Market participants – and indeed the general public – will learn about the authorities’ behaviour and shape their own  10  For more information, see “The Corporate Sector and the Bank of England’s Asset Purchases” available at: http://www.bankofengland.co.uk/publications/Pages/speeches/2010/423.aspx  BIS central bankers’ speeches  5  accordingly. Moral hazard is one aspect of this – that can lead to market participants taking more risky actions because of the perceived backstop provided by the central bank. More generally, communications strategies can be a positive part of the toolkit, in particular by giving out information about the central bank’s monetary policy “reaction function”. For the most part it is helpful for markets to be able to predict what the central bank will do. That way one can often hope to generate the desired responses with less severe policy actions than otherwise. Credibility matters. For example, if people believe that inflation will be 2% in the medium term, and act accordingly, it is much more likely that inflation will stay close to 2% in practice without big swings in monetary policy. Keeping inflation under control is much more costly for the economy if expectations become de-anchored from the official target. But how explicit do we need to be about our forward plans? This is a very live policy debate.
Indeed, there is no “one size fits all” solution, and individual countries must tailor their approach to their own conditions. Moreover, crises typically evolve in unpredictable ways, and policy must be sufficiently fluid to adjust to changing conditions. Nonetheless, past crises have taught us important lessons applicable to the current situation worldwide. First, it is imperative that bankers and authorities be realistic about the size of the problems they face. While it is often difficult to accurately gauge the scale of problems at the outset of the crisis, history shows that problems usually are much larger than they first appear, and estimates often are subject to frequent and significant upward revision. While pressures to muddle through may, at times, be almost irresistible, policymakers and bankers must realize that the costs of inaction and denial are substantial and that problems left unaddressed grow rapidly over time. Second, it is important to recognize that financial system distress typically encompasses weaknesses in many individual areas, and effective solutions need to be comprehensive BIS Review 64/1998  -3-  and multidimensional. Solutions usually involve complex tensions and trade-offs: improving the condition of the banking sector, for example, may have the effect of worsening the condition of the corporate and household sectors, which may, in turn, negatively affect the banks. Similarly, liquidating problem banking assets may put additional downward pressure on a broader range of asset markets and further exacerbate banking sector problems. However, asset retention more often than not erodes values and freezes market liquidity.