Jens Weidmann: Managing macroprudential and monetary policy - a
challenge for central banks
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, at the SUERF/Deutsche
Bundesbank Conference 2011/IMFS - The ESRB at 1, Berlin, 8 November 2011.
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1. Introduction
Ladies and gentlemen,
In the event of an earthquake, the question that decides between life and death is whether
the buildings are stable enough to withstand the tremor of the earth. In the event of a
financial shock, a crucial factor for the severity of the crisis is to what extent the financial
sector is stable, and whether it is possible to contain negative feedback effects within the
macroeconomy. The financial system's recent track record in this respect has not been
wholly convincing, to put it mildly. Therefore, one central question on the global political
agenda is "how to better ensure financial stability?".
Comparing the stability of our financial and monetary system with a building that has to
withstand a substantial earthquake, the two columns monetary policy and microprudential
supervision - which supported that building and which we believed to be strong enough -
turned out to be insufficient. Shocks caused by turbulences on local markets may propagate
much more quickly and widely than it had been previously expected. Hence, an explicitly
systemic view on financial markets is needed as an additional element in our policy-making
building, namely macroprudential policy.
In the following, I would like to elaborate on the question as to how this new column should
be designed. First, I will address the more conceptual aspect of the interrelations between
financial stability and monetary policy, and point out that, since both policy fields pursue
separate objectives, an individual set of instruments for macroprudential policy is needed.
Second, I will concentrate on operational aspects of macroprudential policy. In particular, I
will highlight that macroprudential policy will rightly gain in importance and that central banks
ought to make a substantial contribution without, however, compromising their main objective
- price stability - and their independence. Finally, I will outline that, in addition to this, the
European sovereign debt crisis poses a much more fundamental question: How can central
banks fulfil their mandate if risks to macroeconomic and financial stability emanate from
unsound public finances and structural economic weaknesses, yet policymakers do not
succeed in putting these deficiencies right?
2. Interrelations between financial stability and monetary policy
The question as to what extent monetary policy can contribute to financial stability is certainly
not new. However, the answer had to be and has been adjusted in the light of experiences
throughout the recent crisis. In the decade preceding the financial crisis, central banks kept
interest rates at very low levels, partly due to an environment of seemingly exceptional
macroeconomic stability. Another important factor was certainly the widespread opinion
prevailing at that time, that monetary policy should not lean against a bubble that is building
up, but intervene after a bubble has burst. From today's perspective we know that by
applying such an asymmetric monetary policy approach two important aspects were
underestimated. First, in the low interest environment the search for yield caused market
participants to take riskier positions and contributed to the build-up of systemic risk. Second,
the turbulences when the bubble burst could not easily be contained by making use of
traditional monetary policy instruments but necessitated unconventional measures in several
policy areas. In addition, serious repercussions in the financial sector and the real economy
could not be prevented.
Against this background, the role of monetary policy has been stated more precisely. There
is still no doubt that price stability should be the key goal of a central bank. Fulfilling this
mandate forms the basis of our credibility, and we must not lose sight of this goal when
becoming involved in crisis management. In addition, we should be aware that monetary
policy is not able to fully avoid the build-up of bubbles and the event of crises. Pretending
otherwise would lead to expectations in monetary policy that cannot be satisfied, and this
would ultimately undermine central banks' credibility with negative consequences for our
ability to maintain price stability.
However, as a central lesson from the crisis, monetary policy has to take a closer look at the
possible build-up of financial imbalances - because these have implications for price
stability. In the case of the Eurosystem, this implies that monetary analysis, which already
focuses on longer-term risks for price stability stemming from increasing money supply, will
gain in importance. This will allow monetary policy to extend its horizon and to apply
monetary policy more symmetrically across the financial cycle, in line with the fact that
financial imbalances regularly build up over a longer period of time.
Such a more symmetric approach to monetary policy is based on central banks' primary goal
of price stability, and will contribute to financial stability. However, while price stability is a
necessary prerequisite for financial stability, it is far from being the only one. In addition,
central banks equipped with only one main instrument, i.e. the interest rate are not able to
meet several goals, that is price stability and financial stability at the same time. For
monetary policy to be able to concentrate on price stability, it is therefore indispensable that
macroprudential policy is equipped with an individual set of instruments.
This notwithstanding, monetary and macroprudential policy cannot be seen completely
separately from each other due to potential spillovers. Therefore, some coordination between
both policy fields is warranted, although without blurring the individual objectives.
3. How to design macroprudential policy
With this in mind, I would like to turn to the more practical issues associated with the
question "how to design macroprudential policy?". For efficient macroprudential policy, two
things are crucial: a thorough analysis of the build-up of systemic risk to be able to issue
warnings and recommendations, and the translation of such warnings into policies and
action.
