Financial stability, the crisis, and counterfactuals

In an interesting post on macro-blog, two things are mentioned towards the end:

Specifically, the pre-2008 consensus argued that monetary policy should follow a ‘rule’ based only on output gaps and inflation, but a few dissenters thought that credit aggregates deserved to be watched carefully and incorporated into monetary policy. The influence of the credit view has certainly advanced after the 2008–09 crash, just as respect has waned for the glib assertion that central banks could ignore potential financial bubbles and easily clean up after they burst.

The macroeconomic performance of individual countries varied markedly during the 2007–09 global financial crisis.… Better-performing economies featured a better-capitalised banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part.

In a sense, the better performance of countries with lower debt during the credit crisis is being used as evidence of the fact that central banks should limit credit growth in the economy (that was the assertion I took from reading this section of the post).

Note:  Now, a quick point I want to make before discussing this central point – when inflation targeting is mentioned above it is a separate issue.  The role of monetary policy is to target inflation, but the concept of watching out for financial stability is a separate issue.  At the moment both are taken on by central banks, but I feel that the above description implies that there is a trade-off between “price stability” and “financial stability” – which is false.

So note that, the entire discussion on financial stability says nothing about whether inflation targeting is sensible – and I really wish people would stop pushing the issues together (this comes from the fact that inflation targeting is about managing expectations).

So, to the key point.

Now, can we use the fact that countries with lower debt and better asset positions preformed better during a credit crisis as evidence that the central bank should do something about debt?  My first impression is no – this is a heavily incomplete model … where is the “counterfactual”.

What do I mean by this?  Well, we know that during an event that increased the cost of debt and made borrowing more difficult countries with debt who were borrowing struggled … this is patently obvious.  The potential for such an event was a risk, and this risk was taken on by the respective countries.  If we think individual agents downplayed the risk that is fine – but that only justifies limited intervention even if we do accept it this justification.

What we don’t know is how growth profiles would have been different PRIOR to the crisis if we were messing around in credit markets.  It is conceivable that growth would have been lower if we were arbitrarily restricting peoples access to credit, and as a result it isn’t clear if where we’ve ended up is any worse.


We cannot just say that a crisis happened and then state we need to do something that will prevent the costs of such a crisis in the future – unless we can say that the benefit of doing so will outweigh the costs associated with the policy response.

To be clearer, we know that intervention will have a cost – we need to try and understand if we can intervene in a way where the cost of doing so is less than the benefit associated with intervention.

The example I provided above of people not properly taking into account risks are the sort of lines that policy makers will be thinking about – but all I ask is that they think about them sensibly, and don’t just start regulation for regulations sake.

I of course also ask that they try to keep in mind bits of policy that have been beneficial – inflation targeting has been beneficial, and arbitrarily pinning the blame on that because we feel scared is not cool.  It is becoming increasingly popular, but it is inappropriate.


11 replies
  1. Miguel Sanchez
    Miguel Sanchez says:

    I got the impression they’re arguing that the better-performing countries ARE the counterfactual. Not that that’s a valid conclusion either.

    To pick on an easy example: we saw that countries who ran current account surpluses (let’s say China) did better than those who ran current account deficits (let’s say the US). But globally, current account balances have to sum to zero; the US could run a deficit only because China was willing to run a surplus (and vice versa). What’s more, since China’s surplus was a deliberate product of its economic policies, then those policies have to take some of the blame for the US’s crisis.

  2. Matt Nolan
    Matt Nolan says:

    @Miguel Sanchez

    Yar, but it is a static counterfactual rather than dynamic. The implicit assumptions with any cross-country comparison that does this must be that:

    1) The countries have some type of equivalence,
    2) The relative performance coming into the crisis is irrelevant.

    I have enough trouble with the first issue, but the second is an absolute killer. The counterfactual HAS to include the full set of consequences of policy – not just the benefits during a credit crisis.

    “But globally, current account balances have to sum to zero”

    That is also a fine point. I suspect they would say “we need the relative sizes to be lower, there is just too much debt man”.

    It amazes me that the economics profession studies “present biased” behaviour, and yet is unable to take this into consideration when trying to do economic analysis. It makes me nervous about my own belief that people will find mechanisms to “precommit” to the optimal solution in the face of time inconsistency.

