Decisions on the level of monetary policy restraint are always taken under conditions of uncertainty – about the current economic situation and probable future developments, and whether monetary policy instruments will be effective at any given time. This is why responsible and well-informed parties can easily disagree on what is the best course of action at any time. In the Central Bank’s Annual Report, which is available for perusal here, you can see how individual members of the Monetary Policy Committee voted at the various meetings in 2009. The minutes of the MPC meetings reflect the in-depth coverage of economic affairs at each meeting and the issues the Committee deals with at any point in time. I take the liberty of asserting that all MPC members vote as they deem most appropriate in view of current circumstances and the Committee’s objectives. Moreover, I strongly doubt that interest rate decisions based on some other arrangement, where professional views are less important and transparency less, would yield better results. Under the current circumstances, however, decisions on the level of monetary policy restraint are more complex than they generally have been in the past. That complexity stems in part from the fact that it is not clear where we are headed in the immediate future.
Although a great deal remains unknown about what happened in the financial institutions that collapsed and in the preparation of Government responses before and after the crisis struck, we also know a great deal about what was lacking in regulatory framework and supervision – particularly the elements that Iceland shares with many other countries. In the international arena, there has been extensive discussion of the flaws in regulation and supervision, and improvements are being implemented already. The Central Bank of Iceland is keeping close track of this work, not least through its membership to the Bank for International Settlements in Basel and its collaboration in European and Nordic fora. To my mind, the most important weaknesses in this regard – and they are not limited to Iceland – are the following: First, too much attention was paid to risks in individual institutions, while a comprehensive assessment of risk in the financial system as a whole was much less developed. The old adage – that the whole is greater than the sum of its parts – was forgotten. Second, the institutional framework was flawed, in that it did not promote such a comprehensive assessment of risk. It was unclear who was responsible for responding to systemic risk, and there were too few tools for addressing it, such as variable capital requirements and other restrictions to combat lending and asset bubbles and set limits on risk appetite. Third, liquidity risk was underestimated, not least risk related to liquidity management between currencies and financial institutions’ re-financing in foreign currency.