
2008.
At least in terms of financial sector regulation, the world has entered a new phase.
Experience of the 1930s and the current financial crisis
The swiftness of central bank responses in the early stages of the crisis and their decisive
actions as the crisis continued were mainly due to the experiences of the 1930s. A key role in
formulating monetary policy in 2008 and the years that followed was played by the Chairman
of the Federal Reserve Board, Ben Bernanke, who before his career as a central banker
specialised in research on the Great Depression of that decade.
Bernanke's leadership was of major importance in preventing the total collapse of the
financial system. Without his vision of the reasons behind the Great Depression of the 1930s,
formed during his career as a researcher, the Fed's response would probably have been
much slower and more timid.
Already before Bernanke's work, research had begun to emphasise the role of monetary
policy errors in deepening the 1930s' depression. The key publication was the famous "A
Monetary History of the United States, 1867-1960" by Milton Friedman and Anna Schwartz,
published in 1963. The book claimed that the severity of the Great Depression was due to
the fact that, following the onset of the crisis, monetary policy, particularly in the United
States, was too tight and allowed a steep decline in the stock of money.
Friedman argued that the Fed's failure was due particularly to its collateral requirements, ie
the fact that it held to the "real bills" doctrine. According to this doctrine, the central bank
issued credit only against notes, drafts and bills of exchange arising from actual commercial
transactions. Such securities were not available in sufficient amounts following the onset of
the recession in the '30s, and so the Fed could not increase its lending. According to
Friedman, the Fed should have used extensive purchases of government securities (open
market operations) to prevent a decline in the stock of money, but this was prevented by the
real bills doctrine. This resulted in a fall in the money stock, a collapse in aggregate demand
and a deflationary spiral.
Ben Bernanke published his first research papers on the 1930s' depression already in the
early 1980s ("Nonmonetary Effects of the Financial Crisis in the Propagation of the Great
Depression", American Economic Review, 1983). Bernanke's research emphasised that the
depth of the Great Depression cannot be explained only by monetary aspects (interest rate
level and amount of money), but was mainly due to the banking crisis. Banks were not
helped, and their mass failure led to a collapse in the availability of credit. In the United
States, approximately half of the banks failed in 1930-1933. Bernanke concluded that the
credit crunch caused by the banking crisis and the wave of bankruptcies that followed
deepened the early 1930s' recession in the United States into a full-blown economic crisis.
He criticised the Fed for its failure at that time to act as lender of last resort in order to ease
the banks' distress.
Research on the 1930s crisis has also focused on the importance of the international
monetary system. In a speech on the experiences of the 1930s (given in 2004), Bernanke
notes that the depth and extent of the contraction in the global economy is explained by
attempts to remain on the gold standard. Bernanke refers to studies by eg Barry
Eichengreen (Golden Fetters, 1992), in which the gold standard is regarded as the main
reason for the global slump, and he takes the view that, in those circumstances, abandoning
the gold standard was a prerequisite for recovery from the Great Depression.
The gold standard helped spread the depression around the world, as it prevented countries
with a balance of payments deficit from loosening their monetary policy even when their
internal economic situation had required it. On the contrary, they had to tighten their
monetary policy to remain on the gold standard, and, moreover, their central banks, bound
by the gold standard, were unable to act as lenders of last resort and support the liquidity of
their domestic banking systems. As a result, the recession spread from the countries with a
surplus, which in the 1930s were the United States and France, to countries with a weak
balance of payments (at the time eg Germany and the United Kingdom).
Bernanke and Eichengreen emphasise that, in the 1930s, the international monetary system
did not have a clear leader that would have been responsible for the operation of the entire
monetary system. In particular, the United States, to which the world's gold reserves were
flowing, did not bear its international responsibility. The idea that the stability of the
international monetary system needs leadership and the conduct of monetary policy from an
international perspective originates from research by Charles Kindleberger (The World in
Depression, 1973).
It is clear that the traumatic memories of the 1930s and the related understanding that the
task of monetary policy is to safeguard the operation of the market largely explain the policy
choices of all central banks, and particularly US monetary policy during the current economic
crisis.
The fact that the experiences of the 1930s have again become topical does not necessarily
contradict with the doctrine that was formulated after the 1970s, ie the conduct of monetary
policy geared towards price stability and conducted by independent central banks. We can
expect that the monetary policy thinking and approach towards which the world is apparently
now shifting will be some synthesis of these two. As trust in the self-adjusting properties of
unregulated markets has receded, the monetary and financial market policies of the future
will consist of BOTH the pursuit of price stability (monetary policy conventionally defined)
AND a more systematic and better-organised pursuit of financial market stability.
