This is true even in countries with highly developed capital markets, especially when it is kept in mind that participants in the capital markets rely heavily on the banking system for their financing facilities. Banks cannot play an effective role in the financial intermediation process unless the public has the utmost confidence in the banking system. This confidence is a key reason why banking institutions and banking instruments are crucial to a country’s economic growth and development. The combination of functions typically provided by commercial banks, however, also carries with it the risk that a loss of confidence in an individual institution can spread to the system as a whole, the so-called systemic risk phenomenon. Instances in which a country experiences a loss of confidence in its financial institutions usually result in major damage to the economy. Given the indispensable role that financial institutions play in the success of a country’s economy, governments clearly have a responsibility to subject financial institutions to some form of regulation or oversight. But here again, there is need for balance. Restrictions placed on banks by the financial oversight apparatus cannot be allowed to discourage risk-taking per se, because risk-taking is an inherent part of banking and finance in market economies. To perform successfully, a commercial banking system requires a delicate balance between risk-taking and maintaining public confidence.
The primary purpose of near-term policy actions should be to set the economy on a long-term, permanent path to price stability and sound economic growth. This orientation puts the focus of policy on inflation expectations over the long term -- the time horizon that is appropriate for most saving and investment decisions. Businesses and households are understandably concerned about the long-term consequences of inflation and price level uncertainty. This is the frame of reference reflected in the conceptual definition of price stability offered by the chairman of the Federal Reserve, Alan Greenspan -- that price stability is achieved when people do not consider inflation a factor in their business and economic decisions. Long-term inflation expectations must be anchored to a transparent and rigorous commitment by the central bank to a well-defined standard of price stability, and unavoidable deviations from the goal of price stability must be explained with reference to that standard. In my view, price stability is a means to an end -- the promotion of sustainable economic growth. Only with long-term price stability can the economy expect to achieve the maximum levels of productivity and living standards. Price stability is both important and desirable because a rising price level, even at moderate rates, imposes substantial economic costs on society.