Jean-Claude Trichet: Central banking in uncertain times - conviction and
responsibility
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the
symposium on "Macroeconomic challenges: the decade ahead", Jackson Hole, Wyoming,
27 August 2010.
* * *
Ladies and gentlemen,
As always, it is a great pleasure to be here in Jackson Hole - and to take the opportunity that
this gathering offers each year to reflect on the longer-term prospects for our economies. Let
me mention at the start of my exposition that nothing of what I will say can be interpreted in
terms of the future monetary policy decision of the Governing Council next Thursday. My
colleagues and myself are in our purdah period.
During the financial crisis of the past three years, without ever forgetting their medium and
long term goals of price stability, central bankers have often had to focus on very short-term
developments. At times, we have had to ask what will happen in the next week; in the next
day; or even in the next few hours. Now, as the dust settles somewhat and market conditions
tend to improve, though not without occasional setbacks, it is appropriate - and necessary -
to look again at the more fundamental challenges we face. The chosen topic for this
conference - with its focus on "the decade ahead" - is thus particularly timely.
The financial crisis required prompt, decisive and innovative actions by central banks and
governments around the world. We at the European Central Bank (ECB) have pursued what
I have previously labelled at this symposium a policy of "credible alertness":1 solid anchoring
of inflation expectations combined with bold and resolute action when price stability in the
medium term is threatened and financial developments hamper the transmission of monetary
policy to the real economy.
Looking forward, the advanced economies now face another, related challenge: how to deal
with the legacy of the excesses and imbalances accumulated over the previous decades by
households, firms and financial institutions - notably the expansion of debt, the build-up of
risk and the increase in leverage.
The financial crisis was a symptom of these imbalances. Treating symptoms can relieve the
immediate pain. But such an approach neither cures the underlying chronic problems nor
reduces vulnerability to recurrence. Indeed, the crisis has led to the emergence of yet
another imbalance: a large and rapid growth in public debt.
Treating these more fundamental imbalances is a key challenge for the coming decade, a
challenge that can be expressed in various ways: reducing the debt overhang; establishing
more sustainable levels of leverage; re-absorbing excess liquidity; and restructuring and
strengthening the balance sheets of banks, households, firms, governments and central
banks.
Just as we showed courage in facing the pressing demands of the crisis itself, now
policymakers must be equally courageous in dealing with these longer-term threats to stability and
growth.
That is the topic of my remarks today. I will briefly review the origins and extent of the
imbalances that have accumulated over the past three decades. I will then examine the
implications of the need to deal with these imbalances for today's macroeconomic
policymakers.
Finally, I shall reflect more broadly on the challenges for central bankers in periods
characterised by elevated uncertainty and the need for preventive action. It is in this context
that I will discuss the relationship between the standard and non-standard measures of
monetary policy-making. This is more than a mere technical matter. It goes to the very heart
of our role in uncertain times. Deeply, our decisions on such measures are a reflection of our
fundamental conviction and fundamental responsibility.
I. Debt accumulation in advanced economies
The current debt problems in advanced economies did not start yesterday. They have had a
long gestation over the past few decades, originating in the financial deregulation and
innovation of the 1980s and 1990s. In many advanced countries, new financial products and
institutions emerged, which changed the economic behaviour and balance sheet structure of
the private sector.
On the one hand, financial innovation promised to be welfare-enhancing for society: some
consumers could smooth their spending over time more easily; and access to mortgage
financing became much more widely available, including to segments of the population
previously excluded from the market.2 The benefits of deregulation and innovation appeared
particularly pronounced in the exceptionally benign pre-crisis macroeconomic environment,
which became known as the "Great Moderation".
On the other hand, and with the benefit of hindsight, we can say that the Great Moderation
was the calm before the storm. The easier access to finance permitted by financial
innovation was also leading to higher leverage in the private sector, especially in financial
institutions, to a seemingly inexorable increase in house prices, and to a surge in risk-taking.
Rajan's (2010) analysis of the "fault lines" in our economies reveals some of the deeper
drivers of excessive credit growth, in particular as a way of addressing the macroeconomic
consequences of inequality in societies.
Household indebtedness rose substantially - in some cases, doubling relative to the 1980s -
reaching historically unprecedented levels and exceeding 100% of disposable income in
many advanced economies. Increased indebtedness meant that households were
increasingly stretched to cover their commitments and therefore less resilient to adverse
shocks.
