alan bollard : a tale of two crises speech by dr alan bollard, governor of the reserve bank of new zealand, and mr mike hannah, head of communications department and board secretary, to the canterbury employers ’ chamber of commerce, christchurch, 27 january 2012. * * * thanks to colleagues at the reserve bank of new zealand. this paper does not represent financial advice. introduction as new zealanders get back to work they are looking back over the year as a guide to the challenges that will lie ahead. the year has been marked by two slow - burning but dramatic events that all are having to continue to adjust to : the european sovereign debt crisis and the canterbury earthquake aftershocks. these crises were not predicted, and they have shocked the new zealand economy in quite different ways, evoking different responses. we look at the economic effects and how new zealand is responding. part 1 : the european sovereign debt crisis the european crisis to date a sovereign debt crisis starting among the peripheral euro - economies, and accelerated by the global financial crisis ( gfc ), has blown out with the threat of contagion to larger european economies, affecting funding markets for all countries, including new zealand. the peripheral and central european economies are still threatened, with recession looming, despite a number of policy initiatives. the new year has opened less bleakly than some feared, but credit downgrades and funding market nervousness in europe also indicate clearly that it is too early to call an end to the uncertainty and volatility. the gfc and sovereign debt crises have both severely shaken global financial markets, and reduced wealth and economic activity. they are related crises to a large extent, but they are different crises, and their different natures mean different responses and resolutions. the gfc was essentially a credit and bank crisis, with interbank lending and liquidity freezing as banks lost trust in one another, nervous as to who would be left holding worthless subprime paper hidden in opaque derivatives. it was a crisis that taught us about tail - end risk and the fragility of market liquidity, despite the depth of the market. funding markets ( even highly liquid conventional ones ) can freeze up under stress, despite the apparent availability of funds and credit - worthy borrowers. the european crisis has highlighted the crucial role of sovereign debt markets, where banks have managed to transfer unfunded liabilities to governments, and governments have issued debt to fund the transfers. the european sovereign debt crisis owed much

of its origin to the gfc, but also to the imbalances that had built up in many economies, through large unsustainable fiscal deficits, persistent current account deficits, and demographic and other public liabilities. when governments in a poor fiscal state were required to issue more debt, either to bail out banks or fund ongoing fiscal programmes, the pressure on the sovereign balance sheets became intolerable to markets. new and even roll - over funding became difficult to access and much more expensive. bis central bankers ’ speeches different crises bring different market responses. whereas a banking debt crisis can flare up, the sovereign debt crisis has manifested itself in a “ slow - burn ”, and financial markets have reassessed their capacity to fund large and growing levels of government debt. markets are now incorporating different levels of credit risk for member states, and assessing the differing degrees and credibility of government support – whereas, before the crisis, sovereign debt in the euro zone was viewed as being largely free of default risk. policymakers are still struggling to come up with credible policy responses that will reduce these credit risk premiums without creating the moral hazard that would encourage continued indiscipline by some countries. 10 - year government bond yields source : bloomberg with economic activity at stalling speed, short - term inflation risk is very low. in these conditions, inflation - targeting countries, including new zealand, have seen scope for big cuts in interest rates during the gfc and persisting through the subsequent sovereign debt crisis. however, monetary policy in europe, unlike in new zealand, has had to operate a lot closer to the “ zero bound ”, where policy interest rates are near zero with no scope for further cuts. this has left quantitative easing ( qe ) and other unorthodox monetary policy as options still in europe and the us, as their economies have failed to restart. these tools are worth considering at the zero - interest bound, but they can have unpredictable effects and may be hard to exit. where qe has been employed, it is still too early to judge the overall impact. moreover, monetary policies around the world have begun to take on some features that we tend to associate with fiscal policy, assisting the private sector directly. this casts central banks in a non - traditional role. another lesson from the sovereign debt crisis has been the benefit that new zealand derives from retaining a flexible exchange rate, especially where there are country - specific sources of economic stress. in europe, while the de