That means it is also the best contribution monetary policy can make to combating unemployment. A short-run increase in employment can be obtained by stimulating demand, even if this entails a risk of higher inflation. But this short-term exchange can be risky, as we know not least from the experiences in the 1970s and 1980s I referred to earlier. And just the fear of an unduly expansionary policy that may lead to rising inflation is liable to push interest rates up, leading to weaker growth and employment. For monetary policy it is therefore crucial that confidence in the low-inflation regime is strong. The construction of the inflation target automatically involves some allowance for economic activity. Weaker growth that leads to a capacity surplus normally implies diminishing inflationary pressure from demand. This in turn leaves room for a more expansionary monetary stance: the interest rate is lowered, thereby stimulating demand. Conversely, unduly high demand involves a risk of excessively high capacity utilisation, with upward pressure on prices and wages. To prevent this, the monetary stance has to be tightened by raising the interest rate. In this way, the Riksbank’s endeavour to fulfil the inflation target normally contributes to economic stabilisation. There are, however, situations in which this relationship does not apply. One case is when inflation is being driven from the supply side, for example because an isolated oil price rise is pushing prices up. There may then be grounds for accepting a temporary increase in the price level instead of acting swiftly to push inflation down.
What we observed before the crisis, and what we became painfully aware of when it erupted was, however, that public and private agents in some countries did not change their behaviour, that financial markets did not play any disciplining role and that the loose application of the Stability and Growth Pact and the Broad Economic Policy Guidelines rendered them ineffective as stabilisation devices. The Pact and the Guidelines were not strong enough to prevent the accumulation of a series of imbalances. We also discovered two other gaps during the crisis: too little attention had been paid to how financial markets work within a monetary union and no crisis management mechanism was available. To be stable, the European building needed operational repairs. The stability principles, as conceived in Maastricht, were insufficient and a new culture of stability had to take over. The ECB acted on several occasions to curb the so-called “tail risks” – the risk of the monetary union breaking up – and to gain the time needed for others’ actions to bear fruit. It is worth noting, however, that monetary action can hardly go beyond this as the cracks detected in the building were not of a monetary nature. At the Member State level, fiscal consolidation policies and structural reforms were needed and are being implemented to better accommodate domestic behaviour to the patterns of stability required within a Monetary Union. As for euro area governance, a deep process of reform has been undertaken.