Leverage also increased for non-financial corporations leading to an overall expansion of
balance sheets and a change in their structure. As a result, debt-to-GDP ratios for
nonfinancial corporations in the euro area and the US increased in the past ten years from
roughly 65% to 75-80%.3
And of course, leverage also increased in the financial sector. This development was
particularly evident here in the US, where it was compounded with structural transformation,
including the rise of the shadow banking sector, the spread of the "originate to distribute"
model and the greater interconnectedness between institutions.
But the key trends - an accumulation of risk (despite its apparent off-loading to off-balance
sheet vehicles) and an expansion in the size of balance sheets - were common across
countries. Compared with the rest of the private sector, moreover, the financial sector also
became increasingly dependent on instruments of shorter maturity, thus leaving banks
exposed to liquidity shocks and disruptions in the money market.4
The crisis suddenly brought to a halt the progressive accumulation of private debt. Partly as
a result of large-scale stimulus measures, but also reflecting the impact of the automatic
stabilizers and, to a more limited extent, the cost of supporting the financial system and the
implicit liabilities of guarantees to the banking sector, leverage has started increasing in the
public sector.
Fiscal deficits have shot up to peacetime highs. By the end of this year, government debt in
the euro area will have grown by more than 20 percentage points over a period of only four
years, from 2007 to 2011. The equivalent figures for the US and Japan are between 35 and
45 percentage points. And the response to the crisis has led to a considerable increase in
the balance sheets of central banks.
The key challenge for stability and growth over the coming decade is to ensure a progressive
reduction in the debt overhang and strengthening of the balance sheets of banks,
households, firms, governments and central banks.
The debt overhang bears the ultimate responsibility for slowing down the economic recovery.
Left with the need to reduce their debts and accumulate more assets, households have
significantly increased their saving rates, leading to protracted sluggishness in the growth of
private consumption. The key lesson of history is that sustainable, longer-term growth can
only be ensured once fundamental economic imbalances are treated.
II. Options for reducing the debt overhang
Several ways of dealing with the legacy of excesses and imbalances accumulated over
previous decades have been tried in the past. Let me discuss them in turn to assess whether
they are viable options now. You will not be surprised to know that I exclude any kind of debt
repudiation in the industrialized countries from these options.
1. Inflation?
A recurrent suggestion for solving a debt overhang is the creation of surprise inflation. Again,
let me clearly dismiss this type of action. The history of the debasement of money through
hyperinflation has been disastrous everywhere. Even before reaching extremely high levels,
surprise inflation produces an arbitrary redistribution of wealth and creates a burden for the
unprepared, especially the weakest.
In addition, surprise inflation would destroy the hard-won credibility of central banks
worldwide. After a short period, the loss of credibility, and increased inflation uncertainty
would lead to a world with higher volatility, higher risk premia and higher nominal and real
interest rates. We would be left with no alleviation of outstanding debt, and ultimately with
lower growth as we witnessed during the Great Inflation of the 1970s. The now classic work
on time inconsistency clearly points to the permanent and substantial costs of the loss of
credibility once inflation and inflation expectations cease to be anchored.
2. Living with the debt?
What about the option of "living with the debt"? Some have suggested to ignore existing
financial imbalances "for the time being" and focus only on the short term. Rather than
pressing on with the deleveraging process, more spending could be encouraged to sustain
growth in the short term.
I believe that adopting this view would be very dangerous for our economies. There is a very
clear example of the consequences of choosing to live with the debt: Japan in the 1990s.
The "lost decade" in that country was the result of allowing the banking system to remain
fragile over many years.
Banks appear to have contributed to economic weakness by rolling over the bad debts of
inefficient firms.5 Banks' inadequate capitalisation implied that they were unwilling to take
losses. Low productivity growth in those inefficient firms and the locking in of capital and
labour put a drag on potential output.6 Only a healthy financial system is able to provide
funding for good projects that spur productivity and innovation.7
The lesson from past history is that dealing with the legacy of accumulated imbalances is not
simply a duty to be fulfilled after the economic recovery, but rather an important precondition
for sustaining a durable recovery. The primary macroeconomic challenge for the next
10 years is to ensure that they do not turn into another "lost decade".
