mr. heikenstein discusses the swedish financial crisis of the early 1990s speech by the deputy governor of the bank of sweden, mr. lars heikenstein, at a seminar arranged by the swedish embassy held in seoul, korea on 15 / 7 / 98. let me begin with a thank you to the organisers of this seminar. i am honoured to have the opportunity to share with you some experiences from the swedish financial crisis in the early 1990s. 1. introduction an imf study from 1996 showed that in the past fifteen years, 132 of the fund ’ s 182 member countries had experienced macroeconomic and / or financial crises. today the figure is even higher. crises are a recurring phenomenon. in spite of every effort to prevent them, i fear that crises will continue to occur. we should therefore use the opportunities to learn from each other, both in order to avoid making the same mistakes and to find the appropriate correctives sooner. needless to say, there are no single “ best solutions ”. crisis situations are always specific in some respects, not least with regard to their structural and political environment. had they not been specific, they would probably never have occurred because they would have been “ spotted ” in advance. having said this, however, there are a number of globally accepted “ truths ” about what constitutes a good response to crises. discussions around crisis situations are usually divided into two parts : crisis prevention and crisis management. in this presentation i will be focusing on the latter. to understand the handling of a crisis, it is useful to know which factors generated the problems. hence, my narrative will include the events that led up to the crisis in sweden. i will also comment on the developments in asia, with some emphasis on korea. having sketched this background, i will turn to the actual handling of crises, explaining why we found certain types of solutions useful in sweden - leaving it to you to consider whether the same might apply to some extent to your country. 2. background the macroeconomy first, let me say a few words about the macroeconomic background to the crisis in sweden. there are both similarities and differences between sweden and asia. in the following i will touch on some of them. it should also be remembered that substantial differences also exist between the asian countries. one common factor is the fixed exchange rate. in sweden this led to high levels of foreign borrowing, particularly in the private sector. in addition it made it difficult to counter the gradual overheating of the

reserve : the plot thickens ", speech delivered at the new york university school of law global economic policy forum, new york, april 14. for analytical purposes only, let's assume that we are in a world where inflation is running well within acceptable levels and that the central bank and stakeholders have ultimate conviction it will remain as such. this, of course, smacks of the old joke about economists and can - openers. 5 i'll revisit this heroic assumption later in my remarks. but with the assumption in mind, monetary policy can focus on the real side of the economy. the taylor rule provides a convenient rule - of - thumb for setting monetary policy. 6 the rule posits that the appropriate setting of the real federal funds rate incorporates three components. the first component is the economy's natural rate of interest. this is the real federal funds rate consistent with output equal to potential, on average, over the medium - to long - run. if policymakers set the real federal funds rate at this level, the fed would be neither artificially boosting nor restricting the real economy over long periods. holding the federal funds rate at the natural rate, however, may yield an undesirably slow return of real activity to normal, particularly if shocks have a persistent effect on aggregate demand and supply. to expedite the process, the taylor rule adds a second component to the real federal funds rate, one that purports to be proportional to the size of the current output gap. by setting the real federal funds rate below the natural rate when resource utilization is loose – and, correspondingly, above the natural rate when resource utilization is tight – policy purports to help move the real economy back to normal at a speedier pace. the third component responds to the gap between actual inflation and its desired rate, pushing real rates up when inflation is too high and pushing rates down when inflation is too low. the taylor rule provides a reasonable description of actual monetary policy behavior on average over the past 20 years. the reasonably good macroeconomic performance of this period suggests that central banks should pay some heed to its prescriptions. by design, however, the taylor rule focuses largely on what can be observed in real - time, without accounting for some factors that influence monetary policy. for example, policymakers may try to peer, however imperfectly, into the future when setting the federal funds rate rather than responding solely to the current state of the economy.