Financial Regulation

There is no agreed-upon vision of what the future financial architecture should look like and, by implication, no agreed-upon vision of what the appropriate financial regulation should be. Here I am reminded of Paul Volcker’s famous observation that the only useful financial innovation of the last 40 years has been the ATM. This is surely an exaggeration. But we are still unsure about the right role of securitization, the right scope for derivatives, the role of markets versus banks, and the role of shadow banking versus banking.

Still, it seems clear that some things should change, and indeed, policymakers are putting in place measures in the context of international or national initiatives. One example is the increase in required capital ratios. It may not be a panacea, but it surely can make the financial system more robust. Even so, however, I am struck by the level of uncertainty and disagreement about the effects of capital ratios on funding costs and thus on lending. Reasonable people, as among them Martin Hellwig and Anat Admati, argue that we are not so far from the Modigliani-Miller world, and banks can afford substantially higher capital ratios. Others (and not only bankers) argue that such ratios would instead destroy the banking industry.

Another example is capital flows and, by implication, the role of capital controls. I was struck by Hélène Rey’s discussion in chapter 25, in which she shows how surprisingly meager the hard econometric evidence is for the benefits of portfolio flows. I was also struck by Stanley Fischer’s rhetorical question, what is the usefulness of short-term capital inflows? Clearly, how we think about the scope of capital controls depends very much on the answer to these basic questions.

The Role of the Financial Sector

It has become a cliché to say that macroeconomic thinking understated the role of financial factors in economic fluctuations. Much analytical work has taken place over the past five years to reintroduce the financial system into our models. But we are not there yet. For example, is there a credit and financial cycle separate from the business cycle, as Claudio Borio suggests? Or should we think of financial shocks as another source of disturbance and the financial system as just another source of amplification?

Was Stephan Gerlach right when he asked whether we should really reconsider all of macroeconomics for an event that may happen once every hundred years? Or, instead, are financial shocks and the financial system so central to macroeconomic fluctuations that the IS-LM model—which does not include an explicit financial system—is not an acceptable port of entry into macroeconomics?

By implication, there is no agreement on how or even whether to integrate financial stability and macrostability into the mandate of central banks. Does it require a tweak to inflation targeting or much more radical rethinking? The intellectually pleasant position is to argue that macroprudential tools will take care of financial stability, so monetary policy can still focus on its usual business: inflation targeting. I read, perhaps unfairly, Michael Woodford’s discussion in chapter 4 as suggesting that the crisis should lead us to shift from inflation targeting to nominal income targeting, without a major emphasis on financial stability. I am skeptical that this is the right answer. I think we have to be realistic about the role that macroprudential tools can play and about the fact that monetary policy cannot ignore financial stability. This brings me to my third point.

Macroprudential Tools

At our first conference on rethinking macroeconomic policy, in 2011, macroprudential tools were, to use Andrew Haldane’s phrase, very much the new kid on the block. It was clear that the two standard tools, fiscal policy and monetary policy, were not the right ones to deal with financial imbalances and risks. The question then was whether macroprudential policy was going to be the third leg of macroeconomic policy or just a crutch to help the first two.

We do not have the answer yet. But as more and more countries are using those tools, we are learning. I draw two lessons from the evidence and from the work presented in this volume.

First, these tools work, but their effects are still hard to calibrate, and when used, they seem to have moderated rather than stopped unhealthy booms. This is also my reading of Bank of Korea’s Governor Kim’s presentation in chapter 8.

Second, by their nature, they affect specific sectors and specific groups, and this raises political economy issues. This is clear from Stanley Fischer’s discussion in chapter 7 of the use of loan-to-value (LTV) ratios in Israel.

Governance and Allocation of Tasks among Microprudential, Macroprudential, and Monetary Policy (or, as Avinash Dixit called them, MIP, MAP, and MOP)

How should microprudential and macroprudential regulation be coordinated? It is sometimes said that they are likely to conflict. Conceptually, I do not see why they should: I see macroprudential regulation as simply taking into account systemic effects and the state of the economy in thinking about bank regulation and the situation of each financial institution.

For example, I see macroprudential regulation requiring higher capital ratios from more systemically important banks or when aggregate credit growth appears too high. The question is how to work out the division of labor and the interactions between the two so that this is indeed what happens.