This lesson is consistent with economic theory and evidence. Since the time of Irving Fisher,
economists have explored the impact of a legacy of indebtedness for growth. In various
ways, these analyses suggest that an excessive debt burden - whether emanating from the
corporate, household or public sector - constitute a drag on spending, thereby dampening
growth.
For firms, for example, high indebtedness reduces their net worth and the ability to borrow for
new projects. Consequently, firms will postpone investments until they are able to restore
sound balance sheets. Similarly, households' precautionary saving could remain high until
their wealth-to-income ratios return to more normal levels, following the collapse in asset
values at the peak of the crisis.8
Economic growth can also be threatened by high public indebtedness, which, without a
credible fiscal retrenchment plan, can generate substantial uncertainty. Firms and
households know that ultimately they will have to bear the consequences of the painful
measures needed to reduce debt. As long as it is unclear when the adjustment will occur and
who will bear what fraction of the costs of adjustment, firms and households may delay their
investment and consumption decisions, slowing down the economic recovery. In the data,
evidence points to the existence of a negative association between the level of public debt
and subsequent GDP growth, which is particularly marked at high debt levels.9
Finally, the debt overhang can make it attractive for governments to adopt regulatory
measures that compel the financial and/or household sectors to hold government debt at low
or even negative real interest rates - measures referred to as "financial repression". Forced
investment in government bonds distorts the role of the financial system in channelling
resources to the most efficient firms and slows down economic growth. While the effects of
5
Caballero et al. (2008).
6
Ahearne and Shinada (2005).
7
Popov (2009) investigates how venture capital and bank finance affect large manufacturing firms in local
US markets. Popov and Roosenboom (2009) study how private equity affects the rate of entry of European
firms.
8
Carroll and Slacalek (2009) suggest that a simple buffer-stock saving model can be used to think through the
developments of households saving and consumption after the crisis. When asset values collapsed, the
saving rate jumped up as household began rebuilding their wealth. This process has taken time and, as a
consequence, household spending has been depressed. The tightening of credit availability and the increase
in unemployment risk also dampened household spending. Both induced more precautionary saving, as
households have worried about losing a job and being unable to borrow to finance consumption after
experiencing adverse income shocks.
9
See Reinhart and Rogoff (2010). Similar evidence is found by Kumar and Woo (2010), who also report that an
increase in the initial debt-to-GDP ratio is associated with a slowdown in per capita GDP growth.
BIS Review 111/2010
financial repression on growth are particularly severe, these effects may also occur through
excessive financial regulation.10
So the option of "living with the debt" indefinitely is not a solution to the challenges currently
facing policy-makers, nor is it a means to ensure sustainable economic recovery. We must
focus on policies to address the debt overhang.
3. Growing out of the debt
The most appealing solution to the debt overhang is clearly to achieve strong economic
growth. Strong growth produces higher income and wealth, thus increasing the net worth of
households and firms and reducing their leverage. Robust economic growth also boosts
government revenues and reduces expenditure, especially when large automatic stabilizers
are in place, thus leading to a rapid reduction of the government debt-to-GDP ratio.
A spectacular example of the effect of growth on public finances is provided by the UK, which
managed to reduce the government's debt-to-GDP ratio from close to 240% at the end of the
Second World War to 60% in the early 1970s. How did this turnaround come about?

First, real interest rates on government debt were kept relatively low. This reflected
an environment of "financial repression" - including severe restrictions on the
activities of financial institutions combined with controls on international capital
movements.

Second, economic growth was relatively strong during this period (averaging 2.4% a
year), reflecting both increased productivity and labour force growth.

Third, fiscal policy was overall disciplined and, indeed, in a number of years, fiscal
surpluses were recorded.11
Of course, such processes may well be linked and reinforce one another. For example, fiscal
discipline may yield additional benefits due to favourable confidence effects on interest rates
and growth.
Although the UK's post-war experience is encouraging, it should not lead us to be too
sanguine about future prospects for the advanced economies. First, a return to an
environment of financial repression is neither desirable nor feasible. It would represent a
reversal of the trend in policy over the last 40 years towards freer capital markets.
