would result in a better policy mix. today, in contrast, virtually all central banks in the developed world are independent, and it is hard to think of a country were the treasury decides on the level of interest rates. the last two decades have witnessed an enormous paradigm change on the role of central banks in monetary policy. what are the reasons behind this paradigm shift? a key insight was the expectation - augmented phillips curve. it said that monetary authorities may have an incentive to trigger off a boom by relaxing monetary policy. however, you cannot surprise agents too often. they soon will learn to anticipate this expansionary bias and adjust their behaviour accordingly. the result is high inflation and no expansion. the way out of this time - inconsistency trap is to install a “ conservative ” central banker who sets interest rates independently. central bank independence reduces the time - consistency problem, but it cannot prevent the possibility that monetary policy may be dominated by an unsustainable fiscal policy and thus be ineffective. this was first shown by the “ unpleasant monetarist arithmetic ” of sargent and wallace in the 1970s and, more recently, by the “ fiscal theory of the price level ”. at the emu - level, the relationship between monetary policy and fiscal policy becomes even more complex. there is only one monetary policy for the whole euro area, yet there are as many fiscal policies as there are countries. as a consequence, in addition to the problem of a possible fiscal dominance, there is a free - rider problem as it is possible for countries to reap all of the benefits while bearing only some of the costs of an unsustainable fiscal expansion. this shows how quickly the geographical dimension turns into a political dimension, with important implications for sovereignty. the stability and growth pact is the mechanism designed to mitigate this problem and thus an important part of our monetary constitution. let me conclude by saying that monetary stability consists of both price stability and financial stability. from this perspective the two - pillar approach of the ecb provides an excellent analytical framework. it does not only allow the ecb to integrate asset prices as an indicator of other variables in the second pillar. the ecb ’ s approach also allows it to analyse some aspects of financial stability within the broad framework of the first pillar. as financial instability is very often created by a credit expansion that is too rapid, we have to pay particular attention to the counterparts of money supply. that is what lutz told us many years ago. and

hermann remsperger : monetary stability - institutions matter speech by professor hermann remsperger, member of the executive board of the deutsche bundesbank and chairman of the supervisory board of the monetary stability foundation, at the first conference of the monetary stability foundation, frankfurt, 5 december 2002. * * * the first conference of the monetary stability foundation is dealing with the role of institutions for monetary stability. this is certainly not a new topic. economists have thought about this for centuries and have come up with a wide range of answers. while the questions remain the same, the answers change as the monetary and financial system evolves. rather than going into the details of each of the sessions, let me start the conference off by referring to two issues. the first concerns the involvement of central banks in safeguarding the stability of the financial system. the second is the relationship between fiscal and monetary policy in a monetary union. in my view, a good opportunity to start thinking about price and financial stability is a paper by friedrich a. lutz on “ the basic problem of the monetary constitution ”, first published as early as 1936. its starting point is the observation that money and credit are essentially two sides of the same coin as money results from bank lending. on the credit side, competition between banks should ensure an optimal allocation of resources. on the money side, however, this competition could lead to an excessive creation of money and hence to inflation and instability of the financial system. as a consequence, money is best controlled by a monopolist, while credit is best granted by competing banks. the key idea of the lutz paper is still interesting today, because it explicitly recognizes the link between price stability and financial stability. as lutz himself emphasized, having two very different principles of order for each side of the balance sheet in the banking system does not appear to be a problem in normal times. in periods of crisis, however, a problem appears. to quote lutz once more : state guarantees for deposits and bailouts nationalize bank liabilities, while keeping the asset side in competition. to put it in today ’ s words : the result is a considerable moral hazard. lutz ‘ s insight may not be surprising given that he wrote in the aftermath of the severe banking crises in germany and the us of the early 1930s. it is perhaps more of a surprise that his discussion seems to have been somewhat forgotten afterwards. as recently as in the early 1990s, conventional wisdom appears to have been “ keep prices