Comments on “Procyclical Financial Behavior: What Can Be Done?”
- Stefan Gerlach, and Paul Gruenwald
- Published Date:
- July 2006
I organize my comments around four issues relating to the build-up, monitoring and counteraction of financial imbalances: first, the potential role of monetary policy; second, the use of prudential instruments; third, the effects of taxation; fourth, the institutional set-up for preserving financial stability.
I agree with most of what Lowe and Stevens said about the role of monetary policy in Chapter 4. It could potentially lean against the build-up of financial imbalances during boom periods over and above what “traditional” inflation targeting would imply. That is, though, provided the imbalance can be identified in time. If a credit and asset price boom is strong enough the impending imbalance is usually not to be mistaken. The problem in this case is, however, that small incremental changes in the stance of monetary policy might not have much effect, whereas bigger changes might be very risky for the real economy.
If we accept that monetary policy has a beneficial role to play in this connection, how might that be made operational? One possibility is that monetary policy is set with a longer horizon than the two years usually associated with inflation targeting and that the balance of risk is given more prominence.1
A second possibility is to give more role to monetary and credit aggregates when deciding the stance of monetary policy. That would implicitly provide a longer horizon, given the lags between inflation on the one hand, and money and credit on the other. It also provides a focus on financial sector developments that could be a source of financial imbalances. The ECB’s second pillar has partly been rationalized by these kinds of considerations. It is, however, not clear if and how money and credit could be used as intermediate targets, as opposed to indicators, for the goal of low and stable inflation, given the variable lags and the unstable relationship during periods of significant financial change and innovation. A third possibility is to use discretion within a framework of flexible inflation targeting. There are some recent examples where central banks have openly or seemingly taken housing price booms into account when setting monetary policy.
I think that these are all avenues that deserve closer investigation. However, it is important to recognize that “traditional” inflation targeting is subject to very significant uncertainty. There is, of course, uncertainty associated with forecasting regarding the “correct” model and its assumptions, especially on the future path of the exchange rate. But there is also significant uncertainty about current conditions, not to mention the measurement of the output gap. If we add a role for monetary policy in dampening procyclicality, over and above the goal of keeping inflation low and stable, then the problem of uncertainty becomes compounded. There are at least two aspects to that. First, the identification of the financial imbalance. That involves an assessment of fundamental value, which is always very difficult. Second, the calibration of the monetary policy response. As financial imbalances are often associated with changes in the financial sector that affect the transmission mechanism of monetary policy, this task will be even more difficult.
Having listed all these difficulties I do, however, think that monetary policy will have a role to play at the margin. Moreover, in some cases, the potential impediments discussed above might not be as important in practice as they seem in theory. Most central banks will be much more vigilant when faced with double-digit credit growth and associated asset price increases than they would otherwise. Moreover, I think that central banks will in practice, all other things being equal, have a somewhat higher policy rate and a stronger tightening bias in these conditions than otherwise.
Finally, I think it is important to recognize that the most important contribution of monetary policy is probably not to counteract financial imbalances created by other sources but to try to avoid generating and/or fueling those imbalances. Too lax a monetary policy can contribute to financial excesses even if it does not initially result in higher inflation. In the same way as central banks should be on their guard when faced with credit booms, they should also be vigilant when real short-term interest rates have for an extended period been below reasonable estimates of the natural rate.
The limited role that monetary policy seems to be able to play in reducing excessive procyclicality has resulted in an active look for other instruments. Counter-cyclical capital asset ratios or, alternatively, dynamic provisioning, have been discussed in this book. I have nothing to add there except to note that both should receive serious consideration, although there seem to be important implementation problems.
Public announcements by central banks or financial supervisors on the risks facing the financial system can increase the risk awareness of market participants and result in more prudent behavior. These are probably most useful early in the process of the build-up of financial imbalances. The problems here are that it is more difficult to identify the imbalances at this stage and that the warnings are less likely to be believed. However, at the peak of the financial cycle we can get into a Catch-22 situation where such announcements can make things worse.
In Chapter 4 the authors mention the potential role of capital controls in dealing with procyclicality caused by volatile capital flows. It is indeed a positive development that the debate on capital controls is now more balanced than was the case some years ago. However, even if the imposition of temporary capital controls might be beneficial and prudent in some situations they will always come at a cost. There is a loss of efficiency and market discipline, and external credit spreads can widen. In principle, the estimated stabilization benefits should be higher than these costs if the imposition of capital controls is to be warranted. In practice that cost-benefit analysis is very difficult to do with any precision.
Studies seem to indicate that the efficiency gains associated with unregulated short-term capital movements are small and even nonexistent, but that they can be very significant for long-term capital movements, especially foreign direct investment. However, the costs and benefits for short-term movements might be asymmetric, at least in the short to medium term, in the sense that the costs of imposing new restrictions on short-term capital movements might be higher than the gains from lifting existing ones. The reasons could be associated with negative shocks to market perceptions at the time when controls are imposed, that then subsequently fade away. But then capital controls gradually become less effective anyway.