Second, we should probably not expect the real growth rates in the developed world to go
back to the levels of the 1950s or 1960s, an era now characterised by economic historians
as a "Golden Age".12 That being said, one should never underestimate the room for higher
growth potential through resolute structural reforms, particularly in Europe, which is still
marked by numerous rigidities. And given that population growth rates will differ significantly
among economies in the decade ahead, we have to focus more on per-capita growth rates in
our international comparisons.
III. Policy challenges
To summarise, the crisis and the legacy of decades of debt accumulation have left the
advanced economies with high private sector indebtedness and public sectors that must be
trimmed. Reducing the debt overhang and obtaining sustainable levels of leverage for all
actors in the economy is the only option for achieving the goal of the Toronto summit
declaration in June: to "create strong, sustainable and balanced global growth". At the same
time, creating an environment for strong and sustainable growth will facilitate the adjustment
process needed to address the debt overhang.
The enormous challenge for policy-makers in the advanced economies is thus to set in
motion this mutually reinforcing positive scenario of deleveraging and strong and sustainable
growth. For those governments that are faced with high debt-to-GDP ratios, this implies that
merely stabilising those ratios is not sufficient: efforts to accelerate the pace of consolidation
are needed.
Ageing populations and associated increases in spending on health and pensions require
that all fiscal authorities allow budgetary room to respond to those substantial future costs. In
the euro area, for example, ageing-related spending is expected to rise by around
4 percentage points of GDP over the period from 2004 to 2050.13 For governments that face
a sluggish growth rate, that implies a continuation along the path of structural reform in
product markets, labour markets and financial markets. At the same time, central banks face
the challenge of maintaining price stability.
Let me say here, in front of many colleagues who are participating actively in the global
endeavour to accelerate financial repair and reform - particularly through the remarkable
work of the Financial Stability Board and of many workshops that have been established
including the Basel Committee - that I consider their work decisive. We are now at a crucial
moment in this process. In all what follows I am making the working assumption that we will
rely in the next decade on very solid ground as regards financial rules and regulations and
micro as well as macro prudentials.
I will concentrate now on fiscal policies of governments and on the role of central banks in
the years to come in this context of debt overhang.
1. The role of governments
First, governments. Given the size of the accumulated public debt, fiscal consolidation will
have to be ambitious. In the euro area, to reach the reference value of a debt-to-GDP ratio of
60%, a cumulative drop of almost 30 percentage points will be needed. Such reductions are
not uncommon. Beside the post-war UK experience, sizeable debt consolidations have been
implemented in Belgium, which over a period of 14 years from 1994 to 2007 reduced its ratio
from 134% to 84%; in Ireland, which reduced its debt ratio over a 13-year period starting in
1994 by 69 percentage points; and, starting in the mid-1990s, in Spain, the Netherlands and
Finland, which saw their debt-to-GDP ratios drop in the range of 20 to 30 percentage points.
What we can learn from these historical experiences is that large reductions in debt-to-GDP
ratios are not uncommon and quite feasible. In all cases, the fiscal adjustments mainly
occurred through expenditure cuts,14 but they were also supported by lower interest
payments due to falling interest rates. It is clear that given the currently low interest rates,
governments cannot count on a similar channel, although in some countries with very high
debt levels there may be scope for considerable reductions in yields on government bonds.
Once it becomes clear that policy-makers should not count on artificially low interest rates or
high growth alone to reduce government debt ratios, fiscal consolidation - an increase in
taxation and/or a reduction of expenditure - becomes essential. The concern is, however,
that in the short run the deficit reductions - although unavoidable in the long run - have
negative effects on aggregate demand. The economy, it is sometimes argued, is at present
too fragile and thus consolidation efforts should be postponed or even new fiscal stimulus
measures added.
As I pointed out recently,15 I am sceptical about this line of argument. Indeed, the strict
Ricardian view may provide a more reasonable central estimate of the likely effects of
consolidation. For a given expenditure, a shift from borrowing to taxation should have no real
demand effects as it simply replaces future tax burden with current one.16
There is the additional argument positing that credible fiscal deficit reductions through
expenditure cuts lead the private sector to expect a lower future tax burden, especially when
the nature of the cuts make future tax reductions more likely. This can generate higher
consumption expenditures and more investment. In countries with healthy household
balance sheets, a virtuous effect can take place when governments announce and
implement a reduction of the deficit. Expansionary fiscal contractions arise when the virtuous
effects are large enough to offset the negative government demand effects.17 There is some
evidence suggesting that this outcome is not just a theoretical curiosity.18
The size and likelihood of such positive confidence and expectation effects in the short run
will depend on a number of clearly identified characteristics of deficit consolidation. One such
characteristic is timeliness. As all experiences have demonstrated, postponing a necessary
fiscal consolidation is costly. The confidence of markets in government can show sudden and
large swings, which increase risk premia on government bonds and complicate
consolidation.
