in constantly changing circumstances. today i would like to discuss with you our recent experience of decision - making in an uncertain world. i will outline how the crisis developed and then describe how we at the european central bank ( ecb ) responded – the kinds of information we draw on, the tools we use and the principles on which we base our decisions. i will close with some brief reflections on dealing with uncertainty. ii. uncertainty and the crisis the origins of the crisis lay in changes in the economic and financial environment over the past two decades. during that time, there was a marked decline in the volatility of such aggregate economic indicators as total household consumption and total business bis central bankers ’ speeches production. this led to a widespread perception that we were living in very benign economic conditions. at the same time, some developed countries underwent a process of financial deregulation and innovation aimed at improving efficiency. new financial products were developed with the promise of enabling financial institutions to manage the risks in their lending activities more effectively. as a result, larger segments of the population obtained mortgage financing, and credit generally was more easily available. but the promised benefits of financial risk management turned out to be illusory. risk did not disappear, indeed in many cases it was magnified. and the process of deregulation led to a huge increase in private indebtedness and an accumulation of financial imbalances. at the global level, a number of developed economies were able to finance increased household consumption by borrowing from fast - growing emerging economies that had an abundance of savings. these sustained global imbalances contributed to lower interest rates, which further encouraged the process of credit creation in countries that were receiving capital inflows. it was clear to many careful observers that this process eventually should come to a halt. with the considerable benefit of hindsight, warning signals of the subsequent financial distress in the data for 2006 – 07 are clearly evident. in the name of my colleague central bankers, i gave myself a clear warning in january 2007 on the likelihood of a major market correction due to a significant under - assessment and under - pricing of risks in the financial markets. but the specifics of how a crisis might be triggered and the course of its subsequent propagation proved hard to predict in real time. ultimately, the crisis was ignited in august 2007 by unprecedented tensions in the interbank market, in which financial institutions lend to and borrow from one another. following the bankruptcy of lehman brothers in september 2008, the financial market tensions

probability and highly unpredictable events. the parallel arises as the opening up of interbank market spreads in august 2007 could not be predicted based on historical data, because it was a low probability event. it became predictable – and justifiable – only with hindsight. what happened next was that tensions remained high for a protracted period. in september 2008, spreads increased much further with the bankruptcy of lehman brothers. economic uncertainty – as reflected, for example, in stock market volatility – rose dramatically. the unpredictability of rare events highlights an important distinction between “ risk ” and “ uncertainty ”, which was first made by the famous economist frank knight in 1921. according to knight, “ risk ” refers to a situation of randomness where the range of possible events and the associated probability distribution are known. risk therefore characterises situations such as the toss of a coin or weather forecasting. in both cases, we can characterise the set of possible outcomes and we can compute their likelihood. “ uncertainty ” refers instead to a situation where events cannot be enumerated and / or it is not possible to attach a probability to them. events like the “ black swan ” can more easily be characterised as uncertain, rather than risky. since they have never been observed before, we do not know how to judge their likelihood. iii. permanent alertness, judgement and experience so how did central banks respond to the crisis? i would like to highlight one simple principle : the timing of the policy response is crucially important. financial crises can strike suddenly. the response to the crisis should be commensurably swift and decisive. this requires a stance of what i call permanent alertness, to identify promptly new threats to economic stability and price stability, including those arising from the crisis itself. the decline in banks ’ ability to raise funds on the interbank market led to a tightening of credit conditions facing households and businesses. there was a clear danger that this tightening would lead to a serious decline in economic activity, further credit losses and a vicious downward cycle of distress in financial markets and the real economy. when the crisis intensified in 2008, permanent alertness led to a resolute sequence of actions using the ecb ’ s standard policy tool, the short - term nominal interest rate. but the crisis also demonstrated that deeper market failures in the financial sector might mean that standard policy responses alone prove insufficient to restore economic stability and price stability. identifying these market failures and introducing measures to address them was a second dimension