Jean-Claude Trichet: The crisis and its lessons
Lecture by Mr Jean-Claude Trichet, President of the European Central Bank, at the
University of Venice, Venice, 9 October 2009.
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I. Introduction
Ladies and gentlemen,
It is a great pleasure for me to be at the University of Venice. Ca' Foscari is one of the most
prominent and vibrant universities in Italy. I know it is also one of the universities that is most
open to international exchanges. Its blend of research excellence and cultural diversity
makes it close to the ECB in spirit. The ECB is perhaps the most diverse central bank in the
world in terms of its staff composition: more than 27 countries are represented in our ranks.
And our economic departments constitute a relevant centre of economic analysis in Europe.
As a central bank, we are prime consumers of economic research. For this reason, we
maintain very close interactions with the academic world. We import tools and ideas and are
eager to employ excellent economists from centres of advanced economic studies such as
Ca' Foscari. At the same time, the ECB is an active source of cutting edge economic
thinking. I was very happy to see that last year our electronic Working Papers Series -
posted on our web-site - attracted some 4 million downloads. A number of those articles
have made significant contributions to macroeconomic research.
I am also most delighted to be in Venice. This city talks both to the artist and to the
economist. I have discovered that its name can be construed to signify its charm. As you will
know, Francesco Sansovino, for example, claims that: "[i]t is held by some that this word
VENETIA signifies VENI ETIAM, that is, come again, and again, for however often you come,
you will always see new things, and new beauties".1
But, for all its beauty, Venice was never a place of idle contemplation for its citizens. My
countryman and great scholar of European civilizations, Fernand Braudel, chronicles that
wealthy Venetian merchants in the early 1500s used to instruct their agents to "never leave 'li
danari mortti', money lying dead." "Sell quickly, even at a lower price, in order to 'venier
presto sul danaro per un altro viaggio.'"2 It would be nearly impossible to find a more fitting
description of the inner force that moves a market economy. In a vibrant market economy,
money does not rest and is used to serve the creativity and the effort of undertaking
enterprises.
II. The financial crisis
Let me start my remarks by recalling the origins of the crisis as I see them.
Over past decades, our economies have greatly benefited from the effects of financial
liberalisation and financial innovation. For example, the securitisation of assets has played a
role in facilitating an efficient allocation of economic risks. It allowed the financial sector to
offer credit for productive purposes, at more favourable conditions than was possible in the
repressed credit systems of the past.
More recently, however, managing genuine economic risk gradually ceased to be the main
concern of international finance. Instead, the creation and assumption of financial risk
became the core activity of the financial industry. The decoupling of financial positions from
the underlying flows of goods and services gradually created the conditions for a credit
boom. The credit boom was reinforced by an asset price boom, which credit itself was partly
sustaining. Both the credit and the asset price expansion found formidable amplifiers in the
microeconomics of the financial markets and in global imbalances.
In the financial market, compensation schemes for bank loan managers weakened their
incentive to conduct a prudent screening of loans. Executive pay was a function of overall
volumes, which encouraged turn-over and the origination of loans. At the same time, risks
could be shed - or so it seemed - by selling off the loan to other investors in the secondary
market. As for these investors, increasingly complicated financial structures made it difficult
for them to assess the quality of the assets that they were acquiring. They had to trust the
originators. More than in the past, the viability of the financial system came to depend
critically on trust and confidence.
On a global scale, a chronic shortage of savings in some industrialised economies had to be
financed out of an excess of savings in other parts of the world. So, international
intermediation provided a potent fuel to the expansion of finance.
In August 2007 - suddenly but not unexpectedly - trust and confidence started evaporating.
The circular interactions between asset price appreciation, biased incentives, excessive
complexity and global imbalances went into reverse. Market liquidity became scarce and
investors extremely afraid of the risks that they had been exposing themselves to for so long.
Finally, mid-September 2008, the collapse of a major financial player turned the re-pricing of
risk into major financial panic. The chart of money market spreads tells this tale clearly.
As the collapse of confidence became evident, financial intermediaries made every possible
attempt to restore liquidity buffers. Credit spreads soared. Financial market activity fell
dramatically, and the global financial system came close to seizing up.