In order to facilitate the transition from analysis to action, a clear mandate for
macroprudential supervision is needed. And there are good reasons why central banks
should be involved as long as their independence and the hierarchy of their objectives, with
price stability as the primary goal, are respected. Their extensive knowledge of financial
markets and the macro economy is very valuable for macroprudential purposes, and their
participation will facilitate forming a consistent view for both monetary and macroprudential
policy. In this regard, I highly welcome that the Bundesbank is to be given an explicit
macroprudential mandate.
With the introduction of countercyclical capital buffers, the first truly macroprudential
instrument will be at the disposal of national supervisory authorities. By dampening
excessive credit growth, countercyclical capital buffers will make it possible to "lean against
the wind" beyond the scope of monetary policy and thereby enable monetary policy to better
focus on price stability. This is especially important in a monetary union such as the euro
area. As the common monetary policy has to ensure price stability for the euro area as a
whole, it is not suitable as a means of preventing excessive credit growth in single countries,
which is often aligned with the build-up of systemic risk. For example, it is beyond the reach
of monetary policy to counteract regional overheating in housing markets, which often goes
along with excessive credit growth. In such a case, nationally calibrated countercyclical
capital buffers may prove to be effective.
However, we have to make sure that monetary and macroprudential policy complement
rather than counteract each other. For example, it would be inefficient and detrimental to
both objectives if macroprudential policy tightened its stance to dampen credit expansion,
while at the same time monetary policy was loosened because there is no medium term
inflation risk and an expected economic downturn may contribute to even reduced price
pressure. In order to avoid an inconsistent, suboptimal policy mix, a close exchange of
assessments in both policy fields is necessary - however, it should not lead to a blurring of
the responsibilities of the respective policy areas. It goes without saying that to ensure a
comprehensive surveillance of the financial system, such an exchange of information is also
necessary between macroprudential policy and microprudential supervision, not just in order
to take on board the expertise of microprudential supervision but also to share any relevant
information.
While final decisions about the use of macroprudential policy instruments, such as the
calibration of countercyclical capital buffers, should be taken on the national level, which has
the greatest expertise on the national financial system and has to bear the cost of regulatory
failure, a purely national perspective of macroprudential oversight remains too narrow. As
became all too clear in the course of the crisis, systemic risk does not respect national
borders and the close integration of capital markets and the risks of regulatory arbitrage
require international cooperation, for instance in the design of macroprudential instruments.
In this process, the European Systemic Risk Board (ESRB), whose anniversary we celebrate
with this conference, is a key player. About one year after it was established, its tasks as
central guarantor for financial stability within Europe have increasingly taken shape.
Consisting of representatives of national central banks and microprudential surveillance
bodies, the ESRB builds on the expertise of national authorities with the task of assessing
systemic risk on the European level and issuing recommendations and warnings across
Europe. In addition, its scope is about to be broadened to playing a coordinating role for
macroprudential policies and guarding against protectionism in the regulatory framework.
4. Challenges from the sovereign debt crisis
While the work on a better framework for ensuring global financial stability is in full progress,
the European sovereign debt crisis has turned the focus to the foundations on which the
stability of our monetary and financial system rest: a sound and competitive macroeconomic
base and solid public finances. The specific challenge for monetary and macroprudential
policy in the current debt crisis stems from the fact, that while both policy goals are affected
the possibilities to contribute to crisis resolution are limited. Specifically with respect to
monetary policy, there is the substantial risk that involvement in crisis resolution may entail a
burden shifting from fiscal to monetary policy, and the ultimately necessary political action to
address the root cause of the crisis might be delayed, incomplete, or not happening at all.
One of the severest forms of monetary policy being roped in for fiscal purposes is monetary
financing, in colloquial terms also known as the financing of public debt via the money
printing press. In conjunction with central banks' independence, the prohibition of monetary
financing, which is set forth in Article 123 of the EU Treaty, is one of the most important
achievements in central banking. Specifically for Germany, it is also a key lesson from the
experience of the hyperinflation after World War I. This prohibition takes account of the fact
that governments may have a short-sighted incentive to use monetary policy to finance
public debt, despite the substantial risk it entails. It undermines the incentives for sound
public finances, creates appetite for ever more of that sweet poison and harms the credibility
of the central bank in its quest for price stability. A combination of the subsequent expansion
in money supply and raised inflation expectations will ultimately translate into higher inflation.
In a monetary union of independent countries, one additional aspect that is often missed in
the current discussion is particularly relevant. Monetary financing in a monetary union leads
to a collectivisation of sovereign risks among the tax payers in the monetary union. It is
equivalent to issuing Eurobonds. However, the redistribution of such risks and the related
transfers between the members of the monetary union are clearly the task of national fiscal
policies, and only the national parliaments have the democratic legitimation to make such
decisions. For this reason, the Eurosystem's mandate to ensure price stability rightly involves
the prohibition of any kind of monetary financing.
