Øystein Olsen: Ensuring financial stability in turbulent times Speech by Mr Øystein Olsen, Governor of Norges Bank (Central Bank of Norway), at the Finance Norway conference, Oslo, 12 April 2011. The text below may differ from the actual presentation. This speech does not contain assessments of the economic situation or current interest rate setting. *  *  *  Introduction The experience of the past few years has clearly shown the cost of financial instability. The near seizure of the financial system in autumn 2008 gave rise to the most severe economic downturn of our time. There was a dramatic decline in international trade and in 2009 world GDP decreased for the first time in generations. Economic policy was used actively in most countries to curb the economic downturn. Substantial resources were deployed in the form of stimulus packages and measures to prevent financial market collapse. Nonetheless, unemployment in the OECD area rose by 15 million in the first year after the outbreak of the crisis. The downturn also led to a sharp fall in tax revenues. Budget deficits ballooned and government debt rose rapidly. Global economic growth has recovered, but the effects of the financial crisis are still evident and will continue to be for some time yet. Unemployment is still high and the current situation and prospects for several countries bear evidence of strained government finances.
Norges Bank has therefore devoted considerable resources to developing a suite of models for analysing this interaction. Somewhat simplified, the interplay can be illustrated by developments during the previous banking crisis in the early 1990s in Norway. Households had accumulated excessive debt at that time. They had to tighten spending in order to reduce debt. They increased their financial saving markedly and reduced spending on consumption and housing investment correspondingly. This resulted in a sharp fall in earnings among companies that provided goods and services to households. Banks sustained substantial losses on their loans to these companies. Bankruptcies and lower activity resulted in lower household income and further spillovers to the economy. Such interaction effects are important in explaining that financial crises tend to follow in the wake of imbalances in the property market. It is difficult to determine with certainty when asset prices exceed levels that are not sustainable over time. Nevertheless, a long period of debt-financed increases in house prices seems to be a potent signal of a build-up of risk in the financial system, a signal that should be taken seriously. If we can restrain the build-up of such imbalances, we also reduce the risk of financial instability. The question can be raised as to whether the interest rate should be used to a further extent in preventing the build-up of systemic risk. Higher interest rates can curb the rise in both debt  BIS central bankers’ speeches  3  and house prices during an economic upturn.