The crisis triggered a freefall in economic activity.
Within a few months, from January to July 2009, the distribution of GDP projections for the
current year shifted to the left, increasingly into negative territory. To fully appreciate the
massive change in perspective that this brought for all of us, compare the range of outcomes
that were considered likely in successive rounds of forecast updates.
In January, forecasters predicted on average a decline of 1.5% for this year. In March, they
had become even more pessimistic, and they provided a decline of 2.5%. The uncertainty
surrounding these forecasts was high, but even in March a decline of 4.5% was not seen as
possible. This figure was outside the range of all forecasts and was a zero-probability event.
Four months later, in July 2009, it became the central forecast. This shows the rapid and
dramatic free-fall in economic activity. By now, in September, there has been a slight
improvement, to a 3.9% contraction for this year.
Faced with such unprecedented challenges, central banks around the globe demonstrated a
remarkable unity of purpose. Different economies, different channels of transmission called
for different responses.
In the end, the action taken by the leading central banks paid off. If I can return to my first
picture, money market spreads - a symptom of the lack of trust that had gripped financial
transactions in the early autumn - retreated from their peaks. They are now back at levels
that were prevalent before the intensification of the crisis.
III. The ECB's response to the crisis
How did the ECB meet the challenge? The turmoil started on 9 August 2009. The ECB was
in the vanguard among major central banks. It was first in identifying the severity of market
distress, and the first to act on the very same day. As the financial debacle finally
materialised, in the autumn 2008, the ECB's approach to crisis management was diversified
but consistent.
We activated both conventional and non-conventional instruments of policy. We cut our key
policy interest rate by 325 basis points, bringing it to a level that has no historical precedent
in post-World War Europe. In parallel, we adopted a wide spectrum of "non-standard"
measures. They were designed to ensure that the reductions in our policy instrument were
transmitted to the broader credit market and the economy at large.
These non-standard measures are part of what we collectively define as our policy of
"enhanced credit support".
This policy comprises five building blocks:
1. First, full accommodation of banks' demand for central bank liquidity at fixed interest
rates in our refinancing operations.
2. Second, a further expansion in the list of assets eligible for use as collateral in our
refinancing operations.
3. Third, a further extension of the range of maturities at which liquidity is made
available to banks in our refinancing operations. The longest maturity is now one
year.
4. Fourth, provision of liquidity in foreign currencies, notably US dollars.
5. Fifth and finally, a direct covered bank bond purchase programme aimed at reviving
a segment of the financial market that is important in Europe.
Let me emphasise only a few selective aspects of this policy. First, our primary mission is to
preserve price stability. It implies that the transmission of monetary policy impulses is
functioning correctly and that the money market is not disrupted. In this new unexpected
situation we had to tackle the paralysis of inter-bank transactions in the money market. The
money market is where banks can refinance their assets as a precondition for rolling over
their loans to the economy. The flow of credit is primarily channelled by banks in the euro
area. A complete breakdown in the funding relationships that constitute the money market
would have derailed the bank lending channel altogether. The interruption of the bank
lending channel would have turned the financial crisis into a very profound depression. By
granting unlimited access to central bank liquidity - the "fixed-rate full-allotment" tender
procedures - we put banks in a position to maintain their crucial role in the financing of the
real economy. By expanding the list of eligible collateral, we ensured that banks could
refinance that large proportion of their assets that had become less liquid in the crisis. By
extending the maturity of their liquidity provisions, we gave banks a more medium-term
perspective in their liquidity planning. This measure greatly attenuated the maturity mismatch
between assets and liabilities in banks' books, which would otherwise have further deterred
bank lending activity.
We have also been providing foreign exchange liquidity. This primarily took the form of US
dollar liquidity backed by a swap facility with the US Federal Reserve System. The
malfunctioning of the foreign exchange swap market had made the currency mismatch in
banks' balance sheets extremely severe. Thanks to our policy, they could count on ongoing
access to foreign currency balances. This policy was made possible by the very close
cooperation between central banks in the crisis.
Finally, the Governing Council's decision to intervene directly in the financial market by
purchasing covered bonds was meant to re-ignite activity in a market segment that is
particularly important as a source of funding for banks.