From financial crisis to sovereign debt crisis
It turned out that even though the financial system remained in operation and no systemic
meltdown occurred in autumn 2008, this did not prevent the global economy from falling into
a deep recession, as everybody attempted to reduce their excessive debt ratios and risky
investments. This led to the third phase of the crisis - the global economic crisis or "Great
Recession" - which hit with full force in 2009.
The force with which the financial crisis hit the real economy came as a surprise to
everybody, and the forecast error made must have been the greatest of all time. Global trade
came almost to a halt at the turn of 2008-2009, and in the next year GDP plunged in almost
all developed economies with magnitudes not experienced after World War II.
GDP contracted by over 3% in the United States and 41⁄2% in the euro area. Finland's GDP
plummeted by as much as 81⁄2%, which was considerably more than in 1991 - during the
worst year of Finland's previous economic crisis. The dive in aggregate demand in the global
economy also affected prices, and in several countries inflation even slipped into negative
territory for some time.
However, the severe economic downturn did not affect people's everyday lives to the extent
one might assume on the basis of the GDP figures, at least not at the beginning. Private
demand was maintained by lower interest rates and the increasing government budget
deficits, despite the strong decline in exports and industrial output.
The large general government budget deficits constituted very expansionary fiscal policies,
which could not, however, continue for long. The limits of fiscal policy were reached first in
countries where government finances had been in a poor state already from the very
beginning, as in Greece, or where the collapse of the banking sector and the related bailout
measures had suddenly pushed the government debt burden to excessive levels, as in
Ireland. This led to the next phase of the crisis.
The fourth phase of the crisis - the - came to a head in spring 2010,
sovereign debt crisis
when Greece's high deficits led to evaporation of market confidence, initially in Greece itself,
and subsequently also in other euro area countries with the weakest economic positions. In
this situation, euro area countries' economic developments and credit risks diverged from
each other, and the ECB's monetary policy, which was already at that time accommodative
to growth, was not transmitted evenly across the euro area.
The repricing of sovereign risk hampered the functioning of markets and the transmission of
monetary policy. Euro area financial markets became regionally fragmented and banks'
problems increased. In this situation, the ECB launched a Securities Markets Programme
(SMP) to alleviate the tensions prevailing on the markets. In the context of the SMP, the ECB
purchased government bonds in those market segments that were most dysfunctional.
During the approximately one and a half years the programme was running, total SMP
purchases amounted to around EUR 200 billion.
In order to alleviate the tensions arising from the sovereign debt crisis, banks were also
offered exceptionally long (3 years) longer-term refinancing operations (LTROs) in December
2011 and March 2012. To ensure the availability of liquidity, the range of collateral eligible in
the ECB's credit operations was also expanded. The Eurosystem applies haircuts in the
valuation of collateral, so as to manage the credit risk inherent in collateral policy.
As the euro area crisis protracted, the fifth stage of the crisis - the European confidence
crisis - began in summer 2012, as nervousness in the sovereign bond markets culminated
and fell even upon large euro area countries, namely Spain and Italy. The markets began to
speculate that one country or a number of countries might even have to exit monetary union.
Weakening confidence in the integrity of the euro highlighted the importance of a common
policy stance for the stabilisation of the situation. At the end of June 2012, euro area finance
ministers issued a statement in which they committed to breaking the vicious circle between
banks and sovereigns and also - as already proposed by the European Commission - to set
up a single banking supervisory mechanism for the euro area, which would be headed by the
ECB.
This was one of the starting points for the EU process referred to as "Banking Union", the
lack of which had proven to be one of the shortcomings in the design of Monetary Union, one
reason for its fragility. The declaration also showed that more political capital had been
invested in the euro than had probably been assumed by those who doubted its
irreversibility.
On 26 July - one month after the Eurogroup statement - the President of the ECB, Mario
Draghi, gave a speech in London containing a statement that has already become famous:
"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And
believe me, it will be enough."
The speech had a very powerful and positive impact on the markets. In retrospect, it has
even been regarded as revolutionary, and with good reason. Pressures on the Spanish and
Italian government bond markets began to ease, even though no detailed programme had
yet been presented to concretise President Draghi's statement.
