Trust and public policies
Speech by Mr Agustín Carstens, General Manager of the BIS, at the High-level seminar on central banking: past and present challenges, São Paulo, 19 May 2023.
I would like to thank the Banco Central do Brasil for inviting me today. It is a pleasure to be here, discussing such important issues alongside such experienced and insightful peers and colleagues.
The topic of today's conference – preserving the institutional strength of central banks – is close to my heart. In my remarks today, I would like to provide some personal reflections on how to advance this goal and, even more importantly, to ensure the success of public policies more broadly over the long term. In this, I draw from my experiences as both finance minister and central bank governor in Mexico.
Many factors contribute to the success of public policies. The policies themselves must be well designed. The institutions delivering the policies must have sufficient resources and staff with the necessary technical skills. But there is another requirement, one that in my experience is an even more fundamental ingredient for ensuring the success of public policies. That element is society's trust in public policies.
I should begin by defining the concept of trust in public policies. Essentially it consists in society's expectation that public 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.
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 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 opposite 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 also depends 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, they know 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 through dollarisation to, in the extreme, a return to barter, as has been the result of some hyperinflationary episodes. It can also result in severe financial instability, with very high costs for society in terms of economic growth, employment, inequality and wealth.
These consequences of the loss of trust in money have been a key motivation for the autonomy of central banks. After all, autonomous central banks are nothing more than an institution within the state with a mandate to preserve 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 must constantly 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 Banco Central do Brasil is no exception. But in what does it consist?
Central banks do not directly control inflation. However, their policy tools can influence it. Through an 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 the risk of the economy transitioning to a high-inflation regime for the first time. And once this transition starts, it can become increasingly difficult to stop. Therefore, it has been appropriate that most central banks around the world have been tightening monetary policy through higher interest rates to restore price stability. This strong response must continue as long as necessary, for only by resolve, perseverance and success in this task can trust in money be preserved.
A third example concerns trust in the financial system. This is no less important than trust in the central bank itself. After all, the financial system is what links monetary policy with the real economy. That system has faced several challenges of late.
Several of these challenges relate to the banking sector. It is well known that the money issued by the central bank is not the only money that circulates in a modern economy – in fact, it is the smallest part. What we economists refer to as "commercial bank money", in the form of bank deposits and credit, is the bulk of it. For most people, central and commercial bank money are indistinguishable. This is no coincidence. Over time, institutional arrangements have evolved 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. When one company makes a payment to another one these transactions ultimately settle on the central bank's balance sheet, through the exchange of central bank 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 ability to create liquidity by lending to the banking system. Thus, trust in central bank money transfers to the banking system.
Recent attempts to create private forms of money based on technologies that allow transactions on decentralised ledgers have highlighted the value of the two-tier monetary system. Proponents of so-called cryptocurrencies boast that these can function without central bank intervention, a lender of last resort or a reliable regulatory and supervisory framework. In reality, as cryptocurrencies have provided neither a convenient means of exchange nor a stable store of value, they clearly do not replicate any of the fundamental attributes of money. But they do show that what sustains fiat money over novel technology-based alternatives is the institutional framework and the social conventions that support it. And these qualities are precisely what makes it reliable for the public.
Trust in the financial system also requires stable and solvent financial institutions. This is why central banks and prudential regulators are tasked with monitoring financial stability and setting rules that safeguard the financial system.
Recent banking failures have reminded us of the value of these safeguards. Make no mistake: the primary responsibility for events like the collapse of Silicon Valley Bank and First Republic in the United States or the takeover of Credit Suisse lies with the managers of the institutions involved. But these events also underline the need for an effective supervisory regime and mechanisms for timely intervention to prevent the failure of individual institutions from destabilising the whole system.
Brazil has been spared from turmoil in its banking sector both recently and in past episodes such as the Great Financial Crisis. This results not from luck but from the collective efforts of bank managers, supervisors and the monetary authority. While this is good news, it should not be reason for complacency.
Recent decades have also seen the rapid growth of non-bank financial intermediaries. This sector comprises insurance companies, investment services companies, investment and pension funds, as well as hedge funds, among others. In many countries, non-bank financial intermediation now accounts for over half of the financial system.
The need for greater supervision and regulation of the non-bank sector has become more pressing in the light of recent episodes of instability. Instability stems from the sector's interconnectedness with the traditional banking system and the tendency of different forms of non-bank intermediation to generate opaque and excessive leverage as well as substantial liquidity mismatches. Upsets in this sector can result in systemic financial crises. In recent years, central banks have had to act as "market-makers of last resort" to defuse crises and preserve trust in the broader financial system. These actions may run against central banks' primary objective of price stability. This highlights how 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 whereby, 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 illustrate 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.
In this regard, let me address a common misconception. Central bank autonomy has been a key development on the road to price stability. But autonomy does not mean isolation. A dialogue can, and I would say should, exist between central banks and finance ministries. Monetary and fiscal policy are inherently linked – the policies affect each other, and together they affect economic and financial conditions and therefore the wellbeing of people and the investment plans of companies. Autonomy actually widens the scope for such a dialogue to take place.
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, and the autonomous central banks responsible for implementing it, will be called into question.
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.
Thank you very much for your attention.
