Global policymakers may have “tested the extremes” of their ability to shore up economies in the face of financial crises, Jean-Claude Trichet, European Central Bank president, warned on Thursday.
In one of his strongest warnings yet about the continuing vulnerability of the global financial system, Mr Trichet argued that emergency action by government and central banks risked encouraging expectations that policymakers would always act to head-off a worse-case scenario.
Speaking at Cambridge university, in the UK, he said: “The instruments of counter-cyclical policy have been used so intensely – and more so from one financial cycle to the next – that authorities might have tested the extremes of their control procedures.”
His speech highlighted ECB concern about the risks of “moral hazard” – the rewarding of irresponsible behaviour – created by the exceptional policy steps taken since the collapse of Lehman Brothers in October 2008. It also hinted at the agenda Mr Trichet expects to be set by Europe’s new “systemic risk board”, which he is expected to head and will take an overview of risks to financial stability.
Mr Trichet, a former French bureaucrat with more than 20 years of dealing with international financial crises, noted that the speed at which disruption spread had “accelerated tremendously over the past few decades”. While debt crises in the 1980s occurred over years, the effects of the Lehman collapse “spread around the world in the course of half-days”.
He argued that authorities would need a wide sweep of information as well as analytical skills and the necessary policy instruments to fight future crises.
Earlier, in an interview with two Belgian newspapers published on Thursday, Mr Trichet stepped into the US debate on the future powers of the Federal Reserve.
He said he “would be amazed” if in the future the Fed no longer had a close link with “micro-prudential supervision” – the policing of individual banks – “since this does not appear to me to be the lesson that should be drawn from the crisis at all”.
In Cambridge, Mr Trichet argued that expectations that policymakers would protect against worse-case scenarios “can contribute to an underpricing of financial risk in subsequent phases of the financial cycles. They can encourage concentration of market positions.”
He warned that “repeated attempts to fine tune a mechanical or electronic system after a shock sometimes leads to ‘instrument instability’ that makes the system spiral out of manageable bounds. Economic and financial systems, I suspect, could have some structural similarities with physical systems”.