The focus on price stability, as well as considerable efforts to develop norms and regulations within the field of supervision have undoubtedly reduced the risk of imbalances being able to accumulate over a long period. The question, however, is whether a monetary policy that is normally governed by forecasts of inflation in the short or medium term will be able to prevent the kind of imbalances that I have discussed from building up? If not - is there then any other way to improve the operationalisation of the target for a monetary policy aimed at achieving price stability without abandoning the goal that the decisions be rule-based and transparent? In countries that have experienced long periods of high, fluctuating inflation, discretionary stabilisation policy has been greatly discredited. First, we must point out that even if it is possible with hindsight to say that equity prices, debt levels and investment have been fuelled by over-optimistic expectations of future growth, the central bank cannot possess perfect knowledge of the future. Rising asset prices and a sharp expansion in private credit could be a sign of increased confidence in the economic policy aim of achieving price stability, as well as of reduced risks in the future. Lower public debt, which has been part of this policy, could in that case be reflected in higher private debt and in rising asset prices. Technological advances can also contribute to increasing expectations of future profits and income, and is mirrored in rising asset prices and high debt levels.
Economists from the so-called Austrian School maintained that if the central bank attempted to stimulate the economy with an interest rate that was below a long-term equilibrium level, it would in itself give rise to sharp fluctuations in the real economy. They also claimed that periods of overinvestment, strong credit expansion and rising asset prices could not be avoided in a world characterised by major technological advances. Rather, it was a precondition for the dynamics that spurred growth. Should expectations of future profits prove to have been overly optimistic, the imbalances in the shape of high debt and unprofitable investment should be allowed to quickly unwind without any attempt through economic policy to soften the resultant fall in output. Discretionary stabilisation policy discredited After the Second World War, the dominant view instead was that economic policy should play an active part to stabilise the economy. Fiscal policy was therefore given a more prominent role, while monetary policy and the long-term aim of price stability were pushed into the background. During the first two decades stabilisation policy worked well in many countries. Unemployment fell, growth was robust and inflation was low. The US currency, which in turn was pegged to gold, served during the period as an anchor for inflation and exchange rates in mainly western Europe, where the majority of countries had joined the Bretton Woods system.