When liquidity was abundant, asset values were high and marked-to-market profits were high. Now that liquidity is scarce and asset values lower, mark-to-market losses and write-downs are high. The widespread use of credit ratings in valuing assets and managing counterparty credit risk has also had an impact. Credit rating agencies try to rate through the cycle. And for corporate ratings they may well succeed. But for some structured finance products, such as re-securitisations of sub-prime backed securities they (like many others) misjudged the impact of a downturn in the cycle and the non linearity of returns. As a result, there have been wholesale downgrades of the credit ratings of structured securities over the past 12 months. The problem for the financial system is that these ratings are often hard-wired into decision making. Certain classes of investors are forced to sell assets when they lose a AAA or investment grade rating. Remuneration structures have also amplified risk taking in the upswing. Two features of remuneration in the financial industry are that they are asymmetric (there is unlimited upside for high performance but a floor on the downside) and tend to be based on short-term targets. The asymmetry in reward creates an incentive to gamble and short-term performance targets encourage traders to follow rather than counter a deviation from longrun fundamentals. Even where the incentives were paid in options linked to the medium-term performance of the employer, the apparent rewards have been highly cyclical.
More-aggressive-than-usual policy responses may be appropriate to avoid the negative implications of an encounter with the zero bound. Paradoxically, though, once the lower bound on interest rates is binding, a less-than-usuallyaggressive monetary policy response may be appropriate. I have tried to articulate this in FOMC meetings ever since we started down the path of quantitative easing, drawing on anecdotal reports from my CEO contacts and what I thought was common sense. But my arguments fell on deaf ears until my more learned counterpart at the San Francisco Fed, John Williams, produced a formal study that posited that the aggressive use of unfamiliar policy tools like quantitative easing and Operation Twist add to aggregate economic uncertainty and, if applied at all, should be deployed more cautiously than our more familiar tools.7 Large margins of error In general, the objective of monetary policy is to provide households and firms with an economic environment that makes it attractive to use money as medium of exchange and store of value. Since many private contracts, including labor and debt contracts as well as capital expenditure commitments, extend out several years, a multiyear policy perspective is needed. A multiyear perspective is especially important when the economy may encounter the zero bound. The explanation is that by interfering with the normal conduct of monetary policy, the zero bound increases the likelihood that policy will miss its objectives year after year in the same direction, so that the errors accumulate over time.