Lessons from Jackson Hole
Governor, Reserve Bank of New Zealand
Once a year, Jackson Hole in Wyoming hosts the world's central bankers. Under the craggy ranges of the Teton Mountain Range, we met last weekend to discuss how well monetary and financial policies have worked to save the world from the worst of the crisis, having just been through the biggest economic and financial shock in 80 years. It now looks like we (and the world) have seen the worst, and we are beginning a recovery that many believe will be slow and fragile.
What lessons can be taken from this experience? How well did our policies work? What lies ahead?
We were all surprised by the vulnerability of key financial institutions. It is chaos when a country's banking system does not remain stable, as in Iceland and Ireland. Ours proved stable.
A plain vanilla banking system like ours is much easier to regulate than a more complex Northern Hemisphere one. There, the banking system had significant problems with complicated instruments, non-transparent transactions, misaligned incentives and moral hazard.
Our less complex system came through well, helped by sound parent banks, good regulations here and in Australia, good management, and a little luck. Our prudential policies worked well with bank capital holding up against shocks and losses.
However, when international markets became illiquid – where it was difficult to find cash to meet obligations – Australasian banks needed help. We monitored them more closely. Government guaranteed retail deposits and wholesale funding to enable banks to secure funding. And we widened the range of securities that banks could use to access cash from us.
We also accelerated work on a prudential liquidity policy for banks – moving them from heavy reliance on short-term funding to having a bigger proportion of longer-term funding. When implemented, this policy will mitigate risks from sudden illiquidity in offshore markets.
As the recovery takes place we will also be ensuring capital requirements for farm lending are prudent.
Unfortunately, many finance companies found their weak balance sheets and flawed business models inadequate. But building societies and other smaller institutions with a loyal customer base have ridden through this period.
Financial System Stability
It may not hurt an economy if some financial institutions fail, provided the system remains stable. But larger economies were surprised so many institutions were too big, or too complex, or too intertwined to be allowed to fail.
In addition, the previous decade's build-up in asset prices (housing, equities, commodities and financial instruments) contributed to instability. At Jackson Hole, central bank governors bewailed how hard it is to stabilise an economy with separate regulators.
We have been in a better position. The Reserve Bank is a broad-span regulator that receives information and influences markets via our economic intelligence, prudential oversight of financial institutions, liquidity management, foreign reserves management, payments systems oversight, and provision of banknotes and coins.
Internationally and in New Zealand two important new regulatory standards have been introduced recently: International Financial Regulatory Standards, and Basel II risk-weighted capital requirements for banks.
If not carefully implemented, these new standards could be pro-cyclical – encouraging banks to over-lend during economic booms and tighten in a downturn.
We expect new international standards with the G-20 group of countries looking to re-introduce dynamic provisioning (ensuring banks' accounts provide for potential losses as loans are made). They are also considering counter-cyclical capital instruments (with banks building up capital reserves when the economy is growing, that can be drawn down when it contracts). At the Reserve Bank, we have taken a ‘through-the-cycle' approach to Basel II, to avoid pro-cyclicality, but we are following international developments with interest.
Monetary and fiscal policies can promote economic stability. They achieved a long period of growth and low inflation (the ‘Great Moderation'). However, they did not prevent the build-up of major global imbalances in capital – huge savings and external surpluses in some countries, significant external borrowing and deficits in others – which ultimately contributed to financial collapse.
The Jackson Hole consensus is that the US and some other economies tightened monetary policy too little and too slowly during the early years of this decade. When that happens, small open economies, like New Zealand, feel the stress (e.g. through exchange rate pressures).
When the global crash happened, monetary policies were the first line of defence. Most countries quickly slashed rates. Our nominal interest rates were higher than most: we very quickly cut the official cash rate from 8¼ percent to 2½ percent in nine months, further and faster than ever before. Unlike some Northern economies we expect this rate to trough well above zero.This opens the gates to significant monetary stimulus, although it takes time for the effects to flow through the economy.
In bigger Northern economies, this orthodox monetary policy stimulus was not enough. They have also used unorthodox policies, "quantitative easing", pumping liquidity into the economy to stimulate lending and free-up clogged markets. This new, risky approach seems to have eased financial markets.
This unorthodox quantitative easing has not been necessary in New Zealand. The closest we have got is with our new liquidity management and our acceptance of residential mortgage-backed securities as collateral for loans to banks. These securities are in place but likely to be used only in crisis. Our measures will be much easier to exit from, when the time comes.
Governments can also use fiscal policy for stability, and it has been used widely internationally in this crisis.
In New Zealand there has been significant fiscal stimulus by government. But concern for future government debt levels limits its on-going use.
The mood of the Jackson Hole symposium was that the worst is now over, but we must remain wary of setbacks. New Zealand has come through reasonably well, but the crisis has also exposed some vulnerabilities that may have had harsher consequences had financial markets not stabilised earlier this year. That is why we need to keep focussing on building a stronger, more resilient financial system.
External Communications Adviser
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