The value of trust

Speech by Mr Agustín Carstens, General Manager of the BIS, at Award ceremony, King of Spain Prize in Economics, Madrid, Spain, 6 March 2023.

It is a great honour for me to receive the King of Spain Prize in Economics, which is the most important award for Spanish and Latin American economists. It pleases me not only because I receive the prize from Your Majesty, but also because my selection was the result of a very broad deliberation by a jury of great professional prestige.

This prize, which is sponsored by the José Celma Prieto Foundation, encourages economists to strive for growth and excellence. And this encouragement certainly fell on fertile ground in my case. In 1992, the prize was awarded to Miguel Mancera Aguayo, then Governor of the Banco de México. At that time I had the opportunity to discuss his acceptance speech with him. The greatest lesson I took away from that experience was the realisation that one could distinguish oneself as a Mexican at the international level on the basis of hard work and continuous learning. I thank Miguel Mancera and the Foundation for this inspiration, which I have carried with me for the past 30 years. And of course I would like to thank my family – in particular my wife Catherine and my mother – for their great support over my entire career.

According to the Foundation's announcement, the jury based its decision on my service as a public official involved in economic policymaking. Indeed, I consider myself to be a practitioner of economics. This is not a rejection of economic theory – quite the opposite. Effective economic policy implementation requires the ability to translate theory into practice. This means taking into consideration the political environment, social needs, the complexity of the real world and practical constraints. At the same time, economic science cannot advance without learning from public policies that have been implemented. Circumstances often arise in which practice advances faster than theory. At the end of the day, a virtuous circle between theory and practice needs to be established.

My training as an economist prepared me to navigate nimbly between theory and practice. I began at Banco de México in 1980, while I was still studying economics at the Autonomous Technological Institute of Mexico (ITAM). I started as a foreign exchange trader, which was a fascinating learning experience. I began to understand how markets functioned and how they interacted with economic policy. But in a broader sense, it was a traumatic experience. From the end of the 1970s until September 1982, Mexico accumulated multiple macroeconomic imbalances that culminated in the depletion of international reserves, the abandonment of the fixed exchange rate regime, the imposition of generalised exchange controls, defaults on our foreign debt and the nationalisation of the banking system. It was a fiscal, banking and exchange rate crisis. Everything fell to pieces. This episode marked me in profound ways. I became deeply concerned with the countries' capacity to prevent systemic financial crises – a concern which has stayed with me to this day.

With no international reserves and general exchange controls, there was not much for me to do as a foreign exchange trader. Luckily, in October 1982 I was given the opportunity to attend the University of Chicago to do a doctorate, thanks in part to the support from the Bank of Mexico. There I took classes and participated in seminars with multiple Nobel Prize winners, as well as other outstanding professors who encouraged us to think about how we could contribute to solving the most pressing economic problems.

In late 1985, after finishing my doctorate, I rejoined the Bank of Mexico and again, over economic research, I chose the operational area. Specifically, I joined the great effort spearheaded by the Bank to modernise Mexico's key financial markets.

In the wake of the 1982 crisis, Mexico adopted a multiple exchange rate regime, naturally coupled with extensive foreign exchange controls. Needless to say, that was an extremely inefficient system, and therefore it gradually evolved into a unified exchange rate that followed a crawling peg. Monetary policy could no longer operate solely on the basis of quantitative targets for monetary aggregates, as these were losing their ability to effectively anchor inflation. It was essential to evolve from the financial authorities practically determining the main financial prices of the economy – that is, the exchange rate and interest rates – to policies that would respect the flexibility of those prices, as determined by supply and demand in markets that had to be fully developed. This effort, which lasted until the late 1990s, was remarkably successful. Thanks to it Mexico is today one of the emerging market economies with the most advanced financial market infrastructure.

Having a group of economists who are technically proficient but also experienced in market operations is of vital importance. As a matter of fact, financial markets contribute greatly to the evaluation of policies, which often leads to their improvement. One of the salient features of financial markets is that on a daily basis they pass judgment on implemented policies and issue a verdict on whether they are credible or require fine-tuning. The challenge lies in being able to extract the correct signals from the mass of information emitted by the markets on a daily basis.

At the end of the 1980s and beginning of the 1990s, Mexico carried out many structural reforms: the autonomy of the central bank, trade liberalisation, deregulation of many domestic activities, privatisation of public enterprises and commercial banks, creation of the economic competition authority and the opening to foreign investment, including in domestic public debt. We also renegotiated our foreign debt on market terms (as part of the Brady Plan), which was the first restructuring of its kind and was subsequently emulated by dozens of emerging market economies.

One would have thought that following these reforms, and with an autonomous central bank, Mexico would finally be positioned to enter a prolonged period of low and stable inflation. Unfortunately, we had to endure another crisis before that was the case.

