Previous crises have shown that prompt and decisive balance sheet repair after a period of excessive credit growth is the best way to restore sustainable growth. Post-recession growth may not even be significantly weaker than normal if the overleveraged financial sector aggressively cuts back excess credit in the recovery phase. Like balance sheet imbalances, structural impediments to growth and to an efficient allocation of resources are generally very relevant for the conduct of monetary policy and need to be tackled decisively. Trying to stimulate growth through standard aggregate demand policies may be ineffective and, under certain circumstances, even counterproductive in balance sheet recessions, when structural breaks on potential growth predominate.
It is for this reason that the changes to euro area and EU governance introduced in response to the crisis are so important and need to be implemented with determination. The reforms undertaken in many stressed countries, especially those benefiting from official external assistance, should eventually lay the foundations for a robust recovery. Most importantly, the steps being taken to create a Banking Union should help to address existing balance sheet problems. At the end of this process, the assets in banks' books should accurately reflect the economic realities. At the same time, banks will be required to take corrective action regarding their own capitalisation levels, if needed. The increased transparency of banks' books brought about by the comprehensive assessment should make it easier to raise additional share capital.
Leaving aside the ECB's newly acquired role as supervisor and its traditional contribution to institutional reforms in Europe, what are the implications of a balance sheet recession for the monetary function narrowly defined? Should the policy rule that traditionally assigns the control of inflation and minimisation of excess macroeconomic volatility to central banks be enriched with further elements which become binding at times of financial adjustment?
This, in my view, is the main area of reflections where a vision for the role of monetary policy in a changing financial landscape should take shape. I tend to believe that the objective of repairing prior misallocations of credit and capital across sectors should be incorporated in one way or another as a "high priority" in the policy process. But we immediately run up against three issues here:
The first issue concerns the governance of instrument setting for the central bank. Let us take a very simplified representation of monetary policy-making: a Taylor rule. How would this "high priority" be included in this Taylor-inspired interest-rate-setting process? Would it be an additional objective to be traded off, on a par with inflation and demand conditions, i.e. an additional reaction variable weighted by its own coefficient?
The second issue is one of policy legitimacy. It may be easy to say: the business sector as a whole is over-indebted and we (central banks) need to promote a correction, first and foremost avoiding monetary policies that can induce moral hazard, and thus only obstruct and delay the adjustment that is anyhow inevitable. But it is more difficult to say "within the business sector, this industry deserves less credit relative to that industry" without quickly entering the terrain of allocative policies, which should be alien to our mandate.
The third issue is the one that bothers me most. Let us take it for granted that monetary policy should - at least occasionally - deviate from its stylised Taylor representation and look at and act upon financial imbalances. But one starts wondering: allowing a central bank a lot of discretion in the choice of the horizon for monetary policy is sometimes almost the same as giving it discretion in its choice of the monetary policy objective. I tell myself: we could imagine situations in which the same narrative - invoking structural forces to justify a monetary policy stance that tolerates a sustained deviation from the objective for too long - leads to a symmetric, durable scenario of uncomfortably low inflation, which eventually feeds itself.
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