Fragile Finance - A Look at Macroprudential Regulation

Modern finance is fragile, so what should we do?

Last year, Olivier Jean Blanchard wrote a "Seoul paper" on macro and financial issues, calling for a rethinking of the way macroeconomic policy is conducted.  In the old approach:

We thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job. We thought of fiscal policy as playing a secondary role, with political constraints sharply limiting its de facto usefulness. And we thought of financial regulation as mostly outside the macroeconomic policy framework.

This shift was significant, as previous financial regulation was primarily concerned with the micro picture.  But with the realization that there are serious systemic risks that permeate markets, interest has shifted to trying to look at financial regulation from a macro perspective.  Since then, macroprudential policy has been integrated into the G-20 framework and there is a large and growing literature on how to implement it.

This is an especially thorny issue because we're not quite sure what we're looking at.  Unlike monetary policy, macroprudential policy does not have the equivalent of a DSGE for analysis.  Moreover, what measures of risk should be used?  Capital ratios?  Loan-to-value ratio?  Does one follow a rule based approach or allow for more discretion?  This has been the fundamental problem with more formal analyses of macroprudential policy, as "both theoretical and empirical work linking the financial sector to the macroeconomy is far from a stage where it can be operationalized and used for risk analysis and policy simulations."  There simply isn't enough data to thoroughly analyze macroprudential effects.

A recent study has suggested that certain macroprudential policies, such as caps on loan to value ratios or dynamic provisioning have been effective in reducing the procyclicality of credit growth.  As debt is very fragile and promotes unpredictable complexity, any way to reduce its use in times of economic growth is good to hear.  Ideally, debt can be limited to digging oneself out of holes, and not trying to get to extreme heights of economic euphoria.

Note that this kind of regression analysis, although it is dealing with debt, which increases the probability of black swans, is still appropriate because it's looking at the growth of debt versus the growth of GDP.  Models aren't dependent on the exact magnitude of these parameters, rather we use changes in the parameters to determine if a given policy is appropriate.

However, this macroprudential approach is not without concerns.  It is not sufficient, and safety net policies will still be necessary.  Additionally, capital controls in and of themselves may have severe harm for long run economic growth.  As we're dealing with systemic risk, it may be that the regulations to limit systemic risk only ends up replicating it elsewhere, in industries that are not as easily regulated.  This would be even more worrisome, as previously known risks go on to evolve into unknown unknowns: the realm of Extremistan.

In spite of this, I feel that macroprudential policy will be increasingly important for the future, especially if we move to a more nominally stable NGDP targeting regime.  When aggregate demand is stabilized, the largest welfare costs will arise from aggregate supply shocks.  And as the financial sector is one of the critical industries for system wide credit, the question of how to regulate finance is fundamentally an aggregate supply issue.  In the market monetarist framework of Scott Sumners, macroprudential policy will be critical for shaping the composition of NGDP growth in a post market monetarist world.  This will be also very important for developing nations, as they are disproportionately harmed by large swings in real growth.  A massive drop in export and natural resource demand can let their capital stock deteriorate, damaging their prospects for development.  This move towards "increasing transaction costs" in order to improve global finance echoes Dani Rodrik's arguments for a more sustainable version of global trade.  Much as a better trade does not equal more integration, better finance may not entail more transnational capital flows.  And without stable and robust finance, there shall be neither stable nor robust growth.  That forms the basis of macroprudential regulation.