zdenek tuma : the interrelationship between monetary policy, price stability and financial stability speech by mr zdenek tuma, governor of the czech national bank, at the european banking and financial forum 2005, prague, 22 march 2005. * * * mr. president, excellencies, governors, distinguished guests, it is an honour to be opening the central bankers'forum. as the main part of the conference program concerns the financial sector challenges and opportunities in the “ new europe ”, the central bankers'panel has to necessarily reflect the close, particularly topical, issue of the financial stability and its relationship to a reasonable monetary policy conduct. while my colleagues will discuss mainly the particular issues of financial stability, i, having the privilege to be the chairman of the panel, would like to frame the discussion using a more general and historical context. bearing this perspective in mind, i would like to point to the interrelation between the ultimate goal of monetary policy, the price stability, and the financial stability. first of all, let me start with the definition of financial stability, simply assuming that price stability does not need any further explanation. to be as brief as possible, financial stability can be defined as the soundness of the financial system, that is, its resilience against various shocks. what i understand as a sound financial system can be thought of as a system that, firstly, enables individuals to do all the payments they want at the very moment they like, and, secondly, enables individuals to smooth their consumption across time by saving and borrowing. in this respect, the financial stability issue, which arose during the nineties, is not a completely new one. indeed, it has been of a significant importance since banking emerged. the long years of commodity money system ( so called “ golden standard ” ) could be characterised as years when money supply, i. e. the supply of gold, was so exogenous that it was even out of the central bank's control. consequently, monetary policy was relatively easy to do, just establishing the parity between the central bank banknotes and the gold, but the role of the central bank as a lender of last resort was relatively constrained. under those circumstances, the financial stability was naturally of a high importance, because for any commercial bank the attempt to “ run ” the bank could be deadly. moreover, this could cause stampede runs on others banks and bring the whole system to an end, as the central bank '

the historical record and identified a series of errors - errors of both commission and omission - made by the federal reserve in the late 1920s and early 1930s. according to friedman and schwartz, each of these policy mistakes led to an undesirable tightening of monetary policy, as reflected in sharp declines in the money supply. drawing on their historical evidence about the effects of money on the economy, friedman and schwartz argued that the declines in the money stock generated by fed actions - or inactions - could account for the drops in prices and output that subsequently occurred. 2 friedman and schwartz emphasized at least four major errors by u. s. monetary policymakers. the fed's first grave mistake, in their view, was the tightening of monetary policy that began in the spring of 1928 and continued until the stock market crash of october 1929 ( see hamilton, 1987, or bernanke, 2002a, for further discussion ). this tightening of monetary policy in 1928 did not seem particularly justified by the macroeconomic environment : the economy was only just emerging from a recession, commodity prices were declining sharply, and there was little hint of inflation. why then did the federal reserve raise interest rates in 1928? the principal reason was the fed's ongoing concern about speculation on wall street. fed policymakers drew a sharp distinction between “ productive ” ( that is, good ) and “ speculative ” ( bad ) uses of credit, and they were concerned that bank lending to brokers and investors was fueling a speculative wave in the stock market. when the fed's attempts to persuade banks not to lend for speculative purposes proved ineffective, fed officials decided to dissuade lending directly by raising the policy interest rate. the market crash of october 1929 showed, if anyone doubted it, that a concerted effort by the fed can bring down stock prices. but the cost of this “ victory ” was very high. according to friedman and schwartz, the fed's tight - money policies led to the onset of a recession in august 1929, according to the official dating by the national bureau of economic research. the slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in october. in other words, the market crash, rather than being the cause of the depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it. of course, the stock market crash only