Monetary Policy for a Changing Financial Environment (AEI Studies)


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It was clear that advances in information and telecommunication technology had a major impact on the financial services industry, generating various financial innovations and new business methods, such as internet banking, electronic money, on-line broking services and electronic trading systems. For the real economy, however, the impact was much harder to assess, not least due to a lack of reliable statistics and interpretation difficulties regarding "new economy"-related developments in productivity. Let me now turn to the interaction of the "new economy" with financial markets. It has been long debated what role the development of financial markets played in fostering belief in the "new economy".

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In most industrialised nations, on the waves of financial liberalisation and globalisation, capital markets have been growing tremendously over the past two decades, both in terms of volume and value of transactions and in the development of new types of securities. For the euro area, the preparations for and the actual introduction of the euro have undoubtedly been an important catalyst, improving the efficiency of the euro area capital markets and, to some extent, reducing existing information asymmetries, for both the equity and debt markets in the euro area.

This has certainly been a very positive development which I wholeheartedly support.

Thank you!

Coinciding with the stock market boom in the late s and , corporations in the euro area raised significant amounts of equity capital. New companies, often in the high-tech field, obtained listings at specialised "new markets" stock exchanges for high-growth companies. The growth of the euro area stock markets, in terms of the ratio between market capitalisation and nominal gross domestic product, has been staggering. Over a period of ten years, from to — when prices were at their highest level — this ratio increased about fourfold.

With the benefit of hindsight, the belief in enormous potential profits stemming from investments in "new economy" corporations resulted in a stock market rally, which broke all previous records. Valuations of internet-related companies reached levels that were extraordinary by basically all standards.

New economy, financial markets and monetary policy

In March , the monthly average price-earnings ratio of stocks in the technology, media and telecommunications sectors peaked at 70, compared with an average of around 13 over the previous 25 years. It seemed that the sky had finally become the limit indeed and that a new era had arrived. In parallel with the rise in stock prices, stock market volatility jumped: The excesses, which were particularly evident in the stock markets, are the most notable expression of the interaction of the belief in the "new economy" with developments in financial markets.

However, the growth in debt markets also played its role. The introduction of the euro and the start of the single monetary policy seem to have had a strong, positive impact on the possibilities for corporate issuers — both financial and non-financial — to resort to corporate bond issuance as a financing source. In addition, this process was fuelled by the surge in mergers and acquisitions, as more and more companies prepared to grasp the opportunities of the new dynamic environment. Furthermore, issuance activity by certain sectors linked to the "new economy", such as the telecommunications and high-tech sectors, promoted the development of certain segments of the bond markets, for example the market for high-yield bonds.

We all know where all this optimism about the "new economy" led to.


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Since March , we have seen both a substantial decline in stock prices and rising financial imbalances. I shall now discuss the aftermath of the boom and burst period that we experienced in financial markets.

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If the famous philosopher Erasmus of Rotterdam were to have lived in our times, he would certainly have added an additional chapter to his satirical masterpiece "The Praise of Folly", with its pointed attacks on human weaknesses and excesses, to describe some of the practices in financial markets and corporate behaviour that have been so blatantly evident in recent years.

Unfortunately, when stock prices came down sharply, the costs of the excesses became evidently clear. It has been calculated that buying a thousand Deutsche Marks' worth of beer would have been a better investment than investing the same amount of money in Frankfurt's Neuer Markt at the height of the bubble — at least with the beer you could have made some return by selling the empty cans.

The fall in the value of financial assets since , associated with the fall in equity prices, has led to an increase in leverage ratios of non-financial corporations. The decline in the value of collateral has led to an increase in risk premia when taking up loans or issuing debt securities. This was shown clearly in the spreads of retail bank lending rates over corresponding market rates and in the increasing risk premia on corporate bond interest rates. The ratio of debt of non-financial corporations to GDP, which increased substantially in the second half of the nineties, only started to stabilise last year.

The relatively high debt levels of non-financial corporations, combined with the decline in the value of financial assets, has had adverse consequences on firms' financing conditions via balance sheet effects and therefore on private investment in particular over the past few years. Furthermore, corporations have become increasingly reluctant or have found it more difficult to issue equity capital on public stock exchanges.

One more step

In fact, in the second half of , the value of quoted shares issued in the euro area was at its lowest level since the mid-nineties. The slowdown in equity issuance activity in and was accompanied by a similar decline in debt securities issuance by non-financial corporations. These declines in securities financing partly point to lower capital demand following the economic slowdown, but the worsening of capital market sentiment in recent years may also have induced companies to increasingly rely on other sources of finance. Furthermore, stock market participation of households in the euro area steadily increased in the s.