The above mentioned reforms attracted large short-term capital flows, which were channelled mostly to government securities and banks. Unfortunately, weaknesses in the fiscal accounts and the banking system were developing in parallel. These vulnerabilities proved to be fateful, particularly when the US Federal Reserve started in early 1994 to sequentially raise its benchmark interest rate. This, together with political instability, eroded confidence in Mexico's exchange rate regime, precipitating a full blown speculative attack against the peso. The exchange rate commitment had to be abandoned, triggering the first modern financial crisis among many that have subsequently occurred in emerging market economies.

Around that time, I finally arrived in territory more familiar to economists: the General Directorate of Economic Research at Banco de México. Given the situation the country was in, we had to dedicate ourselves fully to managing the crisis. One of the most complicated aspects was the resolution of the banking crisis, which cost the public treasury approximately 15% of GDP. No less challenging, and undoubtedly more important for the Bank of Mexico, was the design and implementation of a monetary and exchange rate regime that would genuinely work as a nominal anchor for the economy.

For many decades up to that point, the cornerstone of the Mexican economy's nominal anchor had been some kind of exchange rate commitment. But the 1994 crisis made it clear that this was no longer possible, given the liberalisation of capital flows and exponential growth of financial markets, which made currency flows much more volatile. Hence, the adoption of a floating exchange rate regime was inevitable.

In 1994, we initiated a strategy that still sought to control certain monetary aggregates, of course now without financing from the Bank of Mexico to the federal government. But little by little we moved to a more modern framework that fully depended on the central bank's management of a reference interest rate in order to influence the financial conditions of the economy. This led us to converge a few years later on an inflation targeting scheme that has generally produced low and stable inflation levels – that being the Bank of Mexico's primary mandate.

The monetary framework that has been put in place since then, together with the consolidation of fiscal and banking fundamentals, continues to serve the Mexican economy well. Proof of this is that Mexico has been able to cope with the two major world financial crises since the 1920s: the 2008–10 Great Financial Crisis and the one stemming from the Covid-19 pandemic and the Russia-Ukraine war. These crises were definitely felt in Mexico, but they did not derail the economy. This illustrates the importance of further strengthening those fundamentals.

In the late 1990s, armed with the theoretical and practical knowledge I had accumulated over 20 years, it was time for me to spread my wings and temporarily leave the nest of the Bank of Mexico. From 1999 to 2009 I held various positions at the International Monetary Fund (IMF) and the Ministry of Finance and Public Credit (SHCP). At the IMF I was appointed first Executive Director, representing the interests of Spain, Mexico, Venezuela and most of the Central American countries; then I was Deputy Managing Director, managing the Fund's relations with 70 countries of all types. At the SHCP I was first Undersecretary and then Minister, where I was involved in all aspects of public finance. I was also ultimately responsible for the supervision and regulation of the financial system. In 2010 I returned to the familiar terrain of central banking, first as Governor of the Bank of Mexico and, most recently, as General Manager of the Bank for International Settlements.

My activities over the past 23 years have been so broad and varied that after several attempts I gave up on presenting you with a succinct narrative of my main experiences during that time. I simply didn't know where to start. Instead, I have opted for another approach to give continuity to this speech. This consists in answering a question: based on the experience I have accumulated during my career, what would I identify as the fundamental ingredient for ensuring the success of public policies? The overarching concept that summarises my answer is the immense value of society's trust in public policies.

We should begin by defining the concept of trust in public policies. Essentially it consists in society's expectation that the authorities will act predictably in the pursuit of predefined objectives and that they will succeed in their task.

Why is trust so important? If the public trusts the authorities' actions, they will incorporate them in determining their own behaviour. As a result, it is more likely that the authorities will achieve their objectives. In addition, trust fuels the legitimacy of policies. With trust, the public will be more willing to accept actions that involve short-term costs in exchange for long-term benefits. In sum, trust is vital for policy effectiveness.

However, trust is acquired by achieving a number of objectives over time. Hence the importance of setting clear policy goals, as they provide a benchmark against which policy actions can be evaluated: their success or failure can be identified. But setting targets alone is not enough. Policymakers must also move decisively in pursuit of them, particularly when the environment changes.

There is also a positive feedback loop in the dynamics of trust. If policies are effective and legitimate, it is easier for the authorities to achieve their objectives, which in turn feeds back into trust, producing a virtuous circle. However, this dynamic can also work in the other direction and, at times, very quickly. In the extreme, if trust evaporates, the capacity to make effective public policies disappears. It is therefore a constant challenge to preserve credibility, and it requires consistency in public policies over time. Institutional arrangements can be very valuable for this purpose.

