Macro-pru canNOT counteract monetary policy
As if previous studies were not clear enough (see also here for a primer by Justin Merrill), new evidence has just been added to the rapidly growing body of research that demonstrates the very limited effectiveness of macro-prudential measures. MC Klein, on the FT Alphaville blog, points to a new research paper by Shin, Bruno and Shim, and to a 2011 report by the central bank of Spain, which both clearly highlights the flaws in central bankers’ and regulators’ current economic micromanagement worldview.
As Klein says, the Spanish assessment of macro-prudential measures is “not encouraging”. Spain is one of the rare European countries to have actively used macro-prudential tools (dynamic provisioning) in the period preceding the crisis, without having any control on monetary policy. The effectiveness remained limited as we have noticed.
But it gets worse. Shin’s new paper covers 12 Asian countries that have also extensively used macro-prudential policies over the past decade or longer. Results are more than mixed, to say the least. What do they find? (my emphasis)
Our findings therefore highlight a fundamental question in the rationale for macroprudential policy. To the extent that monetary policy works by intertemporal allocation of spending, loose monetary policy encourages greater borrowing to bring spending forward from the future to the present. Macroprudential policies work by restraining borrowing. Our empirical findings suggest that the macroprudential policies have been employed so that they pull in the same direction as monetary policy – that is, macroprudential policies are introduced during periods of monetary tightening. First, the correlations are especially high between monetary policy (interest rate policy) and banking sector CFM and domestic macroprudential policies. The correlation is lower between monetary policy and bond market CFM policies, but this finding likely reflects structural shifts in the capital markets of the countries in our sample.
Second, when we measure the monetary policy stance with the Taylor rule gap (ie the difference between the actual policy rate and the Taylor rule rate), we find that non-interest rate monetary policy tools were used in a complementary way with monetary policy during the first phase of global liquidity (pre-2007) after controlling for global liquidity and country-level variables. Last, our study also suggests that when monetary policy and banking inflow measures are pulling in the same direction (opposite directions), banking inflow measures are successful (not successful) in slowing down foreign investment in domestic bonds. Such a conclusion is also consistent with the principle that when monetary policy and macroprudential policies pull in the opposite direction, economic agents are being told simultaneously to borrow more and borrow less.
This is clear. Unlike what central bankers would conveniently love to believe, monetary policy remains key. Liquidity always finds a way. And macro-pru ‘leaks’ as Aiyar, Calomiris and Wieladek said already some time ago. Basel’s risk-weights make it more capital efficient (i.e. cheaper) to use extra liquidity for real estate lending purposes? Let’s introduce targeted macro-pru tools to prevent too much liquidity from flowing into this sector. Fine. But now, perhaps corporate lending, or equity investing have thus become more attractive from a profitability perspective. Market participants constantly adjust their P&L calculations. Don’t expect them to simply sit on an ocean of unused liquidity simply because you said so. They’re going to use it. Perhaps not on their first or second investment choices. But if the risk-adjusted yield they can extract generate a positive net present value (implied: vs. the opportunity cost of sitting on cash), they will invest. Worst, a long period of artificial surplus liquidity has the potential to suppress risk-assessment: investors panic and attempt to extract any yield from any sort of assets. Macro-pru just transfers the problem. Monetary policy, as Jeremy Stein from the Fed once noted, “gets in all the cracks”.
The authors also warn against a phenomenon I had remarked in a previous post on macro-prudential tools, and which is symptomatic with studies based on regression:
To the extent that new macroprudential policies happen only after a period of discussion within the government, central bank and other public authorities (such as financial regulators), the introduction of such policies often coincides with the late stages of the boom. To the extent that the boom subsides under its own weight, the introduction of the macroprudential policy and the subsequent slowdown of capital flows and credit growth would be a coincidence, not a causal effect. To this extent, the results reported below should be taken with some caution.
In the end, their results question the very validity of current regulatory thinking: “don’t worry about interest rates, we have a macro-prudential toolkit to deal with excesses and financial imbalances”. Well, apparently not. Their reasoning is that business and financial cycles are separate and not synchronised (see Vitor Constancio, from the ECB, here, or virtually any central banker speech over the past 3 years). In fact, those cycles look highly synchronised and very likely to simply be different sides of the same coin, as economists such as Mises, Hayek or Minsky have theorised. Implying that changes in asset and credit markets have no economic consequences and can be dealt with separately is dubious.
An increasing number of studies are now available. Some, like the one in this post, even originates from formerly advocates and designers of macro-prudential policies. The ball is now in the policymakers’ court. (although some don’t seem to care much: remember that BoE’s Mark Carney declared that the BIS was “outside the political reality”… and this new paper was published under the BIS banner…)