IV. Liquidity and exit considerations
Our enhanced credit support policies have boosted market liquidity. Through that channel -
as I showed a few minutes ago - the reductions in our policy instrument could be transmitted
to a whole spectrum of interest rates that are used as re-setting benchmarks for
adjustablerate loan contracts. This has greatly benefited households and firms. But what is the link
between liquidity and price stability? Will enhanced liquidity provision trigger inflation
sometime in the less proximate future? In this respect, let me emphasise two important
aspects of our exceptional policies.
The first aspect is related to the definition of liquidity. Our non-standard measures have
increased central bank liquidity - cash reserves that the Eurosystem makes available to
banks in refinancing operations. But this has not led to an increase in broader monetary
aggregates. In fact, broad measures of money growth are decelerating in the euro area. In
normal times, banks would use an increase in our liquidity provision to expand credit to
households and enterprises. In current conditions, however, liquidity primarily takes the form
of precautionary balances that certain banks are deliberately holding with the Eurosystem.
As long as central bank liquidity serves at least in part banks' precautionary motives, this
extra liquidity will not result in higher inflation in the future.
These considerations bring me to the second aspect of our non-standard policies: the
conditions for their unwinding. Exceptional times have called for exceptional measures. But
we will need to phase out these measures once the rationale for their adoption fades away
and the situation normalises.
The Governing Council believes that it would be premature today to think that the crisis has
been overcome and conquered in a sustainable manner. So, it is not the time to exit yet. Our
future decisions on the phasing-out of non-standard measures will be guided by a
transparent exit strategy. This exit strategy has been designed around four cornerstones.
First, it will be linked to our primary objective and thus to our monetary policy strategy. The
crisis has not changed the ECB's primary objective. This means that any non-standard
measure whose continuation would compromise the maintenance of price stability at any
time in the future will be undone promptly and unequivocally.
Second, the forward-looking initial design of the measures will help us wind them down when
the time is ripe. The ECB's non-standard measures were designed with exit considerations in
mind. A number of measures - think of our refinancing operations - will phase out naturally
by design. At the same time, the size and scope of the outright purchases have been
calibrated so that they would not interfere with the implementation of appropriate liquidity
conditions in a phase of interest rate increases.
technical and institutional capability to
Third, the ECB has the act. The operational framework
of the ECB proved very resilient at the start of the turmoil. It is also sufficiently flexible and
reliable to fit all possible situations which could realistically arise in the future. On the
institutional side, the Governing Council has the unfettered capacity to decide and institute
appropriate policies whenever circumstances warrant this. The ECB rests on a strong
institutional platform, with a clear dividing line between what pertains to the central bank and
what belongs to the fiscal sphere of responsibility.
Fourth, the Governing Council can mobilise its reputation for swift and decisive action
whenever that reputation will be required to support the credibility of its policies. Over the
past decade, our institution has established a clear track record of steady-handedness. This
is also because market participants know that we are permanently alert and that we act
decisively and in a timely fashion when conditions so demand.
V. The current situation
The ECB's "steady-handed approach" to conventional monetary policy action has not
impeded, in fact it has strengthened, a swift transmission of policy changes to market rates
and to credit conditions more broadly. This was possible for two reasons. First,
steadyhandedness makes policy changes more powerful. Private sector expectations regarding
future interest rates adjust and move in a manner consistent with policy-makers' intentions at
all maturities. Second, interest rate reductions have been reinforced by our non-standard
monetary policy measures. These policies have made financial intermediaries less reluctant
to pass on the degree of credit easing that the ECB wanted to implement.
All in all, there are encouraging signs that the substantial stimulus introduced is gradually
bearing fruit. The negative inflationary readings over the summer have been due to large
declines in the price of crude oil in relation to the previous year. In this sense, the fall in
inflation - by boosting the purchasing power of our citizens - has acted as an automatic
stabiliser at a time in which the economic conditions were deteriorating.
Inflation expectations are a good measure of the degree to which the free fall in the economy
and the dis-inflationary process could come to feed upon itself. They have remained stable
around levels consistent with our definition of price stability.
