Macroprudential Follies and Monetary Policy

In a recent article in Project Syndicate Barry Eichengreen appears to criticize the former Fed Chair Alan Greenspan, for expressing doubt that policymakers can reliably identify bubbles, and are generally uneasy about managing asset prices. He writes:

To be sure, central bankers cannot know for sure when asset prices have reached unsustainable heights. But they cannot know for sure when inflation is about to take off, either. Monetary policy is an art, not a science; it is the art of taking one’s best guess. And, as the 2008-2009 crisis demonstrated, merely cleaning up after the bubbles burst is very costly and inefficient.

Eichengreen’s argument, is in fact, part of a post-global-financial-crisis discourse on macroprudential policy. Many  interventionists argue for financial regulation that would be  specifically  designed  to mitigate systemic risks to the financial system as a whole. According to macroprudential regulation’s proponents, monetary policy historically has failed as policy changes have resulted in blunt outcomes i.e., the monetary policy actions in either directions have resulted in a broad sweeping measure for the whole economy that does not properly address the issues specifically feeding financial instability. Thus, they argue that the recent financial crisis was created by a supervisory gap, as various sectors of the financial system often fall under the responsibility of different authorities, making it difficult to conduct a thorough analysis of systemic risk. As a result of these debates, in recent years, a number of new institutions have been popped out to preserve financial stability such as the European Systemic Risk Board in the EU and the Financial Stability Oversight Council in the US.

At the same time, central banks are now assuming an important role in this regard, to the extent that in a recent speech, Governor Daniel Tarullo, a member of the Board of Governors of the Fed, has stated: “I feel secure in observing that we are all macroprudentialists now. The imperative of fashioning a regulatory regime that focuses on the financial system as a whole, and not just the well-being of individual firms, is now quite broadly accepted.” Mario Draghi, President of the European Central Bank has also argued that “As you know, the [Single Supervisory Mechanism] Regulation gives the ECB the power to apply stricter macroprudential measures than the national authorities if it deems them necessary. We can also advise on the calibration of instruments. This goes some way towards insuring against an inaction bias at the national level, thus improving the prospects for a more stable euro area financial system.” As well, the Bank of England has been assigned full responsibility for macroprudential policy.

In 2008 chairman of the House Committee on Oversight and Government Reform, Henry A. Waxman of California, asked Mr. Greenspan: “You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Do you feel that your ideology pushed you to make decisions that you wish you had not made?” Mr. Greenspan conceded that:

“Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact. (…) Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

Unfortunately, it appears that this testament has caused an irreparable damage to confidence in the market’s self-equilibrating potentials. Instead authorities have espoused a partial preference for the risk-management and credit-allocation skills of a few central bank officials. The macroprudential regulation has been justified by arguing that Chairman Greenspan’s 1994 hypothesis, put forward in front of House Subcommittee on Telecommunications and Finance, to the effect that “There is nothing involved in federal regulation per se which makes it superior to market regulation,” is proved to be wrong. Also misguided was his argument for removal of the legislative barriers that prohibited the straightforward integration of banking, insurance and securities activities, when he concluded that:

“In virtually every other industry, Congress would not be asked to address issues such as these, which are associated with technological and market developments; the market would force the necessary institutional adjustments. Arguably, this difference reflects the painful experience that has taught us that developments in our banking system can have profound effects on the stability of our whole economy, rather than the limited impact we perceive from difficulties in most other industries.”

In fact, governments across the world begun to introduce macroprudential regulations in the form of more stringent capital requirements, requiring financial institutions to value their assets more conservatively, asking them to hold more liquidity buffers, placing constraints on risk-taking, enforcing more stable funding restrictions and requiring improved provisions to protect against bad and toxic loans. According to Christian Noyer, Governor of Banque de France, there is a consensus over broad outlines of macroprudential regulation that

First, it involves adding a macroeconomic perspective to the supervision of the financial system, which up till now has only really been addressed from a “micro” standpoint. As the crisis has shown, financial stability does not depend solely on the soundness of the individual components that make up the financial system; it also depends on complex interactions and interdependencies between these components.

Implicit, in Noyer‘s argument is the unsubstantiated claim that even those economies that their financial system were composed of sound micro components suffered from financial instability. This is not true. Canada is perhaps the only country that can legitimately claim that its financial sector was robust at micro level, and as it was expected its economy fared quite well during the global financial crisis. In the words of Mark Carney the governor of the Bank of Canada at the time “the core lesson we learned from those difficult years was the importance of coherent, principle-based policy frameworks.” These frameworks discipline policy-makers and enhance credibility. In the words of his predecessor David Dodge:

Canadian financial institutions took a more cautious approach to financial innovation at some cost to their short-term growth and profits relative to more leveraged foreign competitors, relied relatively less on wholesale funding and kept relatively more liquidity. In part, this stemmed from more stringent, coordinated and effective regulation and supervision in Canada, which provided the right incentives to financial institutions. (…)
Our system of principles-based regulation should continue to serve us well, even more so in a context where most national regulators elsewhere will not conform to the detailed, uniform international standards. What is required here in Canada is a high degree of cooperation between regulators and financial institutions to achieve stability goals. In the past, such cooperation in designing principles-based regulation has strengthened the Canadian system. We should not lose that advantage as we move forward.