I would like to illustrate the value of trust with a few examples. I will begin with one related to the most fundamental aspect of central banking: the nature of money. The social convention of money, as we know it today, is based on the trust placed in it by the public. And as money is the basis of the entire financial system, the system's stability depends also on trust.

Fiat money is an asset with no intrinsic value. Its value derives from the social convention that underpins it, together with the institution that enables it to function – the central bank. Money only has value today if the public knows that others will honour that value, today and in the future. This ensures that when a person wants to use it, he or she knows that it will be accepted and that there will be finality in the payment. Thus, its value clearly comes from trust. This is why the issuer of money is so powerful. However, this power carries with it a great responsibility: those who abuse their ability to issue currency, deprive money of its value and will be rejected by society.

The consequences of the state abusing the privilege of issuing money can be disastrous. These can range from high inflation and sharp exchange rate depreciations, to the abandonment of the national currency in favour of a foreign one (dollarisation) to, in the extreme, a return to barter (in hyperinflationary processes). A further consequence would be severe financial instability, with very high costs for society in terms of economic growth, employment, inequality and wealth. All these consequences of the loss of trust in money have been the main motivation for the autonomy of central banks. After all, autonomous central banks are nothing more than an institution within the state with the key mandate of preserving the purchasing power of the national currency. Autonomy is the social engineering which shores up society's trust in the central bank.

As a second example, consider what monetary authorities constantly must do to preserve trust in money. They must adopt monetary arrangements that allow them to anchor inflation expectations and thus preserve the purchasing power of the currency they issue. Over recent decades, most central banks have converged on inflation targeting regimes. The Bank of Spain did this, and both the Bank of Mexico and the European Central Bank apply their own versions of it today. But in what does it consist?

Central banks do not directly control inflation. However, their policy tools have the potential to influence it. Through the inflation targeting regime, the central bank commits to use its tools to achieve the targets. If the public trusts the central bank to do what is required to keep inflation close to target, then that target, rather than current inflation, becomes a key reference for people in making their price and wage decisions, leading to low and stable inflation. In this situation, inflation variations are usually transitory and reflect changes in relative prices. Inflation becomes self-equilibrating.

The lessons from this process contain warnings for the future. The trust gained can be lost if society doubts the central bank's commitment to the objective of maintaining price stability. This is one of the reasons why the recent rise in inflation in virtually every country is a cause for concern. Some generations are experiencing for the first time the risk of the economy transitioning to a high-inflation regime. And once this transition starts, it can become increasingly difficult to stop. Therefore, it has been appropriate that most central banks have been tightening monetary policy through higher interest rates to restore price stability. This strong response must continue as necessary, for only by resolve, perseverance, and success in this task can trust in money be preserved.

The third example deals with the trust that commercial bank money should command. It is well known that the money issued by the central bank, known as primary money, is not the only money that circulates in a modern economy. Bank money, the result of commercial bank intermediation, is also fundamental to the monetary system. This type of money takes the form of bank deposits and credits. For most people, primary and bank money are indistinguishable, which is no coincidence. Over time, institutional arrangements have been developed to ensure that society's trust in primary money also extends to bank money.

A two-tiered monetary system is the crucial element. The central bank lays the foundation, and on the first floor are commercial banks. The key is that interbank payments be ultimately settled at the end of the day on the central bank balance sheet, through the exchange of primary money between commercial banks. This guarantees the finality of payments and the singleness of bank money. The ultimate settlement of the banking system at the central bank is made possible by the central bank's high flexibility to create liquidity through its lending to the banking system. At times of great instability, it can provide liquidity through its well known function as lender of last resort. Thus, to the extent that there is trust in primary money, it transfers to the banking system. However, this is not enough to ensure trust. The banking system must also remain solvent. Reflecting the high social costs of banking crises, the system is extensively regulated and supervised. This includes through deposit insurance, which is in place to mitigate potential bank runs. All these layers of protection are intended to safeguard the public's savings, and are manifested in trust in both primary and bank money.

To put into perspective the enormous value of the framework I have described which supports trust in primary and bank money, it is useful to refer to recent failed attempts to issue private money through technologies that allow transactions based on decentralised ledgers. This alleged forms of money function without central bank intervention, a lender of last resort or a reliable regulatory and supervisory framework. These have resulted in the proliferation of so-called cryptocurrencies, which cannot guarantee finality of payments or a stable value, and so clearly do not possess the fundamental attributes of money. The corollary of this experience is the confirmation that what sustains fiat money over alternatives based on novel technologies is the institutional framework and the social convention that support it, which are precisely what makes it reliable for the public.

Over the last few decades, we have also seen very rapid growth of the non-bank financial system. This sector comprises mainly activities involving securities, including debt instruments and broader forms of intermediation performed by insurance companies, investment services companies, investment and pension funds, and hedge funds, among others. In fact, in many countries non-bank financial intermediation has for some years now accounted for over 50% of the financial system.

