The BIS Review 7/1999  –3–  exaggeratedly strong exchange rate against the core European currencies – reflecting inter alia market misperceptions about the prospective strength, or rather weakness, of the euro – was itself moderating external demand, especially for manufacturing output, while at the same time exerting a restraining price effect on domestic inflation. But domestic demand growth – including demand for services – continued to accelerate through 1997, and that was the background to the tightening of monetary policy in 1997. We could not avoid that tightening, despite the uncomfortable sectoral imbalance within the economy. To have done so would, as I have said elsewhere, have put the whole of the economy – including the internationally exposed sectors we would have been trying to shelter – at risk of accelerating inflation, so it would not have helped even those sectors in anything other than the short term. Meanwhile, in the euro-zone things were very different. Demand and output growth in the major continental economies remained generally fairly sluggish for much of the period, only really starting to pick up towards the end – helped by relatively weak exchange rates. Unemployment, which is much the most urgent and important issue confronting Europe, actually increased; and, despite some improvement over the past year or so, it remains at or close to double digit rates in all the largest euro-zone countries. Inflation against this background remained low, tending lower – as did interest rates.
The financial soundness of a central bank, the usual lender of last resort in a country, is an important firewall for trouble in the financial system. While a central bank may count with the help of the sovereign, this channel may be a source of concern when sovereign themselves are facing problems, and it also raises some worries about the ability of the central bank to maintain its independence. There are also those who argue that, since the liabilities of central banks can be arbitrarily created, the financial position of a central bank shouldn’t matter. But this argument forgets that doing so may endanger the achievement of the inflation targets that many central banks have taken as their operational goals, affecting their reputation and independence. 2  4  Céspedes et al. 2012. BIS central bankers’ speeches  In 1982, as the debt crisis spread through Latin America, the Chilean financial system, which had channeled substantial foreign-currency-denominated syndicated loans, became largely insolvent. Under these conditions, the government engineered a massive rescue operation through the central bank where several of the most important banks became nationalized and others disappeared, after their assets were absorbed by other institutions. This intervention prevented an even larger collapse of activity than the one we ended up experiencing. The manner in which it was implemented, where shareholder equity was fully diluted and institutions assumed a subordinated debt to the central bank that took a long time to repay, helped maintain the rescue’s moral hazard concerns at bay.