less vulnerable to such mishaps when they occur. while we can strengthen the global financial system, we can never eliminate bubbles and crashes completely. manias, panics and crashes are inherent to capitalism dating back to the tulip mania and south sea bubble of the 17th century and probably before. in theory, investors make independent decisions which collectively result in a stable and efficient market outcome. in reality, uncertainty due to incomplete information and a basic human instinct to herd can prove destabilising and disastrous. for small open economies, the best defence against an uncertain and sometimes dangerous environment is to pursue prudent macroeconomic policies, strengthen their financial systems and improve their governance framework. sound domestic policies and institutions cannot eliminate panic and contagion. but they can cushion the adverse effects and make the economies more resilient to the financial shocks when they occur. thank you.

out to be significantly less important. 3. monetary policy and financial stability given the imperfect status of the economic literature, despite notable recent advances, what should monetary policy do with respect to financial stability? experience suggests a few general considerations that central bankers should take into account in the conduct of monetary policy. i will mention four. the first consideration is that monetary policy can itself produce negative effects on financial stability. as doctors are used to say, first try to do no harm. to understand this concept, we need to recognise that monetary policy can, via the interest rate, affect the intertemporal allocation of resources by influencing agents ’ incentives to borrow. however, there is a limit to this because economic agents cannot go on borrowing unlimited amounts from the future indefinitely. therefore, it is important to realise that the capacity of monetary policy to influence the intertemporal allocation of resources is constrained, particularly by the situation of agents ’ balance sheets. an agent – or a sector of the economy – that contracts a net debt has implicitly chosen to bring forward resources to the present, thus reducing them in the future, in order to pay off that debt ( provided, of course, that it does not intend to renege on its debt obligations! ). financial stability can be defined as a situation in which the intertemporal allocation of resources is felt to be “ in equilibrium ” or “ sustainable ”, which means that it is at the same time in line with the desires of individual agents and with the need to keep up with the debt obligations that have been subscribed. the central bank should not create the incentives for private agents to accumulate debt continuously over time. such an over - accumulation, especially in good times, may jeopardise its sustainability. private agents – no differently from the public sector – may experience solvency problems. we know that low lending rates tend to encourage banks to increase risk - taking, 8 especially when low rates are coupled with strong financial innovation. 9 for instance, when a financial institution has promised its creditors high rates of return but then faces a period of low interest rates that is expected to last for a long time, the only option open is to take on additional risk. another example relates to the typical compensation contract for investment managers, which depends particularly on the annual return achieved ( in excess of an agreed minimum ). when risk - free returns are high, compensation is also see the ecb ’ s june 2007 financial stability review. adalid and detken