It has traditionally been argued that the case for comprehensively regulating non-bank financial activities – beyond the application of conduct of business and client protection rules – is less strong than for banking activities. The argument is that in most of these activities, no intermediation risks are assumed on liabilities taken from the public. However, the need for greater supervision and regulation in the non-bank sector has become more pressing in the light of recent episodes of extreme instability. This stems from the sector's interconnectedness with the traditional banking system and the proclivity of different forms of non-bank intermediation to generate opaque and excessive leverage and substantial liquidity mismatches. Unforeseen events in this sector can result in systemic financial crises. In recent years, in order to defuse crises some central banks have had to act as "market makers of last resort" to preserve trust in the broader financial system. Such actions may run counter to what the central bank has to do to achieve its primary objective of price stability, so greater regulation and supervision of the non-bank financial sector seems indispensable.

Within the universe of debt instruments, one is of outstanding importance. I am referring to public debt, which, if properly used, allows governments to successfully function. From a macro-financial point of view, it is important that public debt be perceived as sustainable. For this, an essential condition is that investors continue to trust the government to adhere to intertemporal budget constraints, without having to resort to central bank financing. This is the subject of my fourth example.

Public debt plays a strategic role. It is considered the instrument with the lowest credit risk, making it essential for grounding the risk of asset portfolios, particularly those of banks. In addition, its prices are the main reference for valuing other forms of debt, for example, corporate debt. Hence, defaults on public debt compromise the stability of the financial whole system. Monetary stability could also be threatened, since conditions could arise wherein, in spite of the central bank's autonomy, it would be necessary to finance debt service with primary issuance, leading to fiscal dominance of monetary policy. Under these circumstances, economies would cease to have a nominal anchor and would be cast adrift. The result would be rising inflation and sharp exchange rate depreciations. We can thus appreciate the vulnerabilities that can be triggered if trust in public finances is lost.

All the examples I have presented leave no doubt that, in order to have a stable monetary and financial system, it is essential to preserve trust in the three pillars of a country's macro-financial policy: monetary policy, fiscal policy and financial regulation and supervision. And this must be achieved not only in each individual area, but for all policies as a whole; that is, there must be consistency among them. In practice, this represents a great challenge due to the multiple authorities involved and the existence of unavoidable political motivations, especially with regard to fiscal policy. This is not an insurmountable problem, but it certainly highlights the need for greater consistency and coordination of public policies. Institutional arrangements that facilitate this process should be enhanced in the future.

Allow me an additional reflection on the credibility of fiscal and monetary policies in the current context. The spike in inflation in many countries resulted in part from supply shocks caused by the pandemic and the invasion of Ukraine. But it also reflects the stimulus to aggregate demand over the last 15 years, linked to very expansionary monetary and fiscal policies, particularly between early 2020 and mid-2022. The objective of these measures was to boost economic growth in the face of very adverse shocks, without giving rise to major inflationary pressures. It would be difficult to conclude that this objective has been fully achieved. However, what is vitally important is that trust in monetary and fiscal policies could be compromised if we continue to attribute to them great power to stabilise economic activity without consequences for inflation.

Over the coming years, monetary policy should focus squarely on bringing inflation back to levels consistent with central bank objectives. This process may run into obstacles, particularly in the final stretch towards eventual convergence with inflation targets. But it is essential to achieve this objective. Otherwise, the credibility of monetary policy would be called into question, as would the credibility of the autonomous central banks responsible for implementing it. Meanwhile, there are clear limits to what can be expected from expansionary fiscal policies. In a world with inelastic aggregate supply, the impulse fiscal policy could give to aggregate demand would surely have to be neutralised by monetary policy in order to control inflation. In addition, it is worth remembering that the public debt to GDP ratio in most countries is at historically high levels, while higher interest rates are expected over the coming years, which will make debt servicing more burdensome. Public debt sustainability concerns may arise in some cases. In my view, the limited fiscal space we will have should be used to address the supply side constraints that limit our countries' growth potential, including those arising from climate change, demographic pressures, educational shortcomings in the light of technological change, deficiencies in health systems and inadequate public infrastructure. Fiscal and monetary policies make great contributions to society. But we must remember that structural reforms are the main tool for sustainably accelerating countries' economic growth potential.

Let me conclude with a final thought. Even though I have highlighted the value of trust in public policies as key for their success, it has to be said that trust is not an end in itself. Trust in monetary and fiscal policies, and financial regulation and supervision is a necessary but not sufficient condition for meeting higher objectives for society's wellbeing, including higher incomes, more and better paid jobs, and an adequate provision of social services to the public. I will continue contributing to these goals just as much today as I did when I first walked into the Banco de México, 43 years ago.

Thank you very much for your attention.