The economy, too, is showing signs of stabilisation. After the strongly negative readings
recorded earlier this year, economic activity in the second quarter is estimated to have
declined by 0.2% relative to the previous quarter. In the period ahead, we expect to see a
very gradual recovery. While the statistical risks to this outlook remain broadly balanced,
there is no room for complacency and we are, as always, alert to any unexpected
developments. On the upside, the impact of the macroeconomic stimulus packages and
other policy measures may prove to be stronger than currently foreseen. On the downside,
the negative feedback between the real economy and the still strained financial sector may
prove more protracted than expected.
VI. Lessons to be learnt
What lessons can we learn from the financial crisis that has shaken our world so profoundly?
The crisis has exposed the fundamental fragility of the international financial system. I had
mentioned that the macroeconomic situation shows signs of stabilisation. We expect a very
gradual recovery ahead, but substantial risks remain.
We have to consider all aspects of finance very seriously. The financial system needs to be
as immunised as possible against its intrinsic tendency towards complacency, irresponsibility
and self-destruction. Three intrinsic weaknesses need correction.
•
First, the pro-cyclicality of the financial system needs to be mitigated by
mechanisms that can provide built-in stabilisers. The quality and quantity of bank
capital and banks' liquidity buffers have to be improved in good times to provide a
sufficient buffer for bank equity to withstand the inevitable increase in credit risk
when the cycle turns. The cyclicality of market economies is inevitable. But the
financial system should not be allowed to amplify swings.
•
Second, the transparency of the financial structures needs to be enhanced.
Financial innovation cannot be built upon - and exploit - gaps in investor
information and a lack of financial literacy. Well-informed decisions by market
agents are a key element of any functioning market economy. All institutions,
instruments and markets that are of any relevance for systemic stability need to
enhance their risk disclosure. The reach of financial regulation needs to be extended
to better reflect the role of highly leveraged institutions and prevent abuse in the
derivatives markets.
•
Third, short-termism in the design of financial contracts needs to be corrected.
Market participants - traders, loan managers, risk committees and boards of
directors - were given strong economic incentives to focus on short-term profits.
Long-term value creation was not a concern in the pre-crisis world. Collectively, this
resulted in excessive risk taking. In tune with the last G-20 pledge, a reform of the
executive compensation schemes and practices is an essential part of our effort to
secure financial stability.
Far from putting off the agenda for structural reforms, the crisis has made them more urgent.
No segment of the market or category of players has been immune to the crisis. The list of
areas that proved dysfunctional can be extended to include the risk management and credit
assessment of banks, accounting standards, audit quality, supervision, and many more
elements. No market segment or financial actor should escape profound rethinking. This
rethinking should have the scope and ambition of a paradigm change. The new paradigm
should be based on three notions.
First, medium-term and long-term sustainability in macroeconomic policies and financial
strategies should replace the myopic perspective that is always a temptation. Herd behaviour
in the financial markets might have two parallels in the macroeconomic sphere. These are:
profligate fiscal policies in times of boom and over-accommodating monetary policy in
downturns. A new medium-term perspective should concentrate policies on medium-term
objectives. Like financial contracts, policies should not amplify economic fluctuations.
Second, authorities and major players in the financial scene should immunize themselves
against complacency. The crisis has proved that unpredictable shocks, however unlikely, can
compound in the aggregate. In these conditions, historical correlations of risks become an
insufficient instrument to check the resilience of an institution or the system as a whole. A
constant monitoring of resilience should become part of the new regime.
Third, the approach should be holistic. The global proportions of the crisis call for a rethinking
of the links between financial behaviour and macroeconomic policies. This has two
implications. The first concerns domestic governance. Major economies need to complement
their micro-prudential apparatus with a new macro-prudential function. Macroeconomic
resilience calls for a systemic analysis of risk. Macro-prudential supervision offers this type of
analysis and can act as a countervailing force to the tendency of the financial system to
amplify economic swings. A far-reaching reform in this direction is underway in the EU. A
new European Systemic Risk Board (ESRB) will be created which will detect risks to the EU
financial system and issue warnings and recommendations to national supervisors.
