Not only does this piece do a nice job of distilling the issues but it also works through one of the pet remedies being bandied about, namely, implementing counter-cyclical regulatory measures, such as increasing capital requirements in boom times. Goodhart reviews some objections and concludes they are valid but not sufficient to obviate the advantages of pursuing such measures.
Note that we have argued againt having central banks act both as monetary and stability authorities based on the cautionary example of the Fed. As Willem Buiter has noted, it is a victim of what he calls cognitive regulatory capture, in which it identifies too strongly with the world view of its charges, namely, financial services firms. Countercyclical measures are simply an updated version of former Fed chairman William McChesney Martin’s prescription of taking the punchbowl away when the party starts getting good. The fact that the US central bank was unwilling to do that says it might not be the right candidate for the job.
Central banks cannot achieve price and financial stability with one instrument (interest rates). A counter-cyclical regulatory system is needed to dampen asset booms and to smooth busting bubbles. To use such macro-prudential instruments effectively, regulators need courage, quantitative triggers, and independence; they will be criticised by lenders, borrowers and politicians in both booms and busts.
The events of the last year have reminded us all that a central bank does not just have one responsibility, that of achieving price stability. It is indeed its first core purpose (CP1); but as the sole institution that can create cash, and hence bank reserve balances, a central bank has a responsibility for acting as the lender of last resort and maintaining financial stability. This is its second core purpose (CP2).
Two goals but only one instrument
One of the major problems of central banking is that the pursuit of these two core purposes can often conflict, not least because the central bank currently appears to have only one instrument, its command over the short-term interest rate. Indeed, a central purpose of the first two great books on central banking, Henry Thornton’s (1802), Inquiry into the Paper Credit of Great Britain, and Walter Bagehot’s (1878), Lombard Street, was to outline ways to resolve such a conflict, especially when an (external) drain of currency threatened maintenance of the gold standard at the same time as an internal drain led to a liquidity panic and contagious bank failures.
Under such circumstances, however, with rising risk aversion, the central bank would find that it had two instruments, due to its ability to expand its own balance sheet, e.g. by last-resort lending, at the same time as keeping interest rates high, (to deter gold outflows and unnecessary (speculative) borrowing). The greater problem, then and now, was how to avoid excessive commercial bank expansion during good times. With widespread confidence, the commercial banks neither want nor need to borrow from the central bank. A potential restraint is via shrinking the central bank’s own balance sheet, open market sales, thereby raising interest rates. But increasing interest rates during good times, (gold reserves rising and high; inflation targets met), i.e. ‘leaning into the wind’, is then against the ‘rules of the game’, and such interest rates adjustments small enough to be consistent with such underlying rules are unlikely to have much effect in dampening down the upswing of a powerful asset price boom-and-bust cycle.
CP1: ‘Price stability’ versus CP2: ‘Financial stability’
Although the terminology has altered, this basic problem has not really changed since the start of central banking in the 19th century. An additional analytical twist was given by Hy Minsky, who realised that the better the central bank succeeded with CP1 (price stability), the more it was likely to imperil CP2 (financial stability). The reason is that the greater stability engendered by a successful CP1 record is likely to reduce risk premia, and thereby asset price volatility, and so support additional leverage and asset price expansion. The three main examples of financial instability that have occurred in industrialised countries in the last century (USA 1929-33, Japan 1999-2005, sub-prime 2007/8) have all taken place following periods of stellar CP1 performance.
We still have not resolved this conundrum. It shows up in several guises. For example, there is a tension between trying to get banks to behave cautiously and conservatively in the upswing of a financial cycle, and being prepared as a central bank to lend against whatever the banks have to offer as collateral during a crisis. Again, the more that a central bank manages to constrain bank expansion during euphoric upswings, e.g. by various forms of capital and liquidity requirements, the greater the disintermediation to less controlled channels. How far does such disintermediation matter, and what parts of the financial system should a central bank be trying to protect? In other words, which intermediaries are ‘systemic’; do we have any clear, ex ante, definition of ‘systemic’, or do we decide, ex post, on a case-by-case basis?
Bank risk and bank-system risk
Perhaps these problems are insoluble; certainly they have not been solved. Indeed, recent developments, notably the adoption of a more risk-sensitive Basel II CAR and the move towards ‘fair value’ or ‘mark-to-market’ accounting, have arguably tilted the regulatory system towards even greater pro-cyclicality. A possible reason for this could be that the regulators have focussed unduly on trying to enhance the risk management of the individual bank and insufficiently on the risk management of the financial system as a whole. The two issues, individual and systemic risk performance, are sometimes consistent, but often not so. For example, following some financial crisis, the safest line for an individual bank will be to cut lending and to hoard liquidity, but if all banks try to do so, especially simultaneously, the result could be devastating.
The bottom line is that central banks have failed to make much, if any, progress with CP2, just at the time when their success with CP1 has been lauded. This is witnessed not only by the events of 2007/8, but also by the whole string of financial crises (a sequence of ‘turmoils’) in recent decades. Now, there are even suggestions that central banks should have greater (even statutory) responsibility for achieving financial stability, (e.g. the Paulson report). But where are the (regulatory) instruments that would enable central banks to constrain excess leverage and ‘irrational euphoria’ in the upswing? Public warnings, e.g. in Financial Stability Reviews, are feeble, bendy reeds. All that central banks have to offer are mechanisms for picking up the pieces after the crash, and the more comprehensively they do so (the Greenspan/Bernanke put), the more the commercial banks will enthusiastically join in the next upswing.
Besides such public warnings, which the industry typically notices and then ignores, the only counter-cyclical instruments recently employed have been the Spanish pre-provisioning measures, and the use of time-varying loan to value (LTV) ratios in a few small countries, e.g. Estonia and Hong Kong. But the Spanish measures have subsequently been prevented by the latest accounting requirements, the IFRS of the IASB; and the recent fluctuations in actual LTVs have been strongly pro-cyclical, with 100+ LTVs in the housing bubble being rapidly withdrawn in the housing bust.
Indeed, any attempt to introduce counter-cyclical variations in LTVs or in capital/liquidity requirements will always run into a number of generic criticisms:
It will disturb the level playing field, and thereby cause disintermediation to less regulated entities (in other segments of the industry, or in other countries). It will thus both be unfair and ineffective.
It will increase the cost of intermediation during the boom and thereby reduce desirable economic expansion (and financial innovation).
It will increase complexity and add to the informational burden.
These criticisms have force. Indeed, there are empirical studies that suggest that countries which allow a less regulated, and more innovative and dynamic, financial system grow faster than their more controlled brethren, despite being more prone to financial (boom/bust) crises. Nevertheless it should be possible to construct a more counter-cyclical, time-varying regulatory system in such a way as to mitigate these problems, so long as the regulations are relaxed in the downturn after having been built up in the boom.
But those same generic criticisms will also mean that regulators/supervisors will be roundly condemned for tightening regulatory conditions in asset prime booms by the combined forces of lenders, borrowers and politicians, the latter tending to regard cyclical bubbles as beneficent trend improvements due to their own improved policies. Regulators/supervisors will need some combination of courage, reliance on quantitative triggers, and independence from government if they are to have the strength of mind and purpose to use potential macro-prudential instruments to dampen financial booms.