If That One Is A Sledgehammer, Then Find Us A Pin

Howard Davies writes:

Bubble-pricking may indeed choke off growth unnecessarily – and at high social cost. But there is a counter-argument. Economists at the Bank for International Settlements (BIS) have maintained that the costs of the crisis were so large, and the clean-up so long, that we should surely now look for ways to act pre-emptively when we again see a dangerous build-up of liquidity and credit.

Hence the fierce (albeit arcane and polite) dispute between the two sides at the International Monetary Fund’s recent meeting in Lima, Peru. For the literary-minded, it was reminiscent of Jonathan Swift’s Gulliver’s Travels.

Gulliver finds himself caught in a war between two tribes, one of which believes that a boiled egg should always be opened at the narrow end, while the other is fervent in its view that a spoon fits better into the bigger, rounded end.

Any mention of Gulliver’s Travels is an invitation to me to wade into this discussion, even though the discussion of whether to ‘lean against the wind’ or ‘clean-up after’ is not a new one.

If loose monetary policy can induce the formation of bubbles, then it follows that conducting the opposite, which is the tightening of monetary policy, could perhaps pop the bubble.

In her speech, also in Lima, Minouche Shafik, the deputy governor of the Bank of England said,

The Bank’s actions in the residential housing market in June 2014 provide an illustration of the benefits of directing targeted macroprudential policy tools at sectoral financial stability risks vis-à-vis raising interest rates.  Motivated by concerns over the growth of household indebtedness, the FPC recommended that no more than 15% of mortgages originated could have a loan-to-income ratio above 4.5.  And in response to fears that households on variable rate mortgages could struggle to meet mortgage repayments if interest rates rose significantly in future, the Bank recommended a minimum 3 percentage point interest rate stress be applied at origination.

So in a first best world where the institutional set up and macro-prudential tools are available, I would let them do the leaning first rather than wield the heavy hammer of monetary policy.

Bernanke is dubious on the efficacy of popping bubbles using monetary policy, writing in his blog,

Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to “pop” an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.

For these reasons, I have argued that it’s better to rely on targeted measures to promote financial stability, such as financial regulation and supervision, rather than on monetary policy. Or, as I put it in my very first speech as a Fed governor, “use the right tool for the job.”

However, the macroprudential approach remains unproven, and we know that, for a variety of reasons, financial regulators did not do enough to avoid the crisis of 2007-2009. So, even if we agree that regulation and supervision should be the first line of defense, we can’t rule out of hand the possibility that monetary policy decisions should also take into account risks to financial stability. To do that in a sensible way, however, requires some weighing of benefits and cost.

Lars E.O. Svensson, the former deputy governor of Sweden’s Riksbank, was perhaps the most vocal about weighing the costs and benefits, the crux of which can be found in this presentation. Keep in mind the instances where policy needed to be reversed, and therefore, proved to be far costlier. The main question is thus, what are the trade-offs between current costs and future benefits of leaning?

In addition, the discussion is not limited to whether leaning should be carried out. Most recently, Jon Danielsson et. al in Voxeu pointed out that there may be a conflict between macro policies and micro policies too,

Claudio Borio noted in 2003 that micro is bottom-up, with the focus on individual behaviour aggregated up to the level of the institution. In some circumstances, the legal person that is regulated is the institution and it takes responsibility for the behaviour of its employees; or employees and the institution may both be regulated and share responsibility. In both cases, conduct is regulated and sanctioned. Implemented by lawyers and accountants, micro is essentially retributive.

Macro is different. It is more supportive rather than retributive, being based on support for the financial system as a whole and the need to maintain its healthy operation at times and under circumstances when market forces do not on their own appear capable of achieving this. The institution is conceptually the smallest unit considered and it is interactions between institutions rather than their internal functions that are of most interest.  Consequently, it is more influenced by economists.

It is not a problem when the objectives are aligned as they have been over the past years, which are to de-risk the financial system and increase capital. However, in an atmosphere of high uncertainty and low rates, we may see this convergence break down.

According to Danielsson, in a stress scenario, a macro policy maker will want to rebalance risk by selling assets and decreasing margins and collateral, whereas a micro policy maker will wish to do the opposite, which is to increase margin and collateral to mitigate risk. (See Buttonwood in the Economist for discussion on collateral.) In addition, a macro concerned regulator will desire a loosening of capital constraints to invigorate the economy.

Despite all these disagreements, I personally think that the most promising development lies in building a strong framework of international macroprudential coordination. After all, in a world of spill-overs and excruciating exchange rates movements, one country’s policy is another country’s counter-policy.

Furthermore, we need to differentiate between ‘temporarily taming the nature’ and ‘long term nurture’ :

  • In the face of crisis, macroprudential regulation is already a part of a policy maker’s toolbox, not only in the US but in other countries as well.
  • In the short-run, leaning against the wind is preferable after having weighed the costs and benefits.
  • In the long run, perhaps the old adage, ‘prevention is better than cure’ is true. Nurturing a healthy economic and financial environment, maintaining an atmosphere less humidly prone to bubbles formation and one that is anchored to reasonable valuation is perhaps possible once we’ve figured out all the fine-tuning.

In my mind, the discussion of whether to deploy these policies is moot as it looks like they are here to stay. Pragmatically then, the discussion needs to move on to how we could manage the deployment better. The first step perhaps, begin with the proper classification of the instability, a systematic measurement of the costs and benefits in addressing the particular crisis, and to garner political and public support by making them understand what is needed to be done and why.

This leads me to the final point, what marks effective policies is the successful management of expectations. Hence, whichever ones the regulators choose to deploy, there is no escape from the need of good communication between the policy makers and the intended policy receivers. In light of previous experience of poor forward guidances, this is an area that should be improved if these policies are to become a more prominent fixture.

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