The second implication concerns international macro-governance. Over the last year, efforts
to find new fora in which risks to the global economic order can be identified, discussed and
addressed have intensified. Throughout the turbulent times, coordinated guidelines have
been put forward at the European and international levels by the Financial Stability Forum,
the Eurogroup and the European Council. They were reflected in the declarations of the G-20
premier forum
summits. The G-20 itself has emerged as the for international economic
dialogue.
Within the G-20, I find it encouraging that there is now a broad consensus between the
emerging market economies and the industrialised countries on the principal directions of
financial reform. In this field, I see a very strong consensus in the global community of central
banks. As first signs of recovery can be observed and as banks are returning to profitability, it
is important to keep up momentum and to proceed with the further steps that are necessary
to ensure that events of such intensity do not recur in the future.
Yet, in the new economic order that will emerge these fora - and each single
macroeconomic authority that is represented at the table - will share a precisely defined
responsibility: the correction of global imbalances. Trade and financial imbalances were a
major source of instability in the pre-crisis world. Now, it is the precise mandate of the world
economic leaders to identify a pattern of growth across countries that is more sustainable
and balanced. They need to evaluate whether the macroeconomic policies that are enacted
domestically by the major economic players are collectively consistent with more sustainable
and balanced growth worldwide.
For this process to be effective, peer pressure needs to be made more compelling than it
was in the past.
Let me say a few words on Italy.
The Italian economy is undergoing an unprecedented adjustment, as are virtually all
developed countries throughout the world. Many Italian enterprises, in particular small and
medium-sized ones, are currently dealing with very challenging times. I am confident that
they will emerge from present hardships with leaner cost structures and a more efficient
organisation of production processes. In the end, the entrepreneurial spirit that is in the
genes of this nation will prevail.
The financial crisis, the macroeconomic response to it and the lessons that we need to learn
have been the themes of my talk today. My main message is that despite all the difficulties,
the crisis is an opportunity for this continent and for this country in particular. Italy is a country
that has traditionally gained confidence in the severest of circumstances. I therefore hope
that reflections on the causes and lessons of the crisis can contribute to economic reform
that can bring a new era of progress for Italy.
First of all, the crisis has shown the health of private finance in Italy. Italy never indulged in
the financial excesses of the recent past. It remains an economy, where finance is first and
foremost support for real economic production. Strong saving propensities and prudent
banking represent a platform of security from which the economy can restart.
But economic reforms cannot be delayed. The crisis can be the trigger for an ambitious plan
to modernise the Italian economy and to make it more dynamic. Labour market institutions
need to be overhauled to make labour compensation better reflect individual effort and
firmlevel excellence. The pricing chain - notably in the service sector - needs to be streamlined
to increase the flexibility of prices. Welfare-enhancing positions that are a drain on
disposable incomes and the economic potential of the country need to be discarded.
I would like to encourage policy makers to tackle these issues.
VII. Concluding remarks
Bold efforts by central banks and governments around the world have been effective in
containing the propagation of a formidable shock. But short-term steps to alleviate the crisis
need to be reinforced by longer-term reforms that can inhibit the development of bubbles,
stabilise financial markets and provide greater financial security to households and
businesses.
A number of elements and - one might even say "totems and taboos" - of the pre-crisis
economic universe have now lost most of their value. This applies to individual financial
players and business models alike. Other elements, however, have maintained their worth. It
is on these latter elements that we should build the future of this continent.
The euro - the single currency - and the macroeconomic framework of the Union have
certainly proved their strength in the last 12 months. The countries of Europe were not left to
weather the storm alone. The financial maelstrom has not turned into any national debacle. A
medium-term-oriented macroeconomic framework had helped - before the crisis - to put
Europe on a solid ground. Those solid foundations have enabled it to withstand the
onslaught.
In the end, the strength to overcome the present hardships will come from the inside. Our
openness to trade, our balanced and dynamic business structures, our talented and
welltrained workforces are part of our future. We know that technological progress will continue
unabated in Europe. Companies and people will continue to prove their entrepreneurial spirit
in large and small organisations. Reflection and endurance will be rewarded by a sense of
personal fulfilment and by collective progress. Private thrift and a sense of prudent
housekeeping are Europe's primary safeguards against the risk of developing into a bubble
economy.
All this will be the engine that will steer the economy towards tomorrow's recovery.
Thank you for your attention.