By Jon Danielsson, Director of the ESRC funded Systemic Risk Centre, London School of Economics, and Robert Macrae, CFA, who has spent the last 25 years applying an engineering approach to problems in investment. Originally published at VoxEU.
Political risk is a major cause of systemic financial risk. This column argues that both the integrity and the legitimacy of macroprudential policy, or ‘macropru’, depends on political risk being included with other risk factors. Yet it is usually excluded from macropru, and that could be a fatal flaw.
The purpose of macroprudential policy is to identify financial risks and take corrective measures before it is too late. If the measures are effective, systemic risks will be diminished, the severity of any negative events already occurring in the financial system will be contained, and the wider economy will be protected.
The successful implementation of ‘macropru’ demands three things of the financial authorities. First, they need estimates of systemic risk (and its impact on the real economy) from the early signs of a build-up of stress to the post-crisis economic and financial resolution. Second, they need the tools to implement effective policy remedies. Finally, given the power of the tools they wield, the authorities need legitimacy, a reputation for impartiality, and political support.
Most discussions about macropru focus on the first two conditions. Our concern is on the third. It is often assumed that macropru has the similar legitimacy to monetary policy, but we do not believe the comparison works.
For monetary policy, central banks have one measure (inflation), and two tools (interest rates and quantity of money) that have powerful but diffuse effects on the economy. The independent use of these tools by central banks is backed up by decades of research, including the work of Nobel prize winners. Given the importance of the mission, the clear understanding of the problem, and the still-fresh memory of the 1980s, it is not remarkable that democratic societies choose to give this power to unelected bureaucrats.
In contrast, the macropru policymaker is faced with a complex, ill-defined policy domain in which there is not a clear consensus on either the problem or the objective. The indicators at this policymaker’s disposal are often imprecise and conflicting. The surgical implementation tools are often ineffective, and the powerful implementation tools are too blunt. Macropru also tends to result in clearly identifiable winners and losers, perhaps even more so than monetary policy. As a result, it is subject to intensive lobbying and political pressure.
This adversely affects both the legitimacy of the macropru regulator, and the regulator’s reputation for impartiality. It makes it harder to mobilise the sort of political support that monetary policy can get. As a consequence, as we argued last year (Danielsson et al. 2015), except in times of obvious, dire emergency, macropru is likely to lose out to policy objectives like micropru when they inevitably conflict.
This may well frustrate the preventive role of macropru, condemning it to be solely reactive. For example, Sebastian Mallaby writes in his recent autobiography of Alan Greenspan (Mallaby 2015) that the Federal Reserve was aware of the risk from the volume of subprime mortgages. It was largely unable to act because Congress supported increased home ownership, and politicians feared a political backlash if this policy were curtailed.
It seems impossible to ignore the profound and intimate way that politics constrains macropru. Yet the macropru agenda typically takes little account of political risk, and when it does the backlash may be immediate. Consequently, macropru regulators must tiptoe around politics, both as a major source of systemic risk and as the dominant constraint on their ability to act.
Why Political Risk Matters
When we look at major stress events in the financial system, only a few have arisen purely from excessive risk-taking by, and misbehaviour of, economic agents. Perhaps the best example is the 1987 stock market crash that originated in an automatic trading rule and portfolio insurance. This crash had limited impact outside finance. Most other stress events, however, have been strongly influenced by politics. The biggest systemic financial crises in the world were caused by war or a transition between political systems, such as in Russia in 1919, Germany in 1923, Japan in 1945 and China in 1949. The severe financial and economic crisis currently occurring in Venezuela is largely political.
In events of this magnitude the financial strains are merely one aspect of a near-total collapse of social institutions. It is unreasonable to expect any regulator to achieve much of value. There are, however, many less-seismic events that are also largely political in origin.
Take Brexit, for example. The only immediate financial or economic impact was a 20% drop in the value of the pound against major currencies. This is not in itself a systemic concern, but there were possible of systemic consequences via the fixed income markets (Csullag et al. 2016). During the referendum campaign, the Bank of England decided to warn of serious economic consequences if there were a vote for Brexit, putting itself on the losing side of an acrimonious political debate. As a consequence, it has come under repeated attacks from politicians. It is having to reaffirm its independence and request support from the post-Brexit UK government in a way that is unusual for a central bank. This clearly highlights the dangers facing central banks if they include politics in their macroprudential considerations.
Populist parties in Europe have their most realistic chance in a generation of achieving power. Given the strains and imbalances within the Eurozone it is not clear how they could be accommodated, and if current assumptions – such as the fungibility of euros – were called into question, the consequences could easily be systemic. Populism must therefore be a source of systemic risk, but how far can (or should) a civil servant working on macropru venture into this domain?