Indeed, deteriorating fiscal situations go hand in hand with higher risk premia.19 In addition,
empirical evidence suggests that risk premia rise in a non-linear and disproportionate fashion
with debt ratios.20 Finally the period after the Lehman default in September 2008, illustrates
that markets can react with larger increases in risk premia on government bonds when the
fiscal situation is not deemed credible in the long run.21
Timeliness does not necessarily mean that all measures are implemented immediately.
Rather, it implies that a credible long-term plan is announced in time. Although fiscal
adjustment itself may be gradual, it is important to announce a credible road-map for fiscal
consolidation as soon as possible. With a credible road-map, and a consistent step-by-step
implementation of the consolidation measures that it involves, the uncertainty diminishes or
perhaps even vanishes completely. As a consequence, fiscal consolidation pushes the
economy towards a durable recovery.
In addition, fiscal consolidation must be well-targeted. Permanent measures are preferable to
temporary ones. Often one-off actions take the form of asset sales or sale and lease-back
operations that temporarily improve budget deficits. Although such measures temporarily
reduce the official deficit numbers, their one-off nature suggests unwillingness to change the
fiscal stance structurally and to support them through a credible longer-term policy. In
contrast, permanent measures can be expected to lead to positive expectation effects.
15
See Trichet (2010).
16
Barro (1979) and Barro (1989).
17
On overview of empirical evidence on non-Keynesian effects is given in Briotti (2005).
18
Giavazzi and Pagano (1990) and Blanchard (1990) investigate experience of Ireland (1987-89) and Denmark
(1983-86), and argue that a reduction in public spending, through positive confidence and expectation effects
led to expansion in the private sector also in the short term.
19
See Table 1 on page 8 in Haugh et al. (2009) for an overview of the literature on the estimated impact of fiscal
variables on interest rates.
20
See among other, Alesina et al. (1992), Ardagna et al. (2007), Bernoth et al. (2006).
21
Schuknecht et al. (2010).
BIS Review 111/2010
Research suggests that fiscal consolidations targeted at reductions in spending and
government wage bill are likely to be more successful than consolidations based on tax
increases. One of the possible reasons why increases in taxes can hamper consolidation
efforts is that they raise unit labour costs if unions do not accept real income cuts.22 Indeed,
often fiscal imbalances and a loss of competitiveness are intertwined. More generally, fiscal
consolidation measures that support structural reform and productivity growth will tend to
have more positive effects.
2. The role of central banks
Let me now turn to central banks. Their role as anchors of stability is all the more important in
times of deleveraging. A credible, medium-term orientation on price stability is the best
contribution that central banks can make toward sustainable, stable growth. A credible
commitment to price stability anchors inflation expectations, depresses inflation risk premia
and contributes to keeping longer-term interest rates low, thus helping to contain the costs of
servicing public and private debts. Such a commitment to price stability must be symmetric,
ruling out both inflation and deflation.
Maintaining inflation expectations anchored at levels consistent with price stability remains of
the essence. Central banks have learnt over the past 30 years that this requires acting in a
predictable manner, within a framework that is understood by price setters as consistent with
the maintenance of price stability in the medium term. At the same time, the framework
needs to strike a balance between fostering predictability through steady-handedness and
the need for flexibility when facing unforeseen circumstances.
In the exceptional times of the past three years, the response to the crisis by central banks
around the world has led to the adoption of non-standard measures, which by their nature
are less predictable in their special features. It would be hard to argue that their precise
implementation could be foreseen ex ante as the obvious and necessary reaction implied by
their monetary policy strategy to a "financial crisis event". Such degree of predictability would
only be attained if central banks could foresee all possible future contingencies, and thus
provide an exhaustive list of their reactions to all of them. Naturally, this is impossible in
response to a crisis, which is likely to emerge in a way that could not be anticipated in its
details.