The policy conclusions that I draw from this are that countries should be careful, both when liberalizing their capital movements and when imposing new controls. On the one hand, integration into the world economy and the development of modern financial markets make eventual capital account liberalization desirable and unavoidable. However, timing and sequencing are important. On the other hand, countries should do their best to try to avoid situations where they are forced to introduce new capital controls and consider carefully whether other instruments cannot do the job. Having said that, we should not reject out of hand the possibility that there might be situations where imposing some new capital controls is better than the alternative.
Central banks and supervisory authorities impose prudential regulations on financial institutions that limit their risk-taking by imposing ceilings on certain ratios or other metrics. These are liquidity ratios or other restrictions on maturity mismatches, ceilings on currency mismatches,2 loan-to-value ratios, margin requirements, etc. These vary from country to country in terms of coverage and ratios. These prudential restrictions could be adjusted in order to counteract financial imbalances. They are also preferable to capital controls, although they might not be substitutes. Financial imbalances might partly be a reflection of the fact that these ratios are set at the wrong level. Even if that is not the case, they could still be adjusted in order to lean against these imbalances and that might be preferable to letting the boom-bust cycle run its course.
I understand that prudential ratios of this kind have been used with relatively good results in Hong Kong and in other countries in the region. In my previous role as chief economist of the Central Bank of Iceland I took part in imposing liquidity requirements on banks in conditions of an unsustainable credit boom that was financed to a significant degree by short-term capital inflows.3 It did not stop the boom. But it slowed the banks down so that the eventual bust was in the end somewhat smaller.
Regarding fiscal policy, I agree that it might have an important role to play in either amplifying or reducing procyclicality. Additionally, taxation can at the microeconomic level be an important source of distortions that can amplify procyclicality. Moreover, changes to the tax code have sometimes been an important source of shocks that have contributed to financial instability. I will mention two examples.
The first example is the contribution of taxation to the stock market boom in the US in the late 1990s. It seems to me that the cut in capital gains taxes in the middle of the boom fueled it at an inappropriate moment. It can also been argued that the accounting and tax treatment of stock options did the same.4
The second example is the tax treatment of interest expenses of households in Sweden that contributed to its banking crisis in the early 1990s. The tax system was reformed in the middle of a credit and housing boom. The reform was beneficial from a long-run perspective. It reduced the tax incentives for borrowing, which were among the factors that had contributed to the credit boom. However, the change resulted in a significant positive shock to the aftertax real interest rate facing households. In the prevailing conditions this shock contributed to the non-performing loan problem which in turn was an important factor in the banking crisis.5
The conclusion that I draw from this is that there might be important financial stability aspects to changes in the tax code that have to be taken into account when the desirability and timing of such changes are evaluated. Even if the changes are beneficial from a long-run efficiency standpoint the timing of their implementation might be important.
Financial stability is influenced by the macroeconomic policy framework, prudential regulations and supervisory policy, monetary policy, fiscal policy, taxation, accounting standards, etc., and the interaction between all of those. It is therefore not as easy as in the case of monetary policy to assign responsibility for financial stability to a single institution with a clear mandate and a defined set of instruments. Central banks, treasuries and financial supervisory authorities all have a role to play. However, if these do not interact sufficiently there is a danger that important aspects will fall through the cracks, especially if the responsibility for macro-financial stability is not clearly defined. One solution is to set up financial stability forums at the national level, where the central bank, the financial supervisory authorities and the treasury meet to evaluate vulnerabilities in the financial system and to consider policy responses. Even if the central bank is given overall responsibility for macro-financial stability, such an arrangement will be useful as the central bank does not have command over many of the instruments that are important for financial stability. Indeed many countries have some arrangements of this sort.6
BäckströmUrban (1997) “What Lessons Can Be Learned from Recent Financial Crises? The Swedish Experience,”Jackson Hole Conference 1997available at http://www.kc.frb.org/PUBLICAT/SYMPOS/1997/pdf/s97backs.pdf.
BorioClaudio and WilliamWhite (2004) “Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes,”BIS Working Paper No. 147.
Central Bank of Iceland (2000) Annual Report 1999available at http://www.sedlabanki.is/default.asp?PageID=253.
GoldsteinMorris and PhilipTurner (2004) Controlling Currency Mismatches in Emerging MarketsInstitute for International EconomicsWashington, DC.
GoodhartCharles A. E. (2004) “Multiple Regulators and Resolutions,”paper presented at the Federal Reserve Bank of Chicago conference Systemic Financial Crises: Resolving Large Bank Insolvenciesavailable at http://www.chicagofed.org/news_and_conferences/conferences_and_events/nles/systemic_goodhart.pdf.