Similarly, the election of President Trump appears to signal a dramatic change in US economic priorities, with the potential for the Fed to make much larger adjustments to US interest rates. Given the vulnerability of fixed income markets to rising interest rates, and with the dollar replacing the VIX stock market volatility index as the ‘fear gauge’ of the financial markets (as argued by Shin 2016), the consequences could well be systemic. This is exactly the type of scenario the macropru authorities should focus on. On the other hand, it is hard to see how the Fed could react.
The Limits To Macropru
Whatever independence is claimed, in practice the financial authorities are authorised by, controlled by, and gain their legitimacy from the political leadership. Not surprisingly, the mandate from political leadership is to look at financial and economic risk, not to look at risk that has been created by politicians themselves. This makes it hard for the financial authorities to incorporate political risk as a determinant of systemic risk, despite its importance.
As a result, political risk is largely missing from the macroprudential debate, despite having always been a major cause of systemic risk. This makes it institutionally difficult for the financial authorities to publicly anticipate crises that have predominantly political causes, and difficult also to mitigate crises once they happen.
If financial regulators take steps to address political risk to achieve macropru stability, whether the succeed or fail we are heading down a dangerous path. Being involved in a political debate with macroprudential consequences jeopardises their reputation for impartiality, threatens their independence, and affects their ability to execute both macropru and monetary policies.
If the authorities visibly react to political initiatives that affect financial stability, there is a danger this would be interpreted as frustrating or twisting democratic decisions. On the other hand, if the macropru authorities are not able to incorporate political risk in their analytic frameworks, how effective can they be?
The authorities face a dilemma. The inability to incorporate political risk in macropru, but the ineffectiveness of macropru if political risk is ignored, may be a fatal flaw in macroprudential policymaking.
Authors’ note: We thank the Economic and Social Research Council (UK), grant number ES/K002309/1.
See the original for references.
Ziiiip – over my head.
The authorities face a dilemma. The inability to incorporate political risk in macropru, but the ineffectiveness of macropru if political risk is ignored, may be a fatal flaw in macroprudential policymaking.
My conclusion. The “authorities” want moar power behind their scalpels and less power behind their jackhammers. How about a hammer and chisel, boys? Can we add those to your toolbox? Or would you like a couple of prybars too? Christmas is just around the corner and the peasants can all pool their skimpy resources to fill up your needy toolbox. You see, the peasants don’t have much since the macropoo boys shipped their jawbs off to China. And can you please, just once use those new tools to hammer the elite, or pry some money off them. If you look into their pockets you will find aggregate demand crammed into them.
Try this, he’s quite a bit clearer,
The Fed has a dual charter for full employment and inflation targeting, but hell that first one is clearly the less important one. Also, they have no direct effect on the quantity of money. The only things that create money is the government running a deficit or banks creating loans. Just because the Fed thinks it is creating money with QE doesn’t mean that is what is happening.
My sentiments exactly. Perhaps the author is mooning about his beloved Blighty. But here in the Homeland, the usual formulation is that the Fed has two targets (employment and stable prices) but only one lever (interest rates).
As the Fed discovered to its sorrow in the 1980s and again in its Golden Era of QE, it has no direct control over the quantity of money, The velocity of circulation has a nasty habit of neutralizing attempts to hike the money supply. MV = PT and all that.
What’s a central planner to do? Declare macroprudential victory, get on his bike, and pedal off into the sunset.
“Just because the Fed thinks it is creating money with QE doesn’t mean that is what is happening.”
Exactly. QE is an asset swap…no net change in the level of assets, only the composition.
One aspect of the Quantity of Money argument is how quantity matters. Quantity plays a part in liquidity, but economic activity occurs mainly when an increase occurs. Increases in the the money supply are the main driver of GDP.
The increases quickly dissipate to savings. Savings by definition don’t generate flow. One exception to that would be business investment, although some if not most of that is borrowed money, but investment has similarities to gambling, putting money on the table with the expectation of winning more.
No one sits down at a poker game where the only money they can win is their own. Investment expects to win increases generated by public investment and expansion of credit.
The only things that create money is the government running a deficit or banks creating loans.
That’s because the population may not use their nation’s fiat except for unsafe, inconvenient physical fiat, a.k.a. currency. Instead, we must work through depository institutions for some strange reasons such as it makes it easier to oppress the poor thereby since they are the least so-called creditworthy.
We should fix that and then “reserves”* would be money too since the population could directly use them.
*private sector account balances at the central bank.