It is important to note that in principle-based policy frameworks monetary policy would be dealing with the monetary policy goals and would not allow macroprudential considerations to contaminate  the transmission mechanism and distort the economic structure. Mr. Noyer ‘s second characteristic of macroprudential policy is that:

“it is preventive. Its aim is precisely to prevent the formation of financial imbalances, procyclical phenomena or systemic risks by limiting excessive growth in credit and in economic agents’ debt levels, and increasing the shock‑absorbing capacity of financial institutions or structures ex ante.”

The argument again assumes a number of untenable implicit assumptions; namely that authorities possess reliable measures of excess or systemic risk, the macroprudential policy makers are themselves experts in detecting and interpreting economic signals, the lag structure of the policy impacts are known and stable, and the policy actions can be precisely calibrated so that they will be efficacious in damping excesses while not unnecessarily reducing well-underwritten credit flows in the economy. In this regard the Bank of Spain’s assessment of the Spanish macroprudential experience shows that virtually none of these conditions are satisfied. That assessment reads:

Dynamic provisioning is not the macro-prudential panacea, since the lending cycle is too complicated to be dealt with using only loan loss provision policies. Indeed the Spanish experience shows that even well targeted and calibrated instruments cannot cope perfectly with the narrow objective for which they are designed, among other things because the required size to fully achieve its goals would have inhibited and distorted financial and banking activity.

 Of course, no proof exists to show that government regulators are more able than private investors at predicting which individual investments are justified and which are folly. The cost of macroprudential regulation in the name of financial stability has been a confused monetary policy that has caused a delay in return to equilibrium, increased uncertainty and a slower economic growth.

In a world that agents can innovate to take advantage of arbitrage opportunities, there would be no reasons for believing that macroprudential policies can have any impact on financial stability. In fact, if regulations were of any use the old Soviet Union would have been a success story, or today’s China’s financial markets would be the most stable in the world. The arbitrage possibilities generated by these regulations leads to financial innovations that would work against those policies annulling their impact. The evidence does in fact already present itself in the form of a shift of financial activities toward less regulated shadow banking system.

Moreover, to assume that macroprudential policies are of any impact must be based on the postulate that economic system can be represented by a stable model and that authorities have already discovered that model. Otherwise, in a fast changing world, in which parameters of taste and technology are responding to new scientific and digital advances at an ever increasing speed no financial authorities have any clue about the nature of an evolving transmission mechanism, the lag structure and the specification of an adequate model.

As Paul Kupiec has argued macroprudential policies will not have a significant impact and thus will not succeed. In fact, his study co-authored with Yan Lee of the Federal Deposit Insurance Corp. and Claire Rosenfeld has found that increasing a bank's minimum capital requirements by 1% will decrease bank lending growth by a paltry six one-hundredths of a percent. As he reported in the Wall Street Journal: There is not much evidence that these policies prevent financial bubbles. But there is great risk in allowing a small group of unelected technocrats to determine the allocation of credit in the U.S. economy.

Furthermore as many analysts have noted the propaganda surrounding macro-prudential regulation or supervision creates a false sense of security and stability. A central bank that is now playing too large a role in the economy in order to stabilize successfully the industrial, construction, and the other goods and services sectors, as well as the labour market, will have more difficulty communicating its monetary policy stance. It’s hard to believe that central banks models and expertise are adequate for executing various goals when the issues in each one of these sectors are complex and are impacted by various technological and competitive factors. The lines between discretion and rules for two sets of monetary and macroprudential would criss-cross and creates a very confusing lag structure for any signal extracting model.

There is no reason to believe that the principal- agent problem is not applicable in this case. In other words, it can be hypothesized that central banks as agents may not be supportive of market mechanism to stabilise independently. A regulated environment maximises the returns to agents in this framework as it entails more secure job prospects because of the needs for intense monitoring of capital and liquidity ratios, continuous inspection of the impact of various restrictions on banking practices, and conduct of periodic stress tests. The increased uncertainty will cause a surge in speculative activity in capital-asset markets which would exasperate the situation and boost the need for macroprudential regulation perpetuating the favourable job prospects of the agents.