Macro(un)prudential regulation

From a free-market perspective, one can only be against macroprudential regulation. Macroprudential regulation is the new fashion among regulators and other policy-makers. It’s trendy, and I understand why: it sounds clever enough to impress friends during a night out. It aims at monitoring a few macroeconomic indicators in order to try to ‘cool’ the system if it seems to be overheating. Those tools are supposed to be countercyclicals: if the economic environment is good, regulators can force the whole banking system to start accumulating extra equity or liquid assets for example, or decide to cap the amount that all banks can lend to mortgage borrowers. As you can guess, it is not the kind of self-regulating financial system I particularly appreciate.

This is once again a typical example of trying to fix the symptoms created by the system’s defects, without touching those defects. Wrong monetary policy? Bad government policies and subsidies? Of course not, the financial system is inherently bad and fragile, regulators and politicians said. Well, to be fair, this is their job and how they make money.

Lars Christensen, chief analyst at Danske Bank and author of The Market Monetarist blog, had a couple of niece pieces against macroprudential regulation recently. In the first one, he quotes and agrees with a recent WSJ article by John Cochrane, financial economist at the University of Chicago (also available on his blog):

This is Cochrane:

Interest rates make the headlines, but the Federal Reserve’s most important role is going to be the gargantuan systemic financial regulator. The really big question is whether and how the Fed will pursue a “macroprudential” policy. This is the emerging notion that central banks should intensively monitor the whole financial system and actively intervene in a broad range of markets toward a wide range of goals including financial and economic stability.

For example, the Fed is urged to spot developing “bubbles,” “speculative excesses” and “overheated” markets, and then stop them—as Fed Governor Sarah Bloom Raskin explained in a speech last month, by “restraining financial institutions from excessively extending credit.” How? “Some of the significant regulatory tools for addressing asset bubbles—both those in widespread use and those on the frontier of regulatory thought—are capital regulation, liquidity regulation, regulation of margins and haircuts in securities funding transactions, and restrictions on credit underwriting.”

This is not traditional regulation—stable, predictable rules that financial institutions live by to reduce the chance and severity of financial crises. It is active, discretionary micromanagement of the whole financial system. A firm’s managers may follow all the rules but still be told how to conduct their business, whenever the Fed thinks the firm’s customers are contributing to booms or busts the Fed disapproves of.

I completely agree with Cochrane.

And I completely agree with both of them. Christensen argues that the central bank’s goal is to provide nominal stability – to have a single target and stick to it, but that macroprudential regulation would involve manipulating many different tools having opposite effects, with likely unintended consequences. He then goes on to argue that if “markets are often wrong”, central banks are even worse and “have a lousy track record” at spotting bubbles.

Another important point made by Cochrane in my opinion is:

Third lesson: Limited power is the price of political independence. Once the Fed manipulates prices and credit flows throughout the financial system, it will be whipsawed by interest groups and their representatives.

= crony capitalism. This has plagued all corners of our capitalist system for ages, and when things turn bad, free markets/laissez-faire capitalism/liberalism/neoliberalism/ultra turboliberalism/add the one you want is blamed… Go figure.

Christensen’s second post, published a few days ago, refers to a Bloomberg article on the so-called ability of a new Finnish model to ‘forecast’ all cyclical up and downswings in the US over the past 140 years… He helpfully remembers that nobody is ever able to constantly beat the market. While this sounds like a rational expectations/efficient market hypothesis point of view (I don’t know what Lars actually believes in), I do agree with him (and no I don’t believe in rational expectations, but constantly beating the market requires non-human skills and information-gathering abilities). He then goes on to say that while this is relatively basic economics, “nowadays central bankers increasingly think they can beat the markets. This is at the core of macroprudential thinking.”

Obviously, the whole thing rests on the myth that the financial system is fragile and must be ‘safeguarded’ or ‘protected’ (see this IMF article) by ‘benevolent dictators’, in Christensen’s words. I would also add that macroprudential ideas are now new and have been already tried one way or another since the early 19^th century (but how many regulators and economists remember that? See an example here).

This is how I see things: no central body can ever have perfect knowledge of what’s happening in the economy and what the various plans, wishes and wants of the millions of actors in the system are (I am obviously not the first one to say this. See Mises, Hayek, Friedman and so many others). As a result, any central intervention is bound to fail or create distortions in the economic landscape.

Central banks are a monopoly: they define nominal interest rates and base money supply unilaterally and can only adjust their policies with a time lag, after they have already affected the economy. A distorting monetary policy can easily kickstart asset bubbles: an increasing supply of ‘high-powered’ money (base money) not matched by an increase in the demand for money can easily lead to excess credit creation. If real estate prices boom due to the flow of credit towards the sector, is it reasonable to try to stop it? The flow of credit is already here, and if it cannot go where it wanted in the first place, it will find another place to go to. China and its wealth management products is a good example of this process.

Let’s consider a current example in the UK. Due to a combination of interest rates maintained too low for too long, misguided government schemes such as Funding for Lending and Help to Buy, compounded by Basel regulations that favour mortgage lending and local restrictions on housing supply, if ever a housing bubble appears, the solution will be to… blame the banks and artificially restrict LTVs or cap lending??? Right…

Finance is a spontaneous process: people can be very innovative at finding ways of bypassing restrictions to achieve their desired financing and saving goals. Macroprudential controls would only move the problem from one sector to another, without correcting its very source. Macroprudential regulation would also introduce an unwelcome dose of discretionary rules and micromanagement, which have destabilising effects on trust, markets and economic actors.

Photograph: Wikipedia