has proved a source of contagion in the past year. the federal reserve's efforts in conjunction with other agencies to prevent the failure of systemically important firms have been controversial at times. one view holds that intervening to prevent the failure of a financial firm is counterproductive, because it leads to erosion of market discipline and creates moral hazard. as a general matter, i agree that preserving market discipline is extremely important, and, accordingly, the government should intervene in markets only in exceptional circumstances. however, in my view, the failure of a major financial institution at a time when financial markets are already quite fragile poses too great a threat to financial and economic stability to be ignored. in such cases, intervention is necessary to protect the public interest. the problems of moral hazard and the existence of institutions that are " too big to fail " must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. going forward, reforming the system to enhance stability and to address the problem of " too big to fail " should be a top priority for lawmakers and regulators. in particular, recent events have revealed a serious weakness of our system : the absence of well - defined procedures and authorities for dealing with the potential failure of a systemically important nonbank financial institution. in the case of federally insured depository institutions, the fdic has the necessary authority to resolve failing firms ; indeed, in situations in which the failure of a firm is judged to pose a systemic risk, the fdic's powers are quite broad and flexible. no comparable framework exists for nondepository financial institutions. the federal reserve is authorized to lend to nondepositories under unusual and exigent circumstances, but such loans must be backed by collateral sufficient to provide reasonable assurance that they will be repaid ; if such collateral is not available, the fed cannot lend. and until recently, the treasury also did not have the authority to inject capital to prevent the disorderly failure of systemically significant private institutions. in the absence of an appropriate, comprehensive legal or regulatory framework, the federal reserve and the treasury dealt with the cases of bear stearns and aig using the tools available. to avoid the failure of bear stearns, we facilitated the purchase of bear stearns by jpmorgan chase by means of a federal reserve loan, backed by assets of bear stearns and a partial guarantee

optimal mix of non - conventional instruments. central banks in general, and the ecb in particular, have been quite innovative. new methods of forward guidance have been developed that have proved very efficient in the euro area in bringing down the short end of the yield curve. the main question, in my mind, concerns the best combination of the other bis central bankers ’ speeches instruments : negative deposit rates and asset purchases. there is no certainty that they can be implemented together in a consistent way. asset purchases are expected to act both through changes in asset prices and a flattening of the yield curve. they inject central bank liquidity that forces banks to hold excess reserves in significant amounts. however, the negative rates create a sort of tax on those reserves. the apparent rationale is that negative rates would push banks to grant new loans or buy assets, therefore reinforcing the impact of asset purchases. but since loans create deposits, and the sellers of assets receive liquidity that they need to deposit on bank accounts too, there is simply no way this liquidity can disappear until the central bank decides to withdraw it. even if residents choose to move into foreign assets, the liquidity in the domestic currency will not disappear and will ultimately be deposited with the domestic banking system. in the end, and as a whole, the banking system is trapped. the question then is how banks will react and with what consequences for the economy. they could impose negative rates on depositors, but that is not always easy, and in the case of households, it could have a negative impact on the wealth sentiment. they could increase their credit margins, with the effect of tightening credit conditions, although that may also be difficult if the demand for credit is weak. or the banking system could simply become weaker, with the paradox that the more a bank is conservative and well - managed, extending high - quality loans and covering them by deposits with no short - term market funding, the more it will be penalized! a second, different challenge, relates to the rigidities in the economy. price rigidity is higher in europe than in the united states as the goods and labour markets are less “ contestable ” and outsiders find it harder to compete. and in the labour market, there is a strong downward rigidity on wages. structural rigidities have complex effects on inflation and monetary dynamics. in the very short run, price rigidity may somehow protect the economy against deflationary shocks and, more generally, increase the output