The assignment I accepted for this paper is not straightforward. The task is to provide a policy maker’s perspective on some lessons from the great financial crisis for monetary policy. Having studied earlier challenging episodes in monetary history, I am well aware of the pitfalls of attempting to draw lessons from a crisis while the experience is still raw. Better to wait a decade or more, to have time to evaluate with greater clarity whether, how and under what conditions things could have evolved differently. On the other hand, there is no time to waste on suggested improvements in the policy framework if the objective is to improve the odds of better outcomes for the future. What better opportunity to offer some early thoughts on the lessons, then, than the occasion presented by this colloquium honouring Lucas Papademos, taking place right after the last meeting of the Governing Council of the European Central Bank (ECB), before the end of his tenure as Vice-President of this institution.
I focus on three issues. First, what lessons can be drawn regarding the institutional framework for monetary policy? Has the experience changed the pre-crisis consensus that monetary policy is best performed by an independent central bank focused on achieving and maintaining price stability? Should central banks be more or less independent? Should their aim be higher inflation instead of price stability, as some suggest?
Second, what lessons can be drawn regarding the monetary policy strategy that should be followed by a central bank? A perennial debate in monetary economics has raged over how ambitious monetary policy should be, how activist it should be in dampening fluctuations and tackling perceived disequilibria and imbalances. Where does the historical behaviour place the ECB in this debate? In the history of central banking, one can identify shifts in the consensus from waves of optimism that policies could be fined-tuned to achieve more to waves of caution when the limits of our knowledge are reconfirmed by reality. Has the recent experience shifted the centre of gravity in this continuing debate?
Third, is monetary policy pursuing price stability enough to ensure overall stability in the economy? Or is there room for improvement regarding how central banks can contribute to greater stability? Would greater central bank involvement in regulation and supervision pertaining to credit and finance allow better management of overall economic stability? Or should the role of monetary policy be seen as completely separate from the broader institutional environment governing financial markets and institutions in our economy?
It is not necessary to elaborate on the consequences of what became “the great financial crisis.” Its severity is evident in the evolution of euro area real GDP (Figure 1). Suffices to note that the level of real GDP fell by nearly 5 percent from its peak in 2008Q1 to its trough in 2009Q2. Events during the crisis, the decisive policy responses, and implications for the future of macro-prudential supervision, were analysed by Lucas Papademos in a number of timely and insightful speeches (Papademos, 2007, 2008, 2009a,b,c,d, 2010). As the person responsible for both financial stability and economic research at the ECB during the crisis, Lucas has been in a unique position to provide insights into the events and guidance on the appropriate policy responses.
