Macroprudential policy & democratic accountability
Last week the IMF’s Chief Economist Olivier Blanchard spoke about 5 lessons policy-makers should take from the financial crisis at the LSE. The five lessons are summarised over at the WSJ and worth a read.
There is much to take from all five, but I am especially struck by the last two.
#4 We don’t know if macro-prudential tools work.
It’s very clear that the traditional monetary and fiscal tools are just not good enough to deal with the very specific problems in the financial system. This has led to the development of macro-prudential tools, which what may or may not become the third leg of macroeconomic policies.
[Macroprudential tools allow a central bank to restrain lending in specific sectors without raising interest rates for the whole economy, such as increasing the minimum down payment required to get a mortgage, which reduces the loan-to-value ratio.] In principle, they can address specific issues in the financial sector. If there is a problem somewhere you can target the tool at the problem and not use the policy interest rate, which basically is kind of an atomic bomb without any precision.
The big question here is: How reliable are these tools? How much can they be used? The answer — from some experiments before the crisis with loan-to-value ratios and during crisis with variations in cyclical bank capital ratios or loan-to-value ratios or capital controls, such as in Brazil — is this: They work but they don’t work great. People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere.
#5 Central bank independence wasn’t designed for what central banks are now asked to do.
There is two-way interaction between monetary policy and macro prudential tools. When Ben Bernanke does expansionary monetary policy, quantitative easing, and interest rates on many assets are close to zero, there’s a tendency by many players to take risks to increase their rate of return Some of this risk actually we want them to take. Some we don¹t want them to take. That is the interaction of monetary policy on the financial system.
You also have it the other way around. If you use macro prudential tools to, say, slow down the building in the housing sector but you have an effect on aggregate demand, which is going to decrease output.
The question is: How do you organize the use of these tools? It makes sense to have them under the same roof. In practice means the central bank. But that poses questions not only about coordination between the two functions, but also about central bank independence.
One of the major achievements of the last 20 years is that most central banks have become independent of elected governments. Independence was given because the mandate and the tools were very clear. The mandate was primarily inflation, which can be observed over time. The tool was some short-term interest rate that could be used by the central bank to try to achieve the inflation target. In this case, you can give some independence to the institution in charge of this because the objective is perfectly well defined, and everybody can basically observe how well the central bank does..
If you think now of central banks as having a much larger set of responsibilities and a much larger set of tools, then the issue of central bank independence becomes much more difficult. Do you actually want to give the central bank the independence to choose loan-to-value ratios without any supervision from the political process. Isn’t this going to lead to a democratic deficit in a way in which the central bank becomes too powerful? I¹m sure there are ways out. Perhaps there could be independence with respect to some dimensions of monetary policy - the traditional ones — and some supervision for the rest or some interaction with a political process.
I agree whole heartedly with both. To see just how complex the picture is becoming, just look at current UK experience. As I wrote last week:
BIS is desperately trying to find ways to expand lending to small business (and Vince Cable today has already said that “The idea that banks should be forced to raise new capital during a period of recession is erroneous”), whilst the Treasury is keen on boosting the growth of housing finance. The OBR’s Robert Chote yesterday argued that “banks are a major constraint on the economy”.
In other words macroeconomic policymakers in the Government – whether from HMT or BIS – all want to see lending increased.
Meanwhile the FPC is saying that banks are not in a position to boost lending without more capital. The FPC is saying this at the very same time that the BOE is jointly running the FLS scheme to try and boost bank lending.
This situation can only be described as ‘messy’.
The UK’s new macroprudential system was devised in 2010-2012 as part of what George Osborne described as his ‘new economic model’ of rebalancing towards high savings, high investment and high exports. Now this model has been abandoned for something that looks very like the ‘old model’, there is an obvious tension between the Bank of England’s Financial Policy Committee’s aim to maintain financial stability and HMT’s drive to increase house prices (at least I assume that is the desire of HMT policy nowadays, either that or the housing finance package announced at the budget is horribly ill-designed).
As Blanchard argues, we don’t really know how this will play out. And as Blanchard touches on his last point, this (regardless of the merits of Treasury policy) raises fundamental questions about democratic accountability.
Politicians are starting to discuss the limitations with the inflation target (see for example Ed Miliband’s recent speech to Policy Network) and potential problems with the Bank’s governance following the expansion of its role (both Ed Balls and Andrew Tyrie have been especially strong on this) and this is to be welcomed but this needs to be a bigger debate.
With QE and funding-for-lending the traditional divide between monetary and fiscal policy is breaking down, with the move towards macro-prudential risk management the Bank is taking on sweeping new powers and with a wide spread recognition setting in that inflation targeting may have reached its limits as policy framework, something needs to be designed to replace it.
But the debate so far has been almost exclusively amongst economists. We need to remember, as Paul [Mason] put it, that ‘central banks are part of the state’ and this isn’t a debate that economists alone can resolve.
Taking account of the political economy of regulation is likely to be especially important for macro-prudential policy. If authorities find it hard to resist forbearance towards individual institutions, they are likely to face even stronger headwinds in dealing with the financial sector as a whole…
From a political economy perspective, macro-prudential policy is most challenging to implement when it is of the greatest use. Macro-prudential instruments are likely to be most useful when they are able to target a particular sector at times when the financial cycle diverges from that in other sectors of the economy.
As the IMF staff paaper and Blanchard both note, macroprudential policy is very likely to drag central banks into questions of political economy.
There has been a lively debate in recent months about the merits of different monetary policy regimes, I think the bigger debate on how much independence a much more powerful central bank should actually have hasn’t really started yet.