“…we must work through depository institutions…”
We still have safes and mattresses.
Reserves are accounting abstractions, not part of the non-government money supply. How would “we” directly use them?
We still have safes and mattresses. paulmeli
You left off the /sarc tag, didn’t you?
How would “we” directly use them? paulmeli
The same way depository institutions use them – via accounts at the central bank or equivalent.*
*e.g. a Postal Checking Service that may not lend on its own.
I was half kidding.
I think the idea that a Postal Checking Service would require ‘use’ of reserves may be a bit misleading. Maybe what you mean is that such a service would have a deposit guarantee as with the FDIC.
“Using’ reserves means using the number system. Every accounting system falls in that category.
I think the idea that a Postal Checking Service would require ‘use’ of reserves may be a bit misleading. paulmeli
It would be the same thing as using reserves since if the PCS was only allowed to accept deposits and not create them as the banks do (“loans create deposits”) then its liabilities would always be 100% backed by its reserves*.
Maybe what you mean is that such a service would have a deposit guarantee as with the FDIC.
No need since the accounts would be inherently risk-free since the PCS could not create additional liabilities for its reserves (i.e. “fractional reserves”), i.e. it could not legally embezzle as the banks do.
“Using’ reserves means using the number system. paulmeli
Using reserves means having an account at the central bank. Accounts at a PCS would not directly use reserves but would be equivalent since deposits would be 100% backed by reserves* at all times.
*ignoring the use of vault cash.
“its liabilities would always be 100% backed by its reserves*”
Seems to me in this case the ‘liabilities’ ensuing from deposits are backed by the deposits themselves.
Seems to me in this case the ‘liabilities’ ensuing from deposits are backed by the deposits themselves. paulmeli
Yes, practically so, since with instant check clearing, one’s deposit (ignoring deposits of physical fiat) into a PCS would not be recognized until the actual reserves backing it were transferred to the PCS’s account at the central bank.
So all liabilities of a PCS would be backed 100% by its reserves at the central bank (plus its vault cash) at all times.
Of course the temptation for government to borrow from its PCS would be very great which is why I prefer that citizens, their businesses, etc. be allowed accounts at the central bank itself.
Technical gymnastics with no connection to the real world.
What matters is that your deposits are safe. If enshrined in law they would be. Law drives the system, not accounting. The accounting is ex-post, nothing more than a picture of what has occurred, like a picture of an crash scene. The picture doesn’t cause the crash.
“Of course the temptation for government to borrow from its PCS…”
OK now you’ve gone off the rails. Next comes the claim that the government must borrow to spend.
If such a thing happened, that would be a political or policy choice, not one borne in engineering reality.
Technical gymnastics with no connection to the real world. paulmeli
Not so. Currently, Social Security recipients, for example, are forced to lend the fiat (a deposit is legally a loan) that might otherwise be deposited into their accounts at the cb or PCS, if they were allowed to have them, to depository institutions. What do you call forced loans? I call them theft.
What matters is that your deposits are safe. paulmeli
Government privileges for depository institutions greatly increase the ability of banks to dilute the real value of current deposits with new deposits (“loans create deposits”) that are largely merely sham liabilities wrt to the non-bank private sector. Example: Try saving up to buy a house.
Next comes the claim that the government must borrow to spend.
If such a thing happened, that would be a political or policy choice, not one borne in engineering reality. paulmeli
You have a point; a monetary sovereign should have no need to borrow its fiat back* since it can simply create more.
A much more realistic danger is that a PCS will be pressured into making loans to the private sector and thus be corrupted into a lending bank – at which point private sector banks can legitimately complain of unfair competition. With individual accounts at the central bank, lending would be at the sole discretion of the account owners themselves and no such danger would exist.
*Especially for positive interest since that is welfare proportional to wealth, not need.
With 0% interest, safes and mattresses, or loan to friends/relatives.
I think he’s saying brilliant economic risk management on behalf of corporate financial capital won’t “work” unless it takes politics into account, but if it does that then it’s politics, not just brilliant risk management on behalf of corporate capital.
I need a lie down.
Central Banks and the wealth effect.
Real wealth comes from the real economy where real products and services are traded.
This involves hard work which is something the financial sector is not interested in.
The financial sector is interested in imaginary wealth – the wealth effect.
They look for some existing asset they can inflate the price of, like the national housing stock.
They then pour money into this asset to create imaginary wealth, the bubble bursts and all the imaginary wealth disappears.
