Justifying macroprudential policy

Here is a good post on VoxEU, that aim to give a strong conceptual framework for justifying macroprudential policies:

The purpose of macroprudential policy is to reduce ‘systemic risk’ …

It is common to distinguish two key aspects of systemic risk. One is the “time-series dimension”: the procyclicality of the financial system, that manifests in excess risk-taking in booms and excess deleveraging in busts. Another is the ‘cross-sectional dimension’: the risk of contagion due to simultaneous weakness or failure of financial institutions. Accordingly, macroprudential policy it thought of as a set of tools that help reduce these two forms of risk (Borio 2009; Bank of England 2011).

Yet thinking about macroprudential policy by looking solely at these two dimensions of risk is unsatisfactory. First, this view, per se, does not provide a justification for regulatory intervention. For example, is it really desirable to avoid any form of cyclicality and have a zero risk of contagion in the financial system? Second, it is not a priori clear what can macroprudential policy achieve that traditional micro-prudential regulation cannot.

In a recent IMF study (DeNicolò et al. 2012), we aim to tackle these questions. We start by articulating that, as for any form of regulatory intervention, the objective of macroprudential regulation must be to address market failures.

Following the crisis we have heard many commentators demand something should be done.  Those with more of an economics bent could see the value of macroprudential policies, however regulation shouldn’t be based solely on the intuitive feel of economists and analysts – instead we should use the descriptive economic framework to help us understand what issues may exist in the financial industry, and then ask whether policy can help to improve outcomes.

Whether the externalities they have identified are fair is another question, one day I will read the paper and have a think – although I probably won’t post on this.  However, actually looking at regulation through a regulatory framework instead of screaming about large movements in arbitrary aggregates is the appropriate way to think about direct regulation in the financial industry (along with a recognition that we provide these firms implicit insurance) – a point of view that has been missing from some writing about the introduction of any such measures.

A point on debt

Around the world there are a lot of complaints that there is too much debt, that debt will prevent a recovery, and that debt is the root of all problems – be it fiscal deficits, debt fueled consumption, or a debt powered housing market.

While there are undeniable issues to keep in mind, there are a few things to remember with these large debt levels – and one of the most important is that there are some people on the otherside of this debt.

Unknown to some is the fact that, as a planet, we are not actually in a net debt position with the rest of the galaxy (although the statistics say otherwise, I think there is an error – rather than us owing money to Martians).  As a result, for every person who has a liability owing there is another person or group who views that as an asset.  When we look at what the “issues” are with debt, we have to keep this point in mind.

Now this sounds like me stating the bleedingly obvious AGAIN … but lets think about some of the conclusions that come out of this:

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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.

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