When share prices collapsed, households experienced substantial losses in their financial wealth, bringing the ratio of financial wealth to disposable income back to levels similar to those witnessed at the end of The costs of the developments in financial markets over the past few years, which were often linked to the "new economy", can also be measured by a critical erosion of trust.

Examples of accounting malpractice, corporate greed and imprudent stock market valuations have started to appear in increasing numbers, undermining the basic trust and confidence of investors in financial markets. There has been a lot of discussion about whether this unfortunate behaviour has been promoted by the widespread use of certain reward mechanisms such as stock option schemes. Trust, as has been demonstrated for example by Francis Fukuyama in his best-seller Trust: The Social Virtues and the Creation of Prosperity , may be invaluable for economic processes, as it facilitates economic interactions and lowers transaction costs.

Policy-makers and regulators can help to restore trust in financial markets and auditing processes by enhancing corporate governance mechanisms. I fully support measures which promote adequate governance of corporate behaviour and thereby contribute to the restoration of trust in financial statements and capital markets. However, at the end of the day the crucial contribution to restoring trust has to come from the corporate sector itself. The sector has to recognise that easy profits are like killing the goose that lays the golden eggs. Executives in private business have a collective interest in promoting high standards of ethical behaviour.

The recent worldwide episodes of substantial asset price swings, with their strong links to the emergence of the "new economy", have intensified the debate among policy-makers regarding the relationship between financial stability and monetary policy. The question arises as to how monetary policy needs to deal with asset price bubbles, which have often been linked to financial stability concerns. As is generally accepted, bubbles are situations in which the prices of various types of assets differ from their fundamental market values.

Asset price bubbles originate in the existence of imperfect information in financial markets, leading to the mispricing of assets and, in turn, to the distortion of investment and consumption decisions. Often, asset price bubbles occur in an environment of regime shifts, prompted by major technological innovations, which gave rise to the belief among a broad spectrum of economic agents that a new era had started.

In this respect, the impact of the "new economy" on stock prices that we have experienced in recent years has not been that exceptional. However, the importance of asset price bubbles and their potentially distorting impact on economic and financial processes does not mean that central banks should make asset prices an explicit goal for their monetary policies.

This idea has been refuted by many, and rightfully so. Asset prices are predominantly driven by real factors such as technological and demographic developments and preferences, which cannot be controlled by monetary policy. Furthermore, economic agents should not be given any cause to act on the basis of expectations that central banks would insure financial markets against considerable losses. Otherwise, there would be serious moral hazard problems and the public would hold the central banks accountable for specific developments in financial markets such as the performance of the stock market.

This might seriously impair the central banks' goal of pursuing price stability, and thus their credibility. Central banks also face considerable problems in terms of identifying financial bubbles. After all, a bubble can only be confidently identified as such once it has burst. However, this does not mean that developments in financial markets, and especially asset price bubbles, are not important for central bank behaviour. On the contrary, we clearly need to monitor movements in asset prices, as they reflect expectations about future economic developments and are important for the monetary policy transmission mechanism.

Furthermore, central banks should always be aware of strong movements in asset prices because of their possible repercussions for financial stability.

New economy, financial markets and monetary policy

In this sense, asset price developments play a role in our monetary policy decisions to the extent that they reveal relevant information for the state of the economy and the outlook for price stability. In this respect, our monetary policy strategy, which gives money and credit a very prominent indicator role, is a great aid. Catalogue Persistent Identifier https: Lanham, Md Wikipedia Citation Please see Wikipedia's template documentation for further citation fields that may be required.

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Monetary Policy for a Changing Financial Environment (AEI Studies) Monetary Policy for a Changing Financial Environment (AEI Studies)
Monetary Policy for a Changing Financial Environment (AEI Studies) Monetary Policy for a Changing Financial Environment (AEI Studies)
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Monetary Policy for a Changing Financial Environment (AEI Studies) Monetary Policy for a Changing Financial Environment (AEI Studies)
Monetary Policy for a Changing Financial Environment (AEI Studies) Monetary Policy for a Changing Financial Environment (AEI Studies)
Monetary Policy for a Changing Financial Environment (AEI Studies) Monetary Policy for a Changing Financial Environment (AEI Studies)
Monetary Policy for a Changing Financial Environment (AEI Studies) Monetary Policy for a Changing Financial Environment (AEI Studies)
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