Closer attention must therefore be paid to the financial fragility that accompanied this process – both to the factors that led to the distortions in asset prices and to the factors that amplified the crisis once the adjustment took place. Let me touch briefly on two of these factors:   The first is financial innovation. Despite a lot of public debate and criticism I believe that financial innovation is essentially welfare enhancing. However, we must not forget that financial innovation can also become a form of circumventing regulation. The way some securitized assets where used was the clearest case of this abuse. They were structured in a way that only secure tranches remained in the balance sheets of banks, and the others were sold, many times to off balance vehicles, allowing credit to expand with a weak capital base. The result was excess demand for certain securitized assets, and excess exposure of highly leveraged intermediaries to these assets. Moving forward, financial innovation needs to move in step with regulation to ensure that it adds value and is not just a form of evading regulation and aggravating financial fragility.   The second is liquidity transformation. Along with important benefits, liquidity transformation entails significant risks. We have known the vulnerabilities of liquidity transformation in the presence of aggregate shocks for a long time; in fact, many countries paid very dearly for this risk before central banks where set up to provide aggregate liquidity.
The dose will depend on the initial conditions of the economy and the magnitude of the shock. A simple example is dealing with uncertainty in financial markets that increases demand for liquidity, which requires the provision of liquidity by the central bank. Is this consistent with price stability? Yes, indeed. If the financial shock consists of a collapse in asset prices that weakens balance sheets and leads to further declines in asset prices, the economic contraction can be substantial. The monetary policy response in this case will be to reduce interest rates, consistently with price stability (as in Bernanke and Gertler, 1999). In the aforementioned cases, policy interventions under financial stress, either lender of last resort (liquidity injections) or interest rate types, are consistent with PS and FS. But it may be the case that the magnitude of the financial shock is so severe than neither price nor financial stability may be fulfilled. The problem is not that these two objectives are mutually inconsistent, but that the shock is too large to be addressed with the standard tools. Nevertheless, the fact that the targets may not be achieved within the “policy horizon” does not mean that monetary policy cannot be effective to reduce the costs of the crisis. If something, output costs associated to the global financial crisis have been, so far, significantly lower than the ones we observed in previous comparable episodes. Macroeconomic policy has a lot to do with this.