masaaki shirakawa : looking through prices in financial markets speech by mr masaaki shirakawa, governor of the bank of japan, at the paris europlace financial forum, tokyo, 3 december 2012. * * * introduction today, i am very pleased to appear before you, for the second time since 2009, at the paris europlace financial forum in tokyo. when discussing the issues facing the financial industry at a meeting like this, it is clear that we have yet to put behind us the great financial crisis ( hereafter “ the crisis ” ), the scars of which have hardly healed, even three years after i last spoke here. we are still dealing with the consequences, not only in terms of needing to fix problems in the real economy but also with regard to rebuilding confidence in finance. there is also extensive discussion on how we could improve the conduct of monetary, prudential, payment and other policies in the light of the crisis. in the following few minutes, i would like to pick up one theme on which i have not fully offered my views so far – that is, how we should view prices in financial markets. the crisis that never should have happened the starting point for my discussion is what people generally thought about finance in general and financial markets in particular before the onset of the crisis. the prevailing worldview at that time was along the following lines. it all started from the innocuous belief that the market was the best arbiter of economic outcomes. if markets seamlessly covered every economic activity, and if they functioned flawlessly in transmitting price signals, decisions made by economic agents on the basis of such signals would intrinsically maximize social welfare. any effort to achieve such a state – completing markets and removing regulation – was regarded as desirable in its own right. of all markets, financial markets were generally regarded as the ones closest to such an ideal state of the economy. on top of this foundation, the financial institutions built an intricate system of risk management. prices determined by financial markets were deemed to reflect the fair value of financial assets. by looking at historical patterns of price fluctuations, it was thought that risks arising from future price movements could be managed effectively. observations of prices were fitted into the bell curve and transmuted into concrete numbers such as value - at - risk. such tools gave financial institutions confidence that they had firm control over the risks they were taking. if too much risk were being taken, then just the right amount of excess risk

, especially in terms of their risk preferences and investment horizons. homogenous market participants tend to magnify mistakes, increasing the risks of market instability. diversity is preferable, but irresistible forces such as rules and regulations regarding capital, risk management, and disclosure could inadvertently homogenize the risk preferences and time horizons adopted by market participants. unfortunately, there are no good answers, and central banks must stand ready to fix any problems as they arise. lastly, while central banks should have deep respect for financial markets, for the reasons i have just explained, they should be willing to stand up to the market from time to time. in order to deliver sustainable economic growth under price stability, central banks must have a very long time horizon. this point is especially relevant for financial stability, because financial cycles tend to be quite long. as alan blinder had noted, central banks must avoid a situation where “ the market reacts, or rather overreacts, to perceptions about what the central bank might do, and the central bank looks to the markets for guidance about what it should do. ” 3 an example of how a central bank should conduct its policy in the face of market expectations is the bank of japan ’ s current commitment to ease monetary policy aggressively. that commitment is conditional on there being no significant risk to the sustainability of economic growth, including the accumulation of financial imbalances. the bank of japan will, in this context, conduct an assessment independent of what markets might be thinking, while taking full account of information derived from markets. turning to europe, the european central bank is committed to fixing the transmission mechanism of monetary policy in the euro area, showing that the bank may have a different view from the market on where the various sovereign spreads should be. concluding remarks today, i have offered my views on how overconfidence in extracting information from financial markets contributed to the formation of financial bubbles that brought about the crisis. the strong emphasis, by market participants as well as public authorities, on the deep wisdom of financial markets before the crisis has now brought about a public backlash against anything that even has a whiff of using finance or market forces to solve social issues. this is unfortunate because, if used wisely, the market is still the best arbiter of economic outcomes, finance is the art of the possible, and well - functioning markets will open new horizons. the lessons for central banks that i have just described apply largely to market participants as well. the financial industry should also read