Risk management in the global economy - the role of the ECB
Speech delivered by Ms Sirkka Hämäläinen, Member of the Executive Board of the European Central Bank, at the Symposium on Risk Management in the Global Economy: Measurement, Management and Macroeconomic Implications, Chicago, 21 September 2000
Almost half a century ago Harry Markowitz began applying principles of risk and return to portfolio theory and since then risk management has developed into a rich and fruitful field. As a central bank system with a multi-currency balance sheet, the Eurosystem (i.e. the European Central Bank and the national central banks of the euro area) now uses many of the modern risk management techniques which grew out of this pioneering work. As a representative of the central bank responsible for setting monetary policy in the euro area, my focus is on a risk which is much more important than our balance sheet, namely the systemic risk of the euro financial system. In this context, managing risk is analogous with maintaining financial stability, and that is what I intend to reflect on this evening.
My speech covers three aspects. First, I will address the globalisation of risk and the implications this has for monetary policy. Second, I will discuss some general thoughts on the possible links between asset prices, financial stability and monetary policy. I shall conclude with the role of the ECB in all of these areas.
1. Globalisation of risk and monetary policy implications
The relationship between savings and investment is increasingly a global one. Markets in which financial assets are traded tend to behave like constituent parts of a single market which simply moves around time zones from one trading platform to the next. This globalisation made economic policy-making dependent on the vote of global financial markets. However, the interests of global financial market participants coincide only partially with the interests of the national community to whom policy-makers are accountable. Hence, policy-makers face a dual constituency with single accountability.
This leads to the question of whether macroeconomic policy-makers can meet domestic objectives through domestic policies alone, or whether the globalisation of the economy also requires the globalisation of economic policy. Recently, there has been quite active debate on this issue. I am thinking primarily of appeals for international co-ordination in the area of financial market rules and prudential supervision principles.
But the debate also encompasses the question of whether domestic monetary policy should try to accommodate international exogenous shocks beyond their influence on domestic economic developments and prices in particular. The question is thus whether national monetary policies should be co-ordinated at a global level.
I would strongly argue against such arrangements. It is strange and difficult to envisage that policy-makers would analyse the global economy primarily in terms of co-ordinating economic policy with a view to steering aggregate demand across the regions of the world. Reducing excess demand imbalances in one region of the global economy by steering demand towards another would risk add to volatility in economic activity. Instead, the major regions of the global economy should strive at ensuring domestic stability.
At the same time, it is of course helpful to have a broad consensus globally on the philosophy and overall goals of economic policies. As regards monetary policy, such a broad consensus on the virtues of price stability has indeed emerged over the last decade or so. If then each central bank were to conduct policy aimed solely at domestic price stability, then in aggregate they would also best contribute to alleviating global imbalances. Monetary policy decision-makers should resist lobbying from those to whom they are not accountable, while at the same time taking into account all domestic and international factors which could jeopardise their internal policy objectives.
Let me now turn to the second aspect - financial stability.
2. Financial stability and monetary policy implications
The relationship between economic imbalances and financial crises suggests that monetary policy should aim at maintaining stable economic conditions and the best way to achieve this is through aiming at price stability. Factors which make economies vulnerable to financial crises usually stem from a combination of unsustainable macroeconomic policies and weaknesses in financial structures - particularly in the context of structural change, deregulation and political instability.
In the classic financial crisis cycle - which we have experienced over and over again throughout economic history - too expansionary monetary and fiscal policies trigger lending booms, debt accumulation and over-investment in real assets which push asset prices up to unsustainable levels. The subsequent tightening of policies to rein in inflation and to correct imbalances leads to an abrupt correction of asset prices, a reduction in output, increased debt-servicing difficulties, higher levels of non-performing loans and declining collateral values which pose a threat to the solvency of the banking system.
We have seen that these financial crises are very costly, both in terms of the fiscal resources required in order to resurrect the banking system's solvency and in terms of lost output with effects throughout all sectors of the economy. I would also like to underline that measuring the magnitude of a crisis in the form of financial costs considerably under-estimates the total effect on the society. Even more important - and impossible to quantify - are of course all the "social costs" related to the human tragedies of those directly or indirectly affected by the crisis.
I think there is one important lesson to learn from the history of financial crises: Policy-makers should make every effort to prevent and pre-empt crises by creating and maintaining a stable macroeconomic environment, especially price stability. It is precisely during favourable economic periods that policy-makers should be most alert to the potential spillover from economic exuberance and to asset price misalignments which could jeopardise financial stability.
The formulation of monetary policy is under all circumstances a difficult task since the transmission mechanism from changes in the policy interest rates to their effects on price developments is complex, involves considerable and variable time lags and is likely to change over time. However, the occurrence of asset price misalignments multiply the difficulty of the task since their role in the transmission mechanism is sometimes very uncertain and difficult to predict.
It is also very difficult to identify whether a certain asset price development reflects a misalignment or not. By their nature, asset prices incorporate expectations about future economic, demographic and structural developments. I would like to highlight some examples of the structural factors which may affect the relative prices of equities and bonds over time - and which may also affect their impact on the transmission mechanism for monetary policy.
A first factor is the generally falling supply of government bonds in most industrialised countries due to consolidation of public finances. We have already seen how the lower supply of certain government bonds have contributed to higher prices and lower yields in some segments of the bond market.
A second factor relates to the demographic developments. By the end of this decade, the baby boom generation of the 1940's will start to retire, thereby changing their behaviour from being investors and to become "divestors". This could lead to a reduced overall savings ratio, which may contribute to a lowering of bond prices and higher yields. At the same time, since retirees are generally more risk avert in their investment policy than people in the middle ages, the same demographic development may affect the relative price of bonds and equities through rising equity risk premia.