Proposals to involve the Eurosystem in leveraging the EFSF - be it through a refinancing of
the EFSF by the central bank or most recently via the use of currency reserves as collateral
for an SPV buying government bonds - would be a clear violation of this prohibition.
Incidentally a support of this scheme by governments would have also circumvented the
parliamentary approval for additional rescue funds provided by Germany. These proposals
have met the staunch opposition of the Bundesbank. The current crisis cannot be solved by
destroying its stability oriented basis. Hence, I am glad that also the German government
echoed our resistance to the use of German currency or gold reserves in funding financial
assistance to other EMU members.
It is sometimes requested that Germany should contribute more strongly to international
stabilisation. However, in my view the most important contribution at the moment is that
Germany remains a stability anchor in EMU with regard to fiscal sustainability and with
regard to its stability orientation. For example, the new national fiscal rules in Germany may
increase confidence in sound public finances, which I believe is currently more important
than any short-lived fiscal stimulus. Therefore, I would advise the German government not to
weaken its fiscal stance by spending any revenue windfalls, but rather to continue the timely
consolidation of the budgets at all levels of government.
From a short sighted perspective flirting with monetary financing may be perceived as a
seemingly easy way out, but policymakers have to implement a true long-term solution to the
crisis. The course of the crisis leaves no doubt about what this requires. First, on the national
level the determination of the affected countries to return to a sustainable path of public
finance and to undertake the necessary structural reforms is required. Second, as such
action will inevitably entail painful and initially contentious adjustments, we need a framework
within the monetary union which ensures sufficient incentives for the member states to follow
this way nevertheless. So far, the decisions taken for crisis resolution within the monetary
union have not addressed these issues sufficiently as the recent aggravation of the crisis has
shown.
The October summit dealt with a number of important crisis issues. One definitely positive
outcome of the summit was the decision to ensure sufficient capitalisation in the banking
sector, given that contagion effects are a major reason for the severity of the crisis.
However, as we currently see, even positive outcomes of the summit fall short of expectation
without the necessary consolidation and structural adjustments in the countries which are at
the heart of the crisis. More generally, the euro area is currently caught up in the fact that its
framework has, in the course of the crisis, increasingly lost consistency. This is harming the
credibility of the current rescue packages. While risks stemming from undesirable and
self-inflicted developments in individual countries have been increasingly communalised by
the assistance packages, the ultimate decision-making power has remained on the national
level and the conditionality that was intended to rein in national policymakers has been
increasingly relaxed.
As a first step, a consistent strategy requires strict conditionality of the agreed financial help
to be enforced in order to prevent the incentives to implement painful reforms and
consolidation measures from weakening further. In the case of Greece, this must imply that
the financial help, which is bound to strict consolidation and reforms, will be halted if Greece
decides against the agreed adjustment process. It is an important and promising signal that
policymakers from EMU member countries have stressed this point, too. What is often
overlooked, however, is that uncertainty about the future of the adjustment programme can
quickly make untenable the situation of central banks which continue to provide liquidity to
Greek banks.
Furthermore, however, policymakers have to decide which direction the currency union is to
take. As I have discussed in more detail in earlier speeches, there are in principle two
conceivable ways to a consistent and economically sustainable framework for the monetary
union. While the first would be a return to the founding principles of the system, but with an
enhanced framework that really ensures sufficient incentives for sound public finances, the
second way would imply a major shift entailing a fundamental change in the federal structure
of the EU and involving a transfer of national responsibilities, particularly for borrowing and
incurring debt, to the EU. Only a clear decision for either option lays the foundation to
preserve the monetary union as a stability union in the long-run. It is up to governments in
Europe to make this decision.
5. Conclusion
Ladies and gentlemen,
Before we had time to implement all the lessons learnt from the financial crisis, the European
sovereign debt crisis has posed new and substantial challenges. This is particularly true for
central banks, as their primary mandate of ensuring price stability not only has to be
internally reconciled with efforts to better ensure financial stability, but is at the same time
exposed to a crisis situation in which the line between monetary and fiscal policy is growing
increasingly blurred.
In this situation, we are well advised not to overburden central banks. Primarily, they should
continue to focus on maintaining price stability, a task at which they have an excellent and
proven track record. In addition, central banks will play an important role in macroprudential
policy, both at the national and at the international level, for example as members of the
ESRB. But, as I said before, the stability of our financial and monetary systems depends on
more than these columns and microprudential supervision. A sound macroeconomic and
fiscal basis is equally important, and it is not central banks but policymakers that have the
means and the legitimacy to ensure this basis.