The concrete content became public at the beginning of August, when the ECB Governing
Council announced a new programme concerning the creation of a programme of
government bond purchases. The details of the programme were communicated during
autumn. Called "Outright Monetary Transactions" (OMTs), the programme was designed to
eliminate such risk premia from the markets as were based on speculations about a
country's exit from the euro area.
No ex ante limits were set on the size of OMTs, but certain conditions were attached to the
programme to ensure its effectiveness and safeguard the ECB's monetary policy. The most
important condition was that the purchases would only concentrate on government bonds of
countries that had signed an economic adjustment programme monitored by the IMF, EU
and the ECB and that, according to the ECB's independent assessment, also adhered to the
programme.
The OMT programme has so far fulfilled its purpose well, as it were: it has considerably
calmed the markets, even though there has been no need to activate the programme.
Evaluation of non-standard measures
The most important forms of expanding the ECB's monetary policy tools in the recent crisis
years can be summarised as follows: elastic provision of credit - ie the "full allotment policy"
- in monetary policy operations, expansion of the list of eligible collateral, the conduct of
long-term credit operations and also, to a certain extent, securities purchases (including also,
last but not least, the so-far unused OMTs). In addition to the Eurosystem's common
measures, some national central banks have conducted certain operations to address
bankspecific solvency problems in their respective countries.
The "forward guidance" introduced this year can be regarded as the newest addition to this
list. Forward guidance refers to regular statements on monetary policy, which for the moment
have been aimed at increasing the efficiency of accommodative monetary policy.
Even though the range of tools for different central banks differs to some extent,
nonstandard central banks measures during the crisis have everywhere resulted in considerable
growth in central bank balance sheets and hence to growth in central bank liquidity. This has
stimulated criticism, particularly from commentators who fear that growth in central bank
liquidity will lead to higher inflation. This debate has been under way in the United States and
the euro area alike.
However, there have been no signs of an acceleration in inflation, at least not in the euro
area. Even though the amount of central bank money has increased, this has not led to a
general increase in the money supply. In fact, the latest indications tell of further diminishing
underlying price pressures in the euro area over the medium term, starting from currently low
annual inflation rates of below 1%.
If changes in the money supply are examined using the concept of broad money, which
means that, in addition to central bank liquidity, bank deposits are also included, we note that
growth in the money supply has recently remained moderate despite the relaxed monetary
policy, and that growth in bank lending to the public has also been weak, often even
negative.
The fact that the increase in central bank liquidity has not been accompanied by an increase
in bank lending and broad money has signalled uncertainty on the money markets and
banks' need to cut their balance sheets, which had often expanded to excessive levels prior
to the financial crisis. Banks strive to increase their liquidity reserves and prefer to keep them
in the form of central bank deposits rather than invest the reserves on the interbank money
markets, as was the case prior to the crisis. This has resulted in a simultaneous increase in
the demand for central bank liquidity and a contraction in bank lending.
At present, a most pressing concern with regard to money supply is that corporate credit
growth is too sluggish rather than too strong. However, if there were any signs of excessive
lending growth in future, the ECB has the means to absorb bank liquidity rapidly, if
necessary.
Charles P. Kindleberger, the famous researcher in the field of financial crisis, has written that
"too little and too late" is one of the saddest phrases in the lexicon of central banking, but that
"too soon and too much" would not be much better. Have central banks and the ECB among
them acted too slowly and parsimoniously, or too generously and hastily?
It is my view that, after the problems that have also hit the European economy in recent
years, the ECB needs to be able to give a positive response to the question of whether it did,
within its mandate, its share and all it could to solve the problems. Decisions are taken on the
basis of the information available at the time. The measures that have been taken have been
necessary in light of the available information. The non-standard measures have even
encompassed notable risks, but the measures have been well considered and, it seems, we
have been able to contain the risks.
Banking union
Alongside crisis management, politicians and public authorities have begun work to reform
financial market regulation, supervision and structures. This reform work will also impact the
position of central banks, albeit differently in different central bank constituencies worldwide.
As regards the euro area, the status and tasks of the ECB will change significantly next year,
as single banking supervision begins and the ECB assumes responsibility for oversight of all
euro area banks. A Single Supervisory Mechanism (SSM) to be set up on these lines will be
part of a wider framework of reforms, the Banking Union. In addition to single supervision,
this also includes a single crisis r