If not done right, it might mean that as a bust starts, the microprudential supervisor ignores systemic aspects and other events and asks for higher capital ratios, while the macroprudential supervisor rightly believes the opposite is needed. The United Kingdom’s approach—the creation of a Financial Policy Committee that can impose capital ratios that vary over time and across sectors to maintain financial stability—seems like a good way to proceed. Andrew Haldane discusses the issues in chapter 5.

How macroprudential regulation and monetary policy should be combined raises more complex issues. There is little question that each affects the other: monetary policy affects risk taking, and macroprudential tools affect aggregate demand. So policymakers need to coordinate.

Given that monetary policy surely must stay with the central bank, this suggests putting both of them under one roof at the central bank. But this in turn raises the issue of central bank independence. It is one thing to give the bank independence with respect to the policy rate; it is another to let it set maximum LTV ratios and debt-to-income ratios. At some point, the issue of democratic deficit arises.

Maybe the solution is not so hard, namely, to give various degrees of independence to the central bank. Stanley Fischer gave us a marvelous analogy and pointed us toward the solution when he said that anybody who is married easily understands the notion of various degrees of independence. Again, the UK’s approach, with its two parallel committees within the central bank, one focusing on monetary policy, the other on financial policy with a limited set of macroprudential tools (not including, for example, LTV ratios), seems like a reasonable approach.

The Sustainable Level of Debt

The rate of fiscal consolidation depends on, among other things, what we think a sustainable level of debt is. Many countries will be managing levels of debt close to 100 percent of GDP for many years to come. There is a standard list of textbook answers as to why high debt is costly, from lower capital accumulation to the need for higher and distortionary taxes. I suspect the costs are elsewhere. I see two main costs.

The first is debt overhang. The higher the debt, the higher the probability of default, the higher the spread on government bonds, and the harder it is for the government to achieve debt sustainability. But the adverse effects do not stop there. Higher sovereign spreads affect private lending spreads, which in turn affect investment and consumption. Higher uncertainty about debt sustainability—and thus about future inflation and future taxation—affects all decisions. I am struck by how limited our understanding is of these channels. Reduced form regressions of growth on debt can take us only so far.

The second related cost is the risk of multiple equilibria. At high levels of debt there may well be two equilibria: a “good equilibrium,” at which rates are low and debt is sustainable, and a “bad equilibrium,” at which rates are high and, as a result, the interest burden and the probability of default are higher. When debt is very high, it may not take much of a change of heart by investors to move from a good to a bad equilibrium.

I suspect that this phenomenon is partly behind the Italian and Spanish bond spreads. In this context, Martin Wolf in chapter 20 asks a provocative question: why are the spreads so much higher for Spain than for the UK? Debt and deficits are actually slightly lower in Spain than in the UK. No doubt, the overall economic situation of Spain is worse than that of the UK, but does this explain fully the difference in spreads? Could the answer lie in the difference in monetary policy? In the UK, investors expect the Bank of England to intervene if needed to maintain the good equilibrium, whereas they believe the European Central Bank (ECB) does not have the mandate to do so. These are central questions that we need to study more.

Multiple Equilibria and Communication

In a world of multiple equilibria, announcements can matter a lot. Take, for example, the case of the Outright Monetary Transactions program announced by the ECB. The announcement of the program can be interpreted as having removed one of the sources of multiple equilibria in the sovereign bond markets, namely, redenomination risk, or the danger that investors, assuming that a country on the periphery would leave the euro, ask for a large premium, thereby forcing exit from the euro in the process. The announcement has succeeded without the program actually having to be used.

From this viewpoint, the recent announcement by the Bank of Japan that it intends to double the monetary base is even more interesting. What effect it will have on inflation depends very much on how Japanese households and firms change their inflation expectations. If they revise them up, this will affect their wage and price decisions, and lead to higher inflation—which is the desired outcome in the Japanese deflation context. But if they do not revise them, there is no reason to think that inflation will increase much.

The motivation for this dramatic monetary expansion is primarily to give a psychological shock and to shift perceptions and price dynamics. Will it work, together with the other measures taken by the Japanese authorities? Let’s hope so. But we are very far from the mechanical effects of monetary policy described in the textbooks.

Although I have had to spare mention of many contributions and insights from the conference captured elsewhere in this volume, the conference has left us with a clear research agenda. We at the IMF fully intend to take up the challenge.