A third factor affecting the role asset prices play in the monetary policy transmission mechanism relates to improvements in technology and their effects on productivity, often referred to as "New Economy-effects". In practice, the impact of technological progress on risks to price stability are not clear-cut. Inflationary demand effects associated with changes in asset prices and wealth creation are likely to counteract deflationary supply affects from productivity gains.
All these kind of economic, demographic and structural developments must be monitored closely by the central banks in order to detect changes in the transmission mechanisms and the emergence of possible asset price misalignments which could threaten price stability - and also financial stability. However, since the effects of all these developments are partly working in opposite directions, partly reinforcing each other - and their timing and magnitude are often uncertain - it is not easy to draw clear-cut conclusions for monetary policy in a pre-emptive manner. This is a huge challenge to the policy-makers, not least to the ECB.
All this suggests that central banks - while clearly and primarily aiming in their policies at the overall price stability - should not neglect asset price developments. However, the inherent volatility in asset prices and their unclear and changing role in the transmission mechanism imply that it would be very difficult - not to say impossible - to use them by any way as a target for monetary policy. For the same reasons, it is also difficult to appropriately incorporate asset prices into the definition of price stability. Against this background, central banks monitor asset pricedevelopments in general and use theinformation as indicators of possible risks to price stability. The question then arises, how should the central bank make use of the information provided by asset price indicators for the formulation of monetary policy.
If it is difficult to assess appropriate monetary policy responses to the upward risks to price stability from rising asst prices, the appropriate responses to falling asset prices may be even more delicate. From the market behaviour point of view, macroeconomic policies which accommodate asset price developments during periods of financial market turmoil easily lead to problems of moral hazard with falling risk premia, thereby artificially driving up asset prices. Safety net provisions or policy responses which help to mitigate a crisis happening today may in this way easily lead to an even worse crisis tomorrow. It should be avoided that financial market participants expect the central bank to expand their monetary base in the event of market turmoil, or a perceived risk for a turmoil.
It is not excluded that such expectations were fuelled by market participants' interpretation of monetary policy responses to the equity market crash in 1987, the equity and credit market turbulence of 1998 and even the relatively generous global liquidity conditions which prevailed during the century date change. But monetary policy is not the only policy area which maybe has contributed to this perception. In some countries, the use of public funds to support equity markets, supposedly depressed by so-called non-economic factors, reinforces the perception that public policy will accommodate downside risks to asset prices.
The asymmetric perception that central banks are more likely to accommodate the effects of downward movements in asset prices than the effects of upwards movements is understandable in the context of equity markets, because equities markets tend to show returns going up by small amounts and gradually over an extended period followed by a sharp downward correction in a short period. Therefore, it is not easy for a central bank to come across as symmetric in its reactions to the information given by asymmetrically volatile asset price indicators within its overall assessment of price developments and financial stability. However, this asymmetric perception is unhealthy - and even dangerous for financial stability.
3. Role of the ECB: a medium-term stability-oriented monetary policy
As to the role of the ECB, the Treaty establishing the European Community states that the primary objective of the European System of Central Banks (Eurosystem) shall be to maintain price stability and, without prejudice to this aim, support the economic policies of the European Community. By unambiguously assigning the primary objective of price stability to an independent central bank, the Treaty recognises that a monetary policy which maintains price stability in a credible and consistent manner will make the best overall contribution to improving economic growth, living standards and financial stability.
Price stability should mitigate the risks of extreme economic misalignments and their social consequences. However, how is this to be achieved? First, the ECB has given a quantitative definition to the price stability concept over the medium term. Second, it has formulated a "two-pillar" strategy giving a prominent role to monetary growth, on the one hand, and using a broadly based assessment of the outlook for price developments and risks to price stability, on the other hand.
I think we all agree on the benefits of overall price stability, so I will not elaborate any further on this point. The ECB assigns a prominent role to monetary growth because of its crucial importance in the transmission mechanism from monetary policy to price developments. The Governing Council of the ECB has announced a reference value for the M3 monetary aggregate which is consistent with maintaining stable prices over the medium term. This could also be seen as one of the ECB's contributions to risk management in the global economy. Every major asset bubble in the past century which led to significant losses in economic output was accompanied by rampant monetary expansion. The ECB's monetary policy strategy aims to prevent this from happening. The type of information on monetary and credit aggregates that we analyse within the first pillar of the strategy gives us very valuable information on, for example, asset reallocation and inflationary risks emerging from asset price developments. These risks would be more difficult to assess and, in particular, to react to in an inflation targeting strategy.
The ECB also conducts a broadly based assessment of the outlook for price developments and risks to price stability. This assessment is made using a wide range of economic variables, many of which have leading indicator properties. These variables include, inter alia, equity prices, bond prices and the yield curve, inflation expectations, the exchange rate and various measures of real activity and fiscal policy. By constantly monitoring these economic variables and taking their expected impact on price developments into account, we believe that we are closely following all new elements of the transmission mechanism in order to pre-empt occurrences of macro-economic and financial instabilities.
Finally, let me conclude by saying that the ultimate responsibility for any risk management must lie with the financial agents themselves. This is the basis of the free market system. They alone should be left to reap the benefits and assume the losses of their risk management activities given the guidance provided by prudential supervision.
This only leaves me with my conclusion on how to conduct policies conducive to global financial stability: regulatory frameworks and prudential supervision should be co-ordinated internationally in order to establish common rules and standards. By contrast, monetary policies should be restricted to contributing to a stable domestic macroeconomic climate by concentrating on the globally accepted objective of price stability.