The bounce back from the world economic slowdown in 1998/1999 was such that in the year just ended world economic activity grew at a rate of some 4½% which equals the fastest rate for 16 years – and compares with an average rate of some 3¼% over the last 10 or 20 years. In large part this recovery was underpinned by unusually strong growth in the US, averaging some 4½% over the past 4 years and surging to a peak of some 5½% at an annual rate in the first half of last year – compared with an average rate of 2¾% over the preceding decade. This remarkable strength of the US economy was possible, without overheating, against the background of unusually rapid productivity growth as investment in IT spread through the US economy improving its supply-side capacity. These developments together implied higher corporate earnings growth in the US pushing up the stock market and at the same time attracting massive direct and portfolio capital inflows into the US – substantially from the Eurozone – which comfortably over-financed a burgeoning US current account deficit and underpinned the strong dollar. However helpful all this was in supporting the world economy it clearly could not continue for ever or without limit.
Many of these instruments, such as providing liquidity, are inherent or traditional while others, such as regulating and watching over payment systems, have developed in recent decades. The experience of the last few years has suggested a need to review or update the available instruments and to generate the operational conditions in which they can be used without delay when needed. During this latest crisis, for example, many central banks were not operationally prepared to receive collateral that was not in habitual use. It has also been suggested that there is a need to incorporate new instruments, principally with a macroprudential approach. However, in the case of some of these instruments – specifically, the use of regulation for countercyclical purposes – evidence is scarce and debate as yet inconclusive. However, beyond the contribution that a central bank can make, financial stability requires a comprehensive framework of financial institutions, policies and practices. The solidity of this framework and its consistency are crucial. Regulation and supervision, whether or not in the hands of the central bank, are critical, but so too are monetary and fiscal policy. The recent sovereign debt crisis in Europe, for example, has demonstrated the importance of fiscal conditions for financial stability. Market discipline and institutions’ management, although discredited by the crisis, are factors that can, with an appropriate regulatory framework and incentives, contribute to stability. The efficiency of regulation and supervision should, in the end, be reflected in good behavior by institutions and the proper functioning of markets.