Per Jacobsson Lecture : Central Banking in the Crisis: Conceptual Convergence and Open Questions on Unconventional Monetary Policy

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2014
• eBook ISBN: 9781484353370

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Central Banking in the Crisis: Conceptual Convergence and Open Questions on Unconventional Monetary Policy

Jean-Claude Trichet

… here is a case in which it is difficult to know what to say about the recent past. There possibly has been another major change in the interpretation of the theory in roughly the last decade … but it is hard to know, for sure.

—Edward Witten

Lecture at the Institute of Physics, July 1, 2010

Introduction

Thank you. Thank you very much indeed Guillermo for all these very nice and friendly introductions. I have a very vivid memory of all encounters in Washington, in Mexico City, many times, in various positions that you had yourself as Minister and as Governor, and in very difficult circumstances from time to time, and admiring the recovery that you had engineered. So thank you very much indeed for this invitation. And let me also say that it’s a great, great pleasure indeed to see so many friends in the room. I appreciate enormously the honor of delivering the lecture in front of so many friends and so many of the best brains that international institutions, policymakers, academia, and central banking can offer.

I would like to reflect with you on central banking in the crisis. Today is a little more than six years after the start of the financial crisis, in August 2007, when the subprime market was gravely disrupted. This disruption triggered major turbulences in the functioning of money markets in all large advanced economies, with abrupt—almost overnight—very substantial increases of the LIBOR-EURIBOR-OIS [overnight index swap] spreads in major markets.

Since then, central bankers have experienced extraordinarily demanding and difficult times, characterized by a succession of shocks that were unseen, in the advanced economies, since World War II. The successive shocks, culminating in the occasion of the bankruptcy of Lehman Brothers five years ago, were potentially even more alarming than those which triggered the 1929 crisis in the industrialized economies. I call the present episode the “advanced economies crisis” (AEC), as we have spoken in the 1980s of the Latin America crisis and in the 1990s of the Asian crisis.

I see many reasons why the financial system of the advanced economies proved as fragile as a house of cards. Without being exhaustive, I would propose five major reasons, which are mutually reinforcing:

• First, the extreme sophistication of financial instruments, the securitization, the generalization of derivatives markets of all kinds, the very rapid growth of shadow banking and of the industry of highly leveraged institutions created progressively a new financial environment that was complex, obscure in many respects, and extremely difficult to decipher.
• Second, there was an extraordinary increase of interconnectedness between all financial and nonfinancial institutions, markets, and economies at national and international levels, fostered by the advances of information technologies and by the globalization phenomenon.¹
• Third, a generalized excess of leverage, private and public, was progressively built in the advanced.² This reason was almost totally neglected by the international community over many years before the crisis, as were forgotten the financial instability hypothesis of Hyman Minsky and the debt-deflation analysis of Irving Fisher.³ This third reason was strongly underlined in the time of the crisis.⁴
• Four, the progressive generalization of a sentiment of excessive tranquility and confidence, both in the public and the private sector. The “great moderation,” marking the period from mid-1980s to mid-2000s, gave the false impression that the low volatility of both output and inflation—in a context of steady growth and low inflation—would last for a considerably longer period of time and was no longer requiring the traditional more prudent and cautious policies. The governance of many private financial institutions was exceptionally loose and the risk management culture dramatically risky. This relative ignorance of longer-term economic and financial risks was largely shared in the public sector, including in central banking, even when the buildup of potential deflationary and inflationary risks (due to public and private sector excessive indebtedness) was particularly accentuated.⁵
• And fifth, closely linked with the previous reason, the large consensus of the international community on the efficiency of markets in almost all circumstances and therefore on the virtues of large deregulation exercises, on the related belief that the financial system could never be far away from a Pareto-optimal single equilibrium and that the possibility of multiple equilibria should be neglected. As a matter of fact, dominant macro models failed to predict the crisis and seemed, during the three quarters following Lehman Brothers, largely incapable of explaining what was happening to the economy in a convincing manner. “In the face of the crisis, we felt abandoned by conventional tools.”⁶

The first two reasons mentioned suggest that the important recent structural changes observed in global finance and in the global economy are presenting important new challenges, both for economic theory and for policymaking. IT [information technology] advances, globalization, and related ongoing financial and economic creativity and innovation are likely to give birth to new emerging properties of global finance that are far from being fully elucidated. The international community can be forgiven for having missed some of these new emerging properties—including the immediate global transmission of financial shocks—which certainly contributed significantly to the acuteness of the crisis.

