To this end, an index of aggregate macro-financial imbalances, or of institution-specific vulnerabilities, is tested against variables such as credit growth, property price changes, private sector leverage and current account deficits, to discover which variables predict that index. Measures of bank leverage, balance sheet growth and maturity mismatches may also be used in order to gauge the extent to which the financial sector is driving developments. Second, to assess the relative importance of different risks for financial stability. This is done using “adverse scenarios” that are designed and macro stress-tested to establish the potential severity of different types of risk and the overall resilience of the financial system to severe shocks. Such models, including top-down stress test of individual institutions, allow risks to be assessed more broadly and at a higher frequency than is possible with bottom-up exercises run by financial institutions, thus enhancing the “real time” information on systemic risk available to policymakers. Third, to assess the financial channels through which risk can be propagated, thereby factoring-in potential second-round effects. The use of contagion and spillover models allows, for example, the assessment of the impact on the financial system of the failure of a particular financial institution or of turbulence in a particular sovereign debt market. BIS central bankers’ speeches  3  We could consider how this framework would have functioned if applied retrospectively. For example, the monitoring of the credit-to-GDP ratio as an early warning indicator of widespread asset-price misalignments would have initiated early warning signals as early as mid-2005.

Equally, excessive public expenditure - which had ultimately to be financed through higher taxation - imposed burdens on the private sector which weakened its capacity to generate employment and income and wealth. So the emphasis now, more or less everywhere, is on effective price stability as the immediate objective of monetary policy - not simply as an end in itself but as a measure of the balance between aggregate demand and underlying supply in the economy as a whole, in order to moderate rather than aggravate the economic cycle, and so to provide the basis for sustainable growth at around the underlying rate of growth of productive, supply-side, potential. And the emphasis now - again more or less everywhere - in relation to fiscal policy is to limit public sector borrowing, and the outstanding level of public sector debt, to levels that can be sustained into the future, without the need for increasing tax burdens or raising real interest rates on the private sector. These objectives of macro-economic policy - monetary and fiscal policy - will be familiar to you in recent years in this country; they are at the heart of the policies being pursued in Continental Europe by those countries that, in just under a fortnight from now, will agree to move ahead to Monetary Union; and they are the policies endorsed, too, by all the members of the IMF in the Madrid Declaration adopted at the IMF Annual Meeting in 1994 and expanded and updated eighteen months ago.