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

otd intermediation model can facilitate risk management. the granting of mortgages to households is favoured by the possibility of managing the related interest - rate risk ; the internationalization of firms depends crucially on the possibility of hedging foreign exchange risk ; and the provision of retirement saving a. sen, money and value : on the ethics and economics of finance, paolo baffi lecture on money and finance, rome, bank of italy, 1991, p. 28. bis central bankers ’ speeches products at low cost over very long time horizons benefits from the ability to mitigate the impact of fluctuations in security prices. with the otd model, credit risk is not concentrated in the banks ’ books, but is potentially dispersed among a multitude of investors. by making bank loans tradable, it reduces their illiquidity premium thus decreasing their cost. however, we now understand that structured finance and otd intermediation, coupled with lack of transparency, favoured excess risk taking and opportunistic behaviour. transactions often took place through scarcely regulated financial intermediaries characterized by high leverage and risk exposure, in particular as regards their valuation ( in which a crucial role was played by rating agencies, without any particular control by regulatory authorities or information providers ), by means of statistical models and often carried out on the basis of incomplete and insufficient data. in many instances complexity was instrumental to opportunistic behaviour fuelled by a distorted system of incentives especially with reference to executive compensation. the high leverage and complexity typical of structured financial instruments allowed them to be used to take high - risk, speculative positions. unnecessarily complex and opaque assets were used to prevent a correct assessment of creditworthiness or mask the economic impact of previous transactions, exploiting the ample scope for interpretation allowed by accounting standards. banks ’ misuse of these instruments may also be linked to the drying - up of the sources of income from traditional credit business. this may have triggered actions designed to conceal from the market and from supervisors the real object of derivatives transactions. the bottom line is that financial innovation can allow more efficient allocation of credit risk, but it also entails a number of dangers, some of them intrinsic to its mechanism, others more generally related to the greater interdependence of the financial system. the ongoing process of financial consolidation and the otd model have produced intermediaries that are closely intertwined with the capital markets. this has had some important consequences for financial stability : a more connected world