The three last reasons are less forgivable. Forgetting Kindleberger as well as Fisher and Minsky, at a time when the debt outstanding was clearly piling up in many constituencies at a global level, was strange. Stating that central banks should neglect an analysis of money, of its components and of its counterparts—as recommended by the mainstream of central banking economists—appears hard to believe, with the benefit of hindsight. Demonstrating an excessive confidence in models that were mathematically oversimplified and ignoring the very existence of tail risks proved mistaken. The crisis was a cruel reminder not only of the “financial instability hypothesis” or of the “debt-deflation” analysis but also of the “Knightian uncertainty,”⁷ which refuses to be encapsulated in probability modeling.

Having to cope with these dramatic events occurring in the advanced economies, independent central banks had the lucidity, the rapidity, and the courage to take bold and swift decisions. They were coping with very different economies from the structural standpoint, having different historical and cultural backgrounds and different conceptual references. One could have expected that, under the pressure of their own national or continental idiosyncrasies, the shock of the crisis would have accentuated their differences and given rise to an even more diverse set of central bank policies, conceptual references, and measures in a selfish, inward-looking mode.

As E. Witten said about theoretical physics, “it is difficult to know what to say about the recent past.” It is even truer in the case of central banking, in a period when uncharted theoretical and practical waters are explored. Past collective mistakes recommend the greatest prudence and caution in expressing new observations and views.

But I think we can say that, contrary to what could have been expected and feared, a phenomenon of “practical and conceptual rapprochement” took place between central banks, in the economic and financial turmoil. This phenomenon has been spectacular not only immediately after the Lehman Brothers bankruptcy, with the closest central bank cooperation ever, but through a multilateral network of swaps lines which remains a historical prowess.⁸ This unseen level of close cooperation has also been symbolically illustrated by the coordinated decrease of interest rates that took place on October 8, 2008.

But the crisis has also started or accelerated a multidimensional process of convergence of key elements of monetary policy thinking and -making. I propose to qualify this phenomenon as a process of “conceptual convergence.” It is far from being achieved, if it ever can or should be. But my own perspective suggests that it is a global feature that should call for great attention both from academia and from policymakers.

After having in the first part of this lecture concentrated on this convergence process, I suggest reflecting, in the second and third parts, on some theoretical and practical issues that are associated with the so-called unconventional monetary policy (UMP) liquidity and quantitative measures and the forward guidance (FWG) generalization, themselves part of the conceptual convergence phenomenon.

A Multidimensional Conceptual Convergence

Perhaps paradoxically, in a period which has been intensively demanding for all central banks in different economies and different societies, one of the most impressive features of the last 15 years and, more particularly, of the last six years, has been what I would call the “convergence” towards a number of close, if not identical, monetary policy concepts. This has been observed, particularly but not exclusively, amongst the central banks of the advanced economies. The “rapprochement” has been indeed remarkable in six major domains:

• The definition of price stability which is now set up in Europe, in the United States, and in Japan at a level close to 2 percent or at 2 percent.
• The concept of communicating through press conferences, which is now generalized, in particular in the United States, in Europe, and in Japan.
• The concept that banking surveillance is better placed very close to the central bank, if not necessarily in the direct hands of the central bank.
• The idea that it is no more anathema for a central bank to examine seriously the evolution of money, whether base money, monetary aggregates, and the dynamics of their components and counterparts.
• The unconventional monetary policy, consisting of real or potential supply of liquidity at a very large scale, either through banks or through outright purchases, was generalized in the advanced economies.
• Finally, one of the most recent dimensions of conceptual convergence was the recourse to “forward guidance” on future decisions on interest rate.

Let us examine more closely these six dimensions.

Price Stability

As regards the definition of price stability, or the level of inflation target, 15 years ago, only two central banks amongst the four major central banks of the advanced economies were mentioning a precise definition or target: the European Central Bank (ECB) and the Bank of England (BOE). Both were mentioning the 2 percent figure: “less than 2 percent”—clarified as “less than 2 percent, but close to 2 percent” on May 8, 2003—for the ECB and “2 percent” exactly for the BOE. At that time, neither the Federal Reserve Board nor the Bank of Japan were signaling their price stability definition or target. Since the recent statement of Bank of Japan (BOJ), on April 4, 2013, all four are mentioning the 2 percent figure, which became a global benchmark amongst all the large advanced economies.

The BOJ statement reads: “The Bank will achieve the price stability target of 2% … at the earliest possible time, with a time horizon of about two years.”

It is important to note that this convergence is recent—2013 for Japan and 2012 for the Fed; the Federal Open Market Committee “Statement on Longer-Run Goals and Policy Strategy” p...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Foreword
• Opening Remarks
• Central Banking in the Crisis: Conceptual Convergence and Open Questions on Unconventional Monetary Policy
• Questions and Answers
• Biography
• The Per Jacobsson Lectures
• The Per Jacobsson Foundation
• Footnotes