One example was when the authority of a European country suggested letting a bank go bankrupt for having made management mistakes. Wisely, it quickly changed its mind, showing that wisdom does not mean never committing errors but rather recognising such errors in time. The consequences of the other example of the mishandling of moral hazard were worse. I refer here to the initial reaction to the euro area sovereign debt crisis. As we have often repeated at the European Central Bank, the negative consequences of openly admitting the possibility of sovereign debt default by one of the euro area countries, and even of demanding default as a centrepiece of any bail-out programme, were perhaps not taken sufficiently into account. And these factors have no doubt contributed significantly to the crisis attaining its current scale. But let us be clear: avoiding the costs associated with the potential bankruptcy of or default by banks and countries is perfectly compatible with laying down rigorous conditionality criteria when extending aid to resolve crises. Averting bankruptcies in specific cases does not mean going “soft” on banks or countries which took on too many risks or incurred excessive debt. Countries or credit institutions should be helped only in exchange for strict conditions. And not only for moral reasons (never helping those who do not help themselves), but essentially because to be able to stand on one’s own two feet it is necessary to enact far-reaching restructuring and reforms.
And while central banks no longer seek to spring surprises on the market, our community could not rule them out if circumstances were to evolve where the market misperceived the implications of a central bank’s analysis of the outlook. But perhaps the most important point for the pricing of risk in capital markets is the following. To the extent that a structural story of some kind holds true, the consequent reduction in risk premia, and the associated rise in asset prices, would broadly be a one-off – even if drawn out. In other words, it would not be sensible for market participants both to place weight on the argument that risk premia were lower because there was fundamentally less risk, and at the same time to extrapolate ex post returns on assets into the future. Headline returns would be lower than in the hypothesised ‘old world’ when risk premia were higher; and would be a lot lower than during the period when risk premia were falling to a new, lower level (Diagram A). This may not be completely idle speculation in a market environment where, anecdotally, fund managers have been chasing returns. And, of course, to the extent that past returns have in degree been extrapolated into the future, the effect might be an over compression of risk premia. That has to be for you and other market participants to judge.