First I will review the harmful effects that the ongoing crisis will have on the future development of financial markets. Next I will discuss financial bubbles and booms in monetary policymaking, and the nature of the present crisis and possible consequences, to wrap up with the implications of the world growth scenario on the Chilean monetary policy. In the present turmoil, authorities have acted as lenders of last resort providing liquidity to ensure proper market functioning. Nonetheless, regarding financial bailouts two costs have to be balanced: averting a financial collapse with catastrophic consequences on the one hand, and the negative signals that come from said bailouts, on the other. Not only have the too-big-to-fail institutions been rescued, but also entities whose connections with the system are such that if they fail the whole financial system may be shaken. Troubled companies’ shareholders should not be bailed out, because it is important that risk evaluation is done more diligently in the future. Care must be taken in rescuing debtors of defaulted firms, because it may relax borrowing and repayment discipline, and punish good creditors by comparison. The tradeoff between these two objectives is clearly illustrated with the developments of the past week. Allowing the demise of Lehman Brothers was a sign that bailouts would not be up for grabs and even the downfall of a large investment bank would be accepted, but this may have accelerated the devastating chain of events that followed.
In response, the US and other major industrial countries introduced a series of extraordinary measures from late 2008, which successfully stabilised and prevented the collapse of the global financial system. However, these extraordinary measures, including quantitative easing policies, do not seem to be very effective in stimulating economic growth and creating jobs. In the US, for example, the sharp fall in housing prices has significantly damaged household balance sheets. Such kind of balance-sheet driven recession has substantially impaired the responsiveness of the economy to monetary stimulus, as consumption and credit growth will remain sluggish until household balance sheets are repaired. I believe that US households still have some way to go in repairing their balance sheets through de-leveraging, before they regain confidence in consumption and investment. At the same time, the US fiscal conditions have deteriorated since 2008 and this has restricted the headroom for the government to launch further fiscal packages to stimulate growth and create jobs. The situation in Europe is in no better than the US. The sovereign debt problems of the Eurozone have already spread to Spain and Italy, and have even threatened the stability of the debt markets in the core countries of the Eurozone. It now appears that the rescue package announced by the European Union in late October is no longer sufficient, and hence the market is expecting the European Union Summit tonight to introduce stronger and more effective solutions to resolve the European debt problems.