1929 – US (margin lending into US stocks)
1989 – Japan (real estate)
2008 – US (real estate bubble leveraged up with derivatives for global contagion)
2010 – Ireland (real estate)
2012 – Spain (real estate)
2015 – China (margin lending into Chinese stocks)
Central Banks have now got in on the act with QE and have gone for an “inflate all financial asset prices” strategy to generate a wealth effect (imaginary wealth).
The bubble bursts and all the imaginary wealth disappears.
The wealth effect – it’s like real wealth but it’s only temporary.
Financial asset price inflation is just dangerous.
The theory is there but not in mainstream economics.
Irving Fisher looked at the debt inflated asset bubble after the 1929 crash when ideas that markets reached stable equilibriums were beyond a joke.
Fisher developed a theory of economic crises called debt-deflation, which attributed the crises to the bursting of a credit bubble.
Hyman Minsky came up with “financial instability hypothesis” in 1974 and Steve Keen carries on with this work today.
Steve Keen saw the private debt bubble inflating in 2005. He had the right theory and it wasn’t a “black swan” to him.
In 2007 Ben Bernanke could see no problems ahead and his models didn’t include money and debt. He had the wrong theory.
This is how important this theory is.
When are the Central bankers going to get up to speed?
Australian and Canadian Central Bankers, if you are having a sneaky peak, I am afraid it’s too late.
You have let your real estate bubbles get totally out of hand.
Black Swans aren’t unpredictable.
Let’s have a look at the US money supply:
Everything is reflected in the money supply.
The early 1990s recession
The dot.com boom
The near vertical rise towards 2008, the black swan is coming, but it isn’t a black swan when you understand money.
When you see overall debt increasing rapidly a credit bubble is forming, you can then nip it in the bud before the damage gets out of hand. This also can be seen in the nation’s money supply (debt = money).
Idiot bankers securitising bad loans and NINJA mortgages and leveraging it up with derivatives before 2008.
Most people don’t understand money.
Money and debt are opposite sides of the same coin.
If there is no debt there is no money.
Money is created by loans and destroyed by repayments of those loans.
It is a well kept secret as everyone would have realised what the bankers were doing before 2008 by looking at the money supply (including Ben Bernanke), they are inflating a credit bubble.
Understanding money (get your Central Banker a copy)
From the BoE:
If you want to really understand it buy ………..
“Where does money come from?” available from Amazon.
“Money is created by loans and destroyed by repayments of those loans.”
Money is also created when Congress passes spending bills (once the President signs off on them) and destroyed when we pay income or SS taxes.
According to the Constitution, Congress has the sole power to create money (for the US). The FRBS is a creation of Congress. The banking system (Fed) is functionally a subcontractor below Congress in the hierarchy of power.
The Fed does not have the power to say no when Congress appropriates funds and directs Treasury to write a check or mark up a bank account in the non-government.
That BOE page (and virtually all central bank opinion) puts forth a highly stylized view of the origination of money, specifically the Unit of Account. It does not present a real-world accounting of where the currency that the non-government uses originated. Not surprising since bankers have always promoted their own importance and would like us to believe they are at the top of the hierarchy of money creation.
For the US, over history, the Government has spent ~$80T, while the current outstanding balance of credit is at around $47T. If we include debt held by the public (we shouldn’t because it doesn’t add anything to spending) the total is ~$61T, still less than what the government has spent.
What matters economically is the source of spending. For that there is no doubt… the government plays the biggest role here (except for three or four years in the 2000’s. Look where that ended up).
In 2015 the government spent $4T, while business investment was $3T and credit expansion ~$1.25T.
The confusion (?) comes from conventions of government accounting in the National Accounts. Income taxes accrue only against Federal Spending so we end up with the concept of ‘deficits’ as a budget item (and constraint) when in fact money borrowed form banks are also deficits.
Further, the idea that income taxes can only accrue against Income derived directly from federal spending and not income derived from credit expansion or business investment is absurd, since the latter account for roughly half of all income (GDP).
Using National accounting in this way leads (falsely) to the conclusion that some 95% of our money originated from banks, which is widely promoted.
Interesting article and demonstrates that the attempt to divorce politics (dirty) from econmics (pure) leads to a dead end. The problems raised above are not solvable by regulators. A classic double bind. The take home for me, is that there is no technocratic fix to societies problems. We all need to engage in honest politics.
Seems to me the authors are arguing for supranational bank regulatory apparatus beyond the reach of national politicians and sovereign control. Although macroprudential policies are necessary to address systemic risks under current financial system structures and global interrelationships (thinking derivatives exposures), I believe restoration of the Glass-Steagall Act and strong microprudential regulation and law enforcement would offer an alternative and superior avenue to achieve similar policy objectives while preserving domestic control of the nation’s financial system, monetary sovereignty, and economic and monetary policy flexibility.