Nevertheless, in the case of the ECB, the non-standard measures adopted during the crisis
are ultimately embedded within the same medium term-oriented framework and their
effectiveness depends on the credibility of this framework. Both our programme of enhanced
credit support, the main aim of which was to facilitate banks' liquidity management and
access to funding at a time when money markets in particular started to be dysfunctional,
and the more recent Securities Market Programme, under which the ECB intervenes to
ensure depth and liquidity in dysfunctional securities market segments, are ultimately aimed
at reducing the risks to medium-term price stability arising from the possibility of "disorderly
deleveraging" and the associated disruption of the transmission mechanism of monetary
policy.
There is therefore a certain parallel and a common motivation in these programmes. The
common motivation is the need to ensure as much as possible a proper transmission
channel for monetary policy, even in difficult circumstances. A central bank cannot permit its
chosen monetary policy stance not to be transmitted to the real economy. The parallel is that
the first programme designed in the crisis in 2008 focused on the turmoil in the money
market that at the time was dysfunctional and prevented a proper transmission of the chosen
monetary policy stance to the financial system and the real economy. The second
programme, set up this year, focused on the turmoil in the sovereign bond market. This
market is of significant importance in the transmission of monetary policy because interest
rates on government paper are important reference rates, and because government paper is
widely used as collateral and represents an important asset on balance sheets of financial
institutions.
Reflecting on the decisions taken in the crisis so far and the challenges in the decade ahead,
I would like to share with you some reflexions on three issues that are in my view of great
importance for public authorities, particularly central bankers. First, the issue of uncertainty.
Second, the issue of crisis prevention. And third, the issue of the relationship between
standard and non-standard measures taken by central banks. It seems to me that these
three issues could very well characterise the next decade.
(i) Uncertainty
First, uncertainty. Today, central bankers have to take decisions in an environment marked
by a degree of uncertainty in the economic and financial sphere that seems to me largely
unprecedented. This uncertainty does not have a single cause. Rather, it is the outcome of a
combination of factors. The acceleration of major advances in science and technology (not
only information technology), the ensuing structural transformations of our economies, the
ever-growing complexity of global finance and the overall process of globalisation are itself
creating a multidimensional acceleration of change.
These phenomena contribute not only to a wider degree of uncertainty in underlying
probability distributions, including fat tails. They also entail a much more significant element
of Knightian uncertainty - that is, the type of uncertainty in which there is no underlying
probability distribution.
The inherent and multidimensional phenomenon of uncertainty represents an additional
difficulty for all economic agents. And it is undoubtedly a major challenge for public
decisionmakers and particularly for central banks.
As decision-makers in such demanding circumstances, I would stress several attitudes that
seem to me more important than in the past:

First, the need to be humble - to have a greater degree of humility in the face of
facts that are not only surprising or "abnormal" but sometimes close to incredible.
Several times in the past three years I have been reminded of Thomas Huxley's
famous assessment of many scientific "beautiful theories" being killed by "ugly
facts"!

Second, the need to be alert: even before the crisis, I proposed a posture of
"credible alertness", suggesting that it was the best approach for a central bank to
anchor inflation expectations firmly, while being ready to take action at any point in
time. What is recommended in normal times seems to be even more advisable in
times of accelerated and unpredictable change: a central bank has to be even more
prepared to act without being the prisoner of previous commitments - not, of course,
on goals - which must always be clear and immutable - but on policy actions. This
is true for decisions on "standard measures" as well as for decisions on
"nonstandard measures".

Third, the need for swift action: In periods of accelerated change, the sequence of
unfolding events means that even small changes in initial conditions can make a
huge difference over time. This is naturally the case in a crisis. It has been noted
that crises are "Lorenzian" in the sense that "the flap of a butterfly's wings can cause
tornadoes".23 But it seems to me that the necessity to stand ready to take decisions
swiftly goes beyond the unfolding of a crisis: in periods of accelerated change, swift
action might be essential to prevent loss of control of the situation. Again, this
seems to me to be true both for standard and non-standard measures.
(ii) Crisis prevention
The second major issue for the next decade is crisis prevention. It is generally accepted that
prevention is better than cure. Nevertheless, I have been struck by the fact that, in very
difficult periods, when, unfortunately, the long-term ex ante prevention of turbulence has not
been effective, the immediate