Gradually, unease increased because of security policy developments. The financial unease gradually infected the real economy; confidence among companies and consumers began to fall in several countries over the summer and it became increasingly clear that total demand had been negatively affected. This contributed to enabling the Riksbank to lower the repo rate twice during the autumn, measures that were in my assessment quite fitting under the circumstances. What we can observe today, compared with one year ago, is that the questions baffling forecasters are roughly the same and that they are dominated by the question of how far the adaptation process following from the stock market bubble has come. Today an additional factor making assessments more difficult is the threat of war in the Middle East. We do not know whether there will be a war or how it will all end. The crisis also creates uncertainty that makes it difficult to correctly interpret economic signals. In addition, the more prolonged the crisis is, the greater the risk that the actual uncertainty will have a negative effect on the real economy. I shall now turn towards the future and discuss developments over the coming 1-2 years. Right conditions for a recovery in the USA… One difference now compared with the situation one year ago is that the adaptation of the imbalances in the US economy has probably progressed further.
Price stability itself has coincided with – some would say produced – a prolonged period of strong growth and low output volatility, which, as you know, has been dubbed the “great moderation". One major disappointment however, has been that price stability has not led to financial stability. On the contrary, it seems that, over the last two decades, financial crises have become more frequent, with increasingly serious consequences for growth and welfare. To get a sense of this puzzle, it may be useful to look at the intrinsic dynamics of the financial system. Both in normal times and times of stress, amplification mechanisms are at work, which exacerbate the impact of any specific shock. These mechanisms act through changes in leverage, liquidity, and risk aversion. These three factors interact in a complex and sometimes unpredictable way. For instance, growth in leverage may be fuelled by an increase in risk appetite. In turn, larger balance sheets of financial intermediaries give rise to liquidity expansion and growing risk appetite. It is easy to see how these dynamics can create strong procyclicality in the evolution of asset prices and credit aggregates. It is also likely that procyclicality is partly created, or accentuated, by our accounting and prudential regimes. If financial procyclicality was a short-term, mean-reverting, phenomenon, there would be little cause for concern. Unfortunately, those same mechanisms allow for the progressive buildup, over a long period of time, of significant imbalances and deviations in asset prices. At some stage, the correction becomes unavoidable, and is generally abrupt.