Odd little summary of the fatal flaw with money management. Politics corrupts finance but finance can’t regulate itself without politics. So just do your best. It’s an imperfect world out there. Money really isn’t defined by a debt and credit relationship – that just defines how it works. Money is intrinsic to society; it’s cooperation. No matter what trinkets are transacted. And politics? Let’s see… society is cooperation, cooperation is policy, policy is politics… oh gosh – I think these guys believe politics was immaculately born out of nothing but greed. Certainly no nasty carnal pedigree of thousands of years of human progress… no no no – we all know progress only comes when the assets of the rich are protected from the filthy rabble.
“If financial regulators take steps to address political risk to achieve macropru stability, whether the succeed or fail we are heading down a dangerous path.”
Help me! These guys are political to the core, and always have been. They do whatever it takes to protect the interests of their golfing buddies. Sometimes it more overt…”let’s foam the runways!” And sometimes it’s painfully opaque…”we’ll just slowly squeeze the Greeks (Puetro Ricans, choose your favorite whipping boy) until we achieve total debt servitude.”
This is the kind of Academic Paper Crock of Shit that we all have to continue to struggle against. But, we need to see this kind of nonsense now and then to remind ourselves how academics blithly display their elite-class interests.
Do the French still have their guillotines moldering away in a few ancient warehouses?
I beg to differ. Some of those subprime mortgages were for the primary residences of honest lower income people. But some were NINJA (No Income, No Job, No Assets) loans that were immediately bundled into some type of mortgage backed security. Corrupt initiators of such loans would “earn” commissions, and the people who bundled them would “earn” bonuses. In addition, some lower quality mortgages were for second or third homes of rich borrowers. Such people might be able to easily afford their first home, but a financial downturn could force them to default on their second or third mortgage.
It’s wrong to blame the Great Financial Collapse on sound policies that encourage home ownership. The regulators could and should have prevented the Collapse, despite any political complications.
I was struck by that comment for another reason. I haven’t read mallaby’s book, but is he really saying Greenspan knew but couldn’t react for political reasons!? Omg! Despite Greenspan acknowledging there was a flaw in his worldview, now it’s “I was handcuffed.” Good grief. His legacy is restored. Hail the maestro!
” two tools (interest rates and quantity of money) that have powerful but diffuse effects on the economy. ”
How can anyone say this, after almost a decade of QE, zero interest rates, and economic stagnation? The Lost Decade didn’t happen? Ask Donald Trump – speaking of political risk.
If anything, this is an argument for “macroprudential” effectiveness, so he shouldn’t throw it away. Thanks fo rthe new word, incidentally. I may understand it by the time I finish the article.
I hate to keep reminding folks that by far the biggest risk is external — i.e. polar ice melt, methane emission, species die-offs, deforestation, etc. How come massive ecosystem destruction doesn’t even register in the accounts and planning, except when it’s too late to correct the course of civilization?
FYI: posted comments are still carrying over in the box: eg: (addendum: WordPress caught the duplication, at least.)
And my further comment just vanished – don’t know if the moderator can see it. I thought it might be actually useful, so I’ll check back.
Thanks for sending us the FYI.
(1) “posted comments are still carrying over in the box”: What did you mean by this? I looked through all the posted comments with the text you cited and they looked normal on my browser.
(2) “my further comment just vanished”: You had another comment just like this one, but also containing stuff from your comment on QE and the Lost Decade . Is there another comment by you that you mean? I looked around and couldn’t find anything else that hasn’t by now posted.
In general, we’re interested in hearing about cases where comments are vanishing when they shouldn’t. If you want to provide more information the next time something like this happens, you can also email me at email@example.com.
I thought this was going to be interesting, but it’s just archetypal libertarian-economist giddiness to blame ‘governments’ and ‘politics’ for everything.
“Populism must therefore be a source of systemic risk, but how far can (or should) a civil servant working on macropru venture into this domain?”
In this world, populism is automatically assumed to be a negative, irrational, ‘political’ force when compared to the rational, apolitical technocratic institutions erected by economists. The relationship between the rise of the former – and the problems it might try to address – and the failure of the latter is ignored, as is the fact that all and every economic institution, from central banks to financial regulation to the civil service, makes decisions which are ultimately political in nature.
Economists are going to need a much better understanding of the idea of populism, and their own failures, if they are to address any of the challenges we currently face.
PS In an article about financial crises, it is a remarkable feat of mental acrobatics to criticise the Chinese revolution but not 2008