  3. Talosaga
    Talosaga says:

    I think you have misinterpreted the comment about inflation targeting. They seem to be saying that ‘core’ monetary policy instruments, like the OCR or Open Market Operations, should take into consideration credit aggregates and target financial stability. Optimal monetary policy under this framework would differ from pure inflation targeting, so there would be a trade-off. This is different from proposing new macroprudential tools to maintain financial stability.

    This argument sort of assumes that other financial stability instruments (regulations, capital requirements) are insufficient to achieve financial stability and that ‘core’ monetary policy can be used to influence ‘financial stability.

  4. Matt Nolan
    Matt Nolan says:


    Good point – I said above that I was rolling with my interpretation because I didn’t find what was being said particularly clear.

    Specifically, the main thing for me is “why” they think credit aggregates are important. I see two channels for them mattering:

    1) They are relevant for inflation outcomes, and so should be used when setting monetary policy.
    2) They are relevant in terms of financial stability, and should be looked at in terms of this broader framework and its separate set of instruments.

    Without separating the two, I feel like inflation targeting gets attacked for no reason. After all – it is future inflation that is being targeted, so the current framework should take into account any information credit aggregates provide regarding to inflation outcomes. It doesn’t change “pure inflation targeting” in any way.

  5. Falafulu Fisi
    Falafulu Fisi says:

    Since crisis can be affected by connecting economic networks (either countries to countries, firms to firms, etc,…), I thought the following on network theory would be interesting.

    Systemic Risk in a Unifying Framework for Cascading Processes on Networks

    There are many publications out there on the specific application of network theory to economic/financial networks, where the above paper is a general application of network theory to a varieties of domains.

  6. Falafulu Fisi
    Falafulu Fisi says:

    I think the following may be of interest too.

    Backbone of complex networks of corporations: The flow of control

    Some may ask why I’m posting materials related to complex network theory? Well, some of the research coming out of this area have been able to give reasonable explanation of crisis (ie, it is only a toy model and may not be the exact or true underlying mechanism that drives such process).

  7. andrew coleman
    andrew coleman says:

    One needs more context here. If one goes back a century, when most countries were on the gold standard, there was no inflation but countries frequently suffered from financial crises. The changes in central banking which lead to the creation of modern central banks and the use of fiat currencies were largely to prevent these crises. The advantage of having a fiat currency is that a central bank can intervene more or less without limit to provide liquidity at a time of crisis; the cost is that during the non-crisis times central banks are prone to inflation. The breakthrough of inflation targeting (or price level targetting) was meant to be that society could do both: have central banks that could intervene during crises; and have a means of preventing central banks from debasing the money supply and causing inflation.

    I think many central bankers took their eye off the ball fifteen years ago, buoyed by their success against inflation, and forgot about the credit cycles. Their main models didn’t have credit cycles (the RBNZ forecasting model didn’t even have a financial sector let alone room for credit cycles); the earlier literature by Bagehot, Marshall, Von Mises and Keynes was ignored as irrelevent; and the mantra than monetary economics concerned the way that the price, terms and conditions and the quantity of nominal debt contracts was replaced by an insistence that one only needed to target interest rates. The problem was not inflation targetting but the narrow version that ignored the role of credit that was implemented by many central banks. The misuse of the Phillips Curve by over-zealous central bankers may be the real fault. Hopefully they have learnt their lesson; it is just a pity that the warning signals about the problems of excessive credit creation that were highlighted by people such as Borio and Lowe in the early 2000s (and written about at length prior to 1930) were ignored.

    While the central banks are building gates on their barns now that the horses have bolted, the real question is whether they will have the gumption to close them when they are next needed in a few years time. I wouldn’t like to bet on it: two centuries of financial crises suggest otherwise.

    Perhaps the best we can hope for is that the next generation will read Lombard St before they need it rather than after (and when doing so read Chapter 8 on central bank governance) ….and that they manage to control inflation. After all, in New Zealand we have now had the price level increase by 50 percent since 1992, despite the legislated goal of the Bank to achieve stability in the general level of prices.

  8. Falafulu Fisi
    Falafulu Fisi says:

    Matt, my previous comment is being held in moderation, may be because of 2 links I posted (rather than 1).

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