zhou xiaochuan : changing pro - cyclicality for financial and economic stability essay by mr zhou xiaouchuan, governor of the people's bank of china, on " changing procyclicality for financial and economic stability ", beijing, 26 march 2009. the major points were presented at the g20 meeting of financial ministers and central bank governors in sao paulo, brazil, on 15 november 2008. * * * much has been discussed on the root causes for the current financial crisis, including but not limited to lessons on monetary policy, financial sector regulations, accounting rules. this note aims to stimulate debate and discussions on some of the pro - cyclical features in the system, possible remedial measures, and how monetary and fiscal authorities can play their professional roles at times of severe market distress. it also touches upon china's financial sector reform and macroeconomic policy to counter slowdown in economic growth. the major points here were presented at the g20 meeting of finance ministers and central bank governors in sao paulo, brazil on november 15, 2008. 1. the built - in pro - cyclical features in financial architecture when we discuss system stability, we can borrow some concepts from electronic engineering or control theory. in a complicated system, there are usually many feedback loops, some of them are positive, some of them are negative. a positive ( plus ) feedback loop enlarges amplification ( like multiplier ), tends to create oscillation ( like boom and bust procyclicality ) and zero - point shifting ( like a reference of bubble ). while a negative ( minus ) feedback loop can reduce amplification, help for system stability and self - correction of zeropoint. in economic and financial systems of recent years, we have too many positive feedback loops on macro and micro levels, and a small number of negative feedback loops. thus the system shows a strong pro - cyclicality. what we need to do is not to totally rebuild the system, but to add a few negative feedback loops, which are able to sufficiently change the characteristics of our system. financial crises normally originate in the accumulation of bubbles and their subsequent bursts. usually, economists pay a lot of attentions to pro - cyclicality on the macro level. however, on the micro level, there are quite a number of notable pro - cyclical features embedded in the market structure today, which should be addressed as we deal with the current crisis and reform the financial system. in the current market

sine qua non of a sustainable expansion. it was the rise of inflation, in one form or another, which spelled the death knell of our previous expansions. • in the long expansion which began in the 1960s and ended in 1974, inflation had already risen to 10 % by the september quarter of 1973, which was before the effects of opec i had been felt. following the rapid wage escalation of 1974, inflation then peaked at 17½ % early the following year. • we had a rather weak expansion in the 1970s, which received a boost from the rises in commodity prices associated with opec ii in 1979. but by 1981 another wage escalation pushed inflation from a low point of 8 % in 1978 to a peak of 12½ % in 1982. • in the strong, but shorter - lived, expansion of the 1980s the story was rather different. although the increases in prices and wages were a good deal higher than we have become accustomed to in the 1990s, there was no sudden acceleration in the latter stages of the expansion as there had been in earlier episodes. it was a boom in credit - financed asset prices and the associated speculative activity that did the damage. at some stage the boom was bound to be followed by a bust, whether of its own accord, or as a result of monetary tightening. while asset price inflation is conceptually different to cpi inflation, and is further removed from the ordinary operation of monetary policy, it is nevertheless a classic case of the type of imbalance that can occur in the latter stage of an expansion and lead to its abrupt and painful ending. there are several other types of imbalances that often accompany the latter stages of an expansion and that can be a warning of danger. one is monetary excess, which is usually manifested as excessive provision of credit, and which often ends up financing speculative activity. i have already mentioned this in relation to the 1980s, when the credit expansion was primarily to business and resulted in the over - leveraging of that sector. it is also possible for the imbalance to show up as over - lending to households, as happened in the uk in the late - 1980s. another imbalance that can occur is in physical investment. we are accustomed to thinking of investment as a good thing and only ever worrying about it if it is too low. but over - investment can also be a problem at times in that it can lead to the build - up of over - capacity. this in turn can lead to a