Macroprudential regulation: where central bankers stand depends on how they think

Central bankers Glenn Stevens and Janet Yellen: both converts to macroprudential regulation. William West/AAP

Perhaps the most interesting type of reform to have emerged from the global financial crisis is the call for “macroprudential” regulation. Macroprudential regulation, in broadest terms, seeks to manage the level of risk in the financial system at the aggregate – and hence “macro” – level.

Reserve Bank Governor Glenn Stevens, a reluctant supporter of macroprudential regulation, has suggested there’s room for it to be used in Australia for a “limited time”.

“That’s the kind of thing that is in my mind, nothing more. I don’t think that’s any kind of change of tune or anything – I’ve always said I have a certain scepticism about macroprudential tools as a panacea, but I remain open to using them if it seems sensible to do so.”

A crisis of ideas

The global financial crisis was not simply an economic crisis. It was also a crisis of ideas. In its heady early days, world leaders like Gordon Brown and Nicholas Sarkozy called for a “new Bretton Woods”. Closer to home, Kevin Rudd would suggest that the crisis “has called into question the prevailing neo-liberal economic orthodoxy of the past 30 years.”

Yet, expectations of rapid change were soon frustrated. Instead, policymakers like US Treasury Secretary Timothy Geithner recognised the wisdom expressed by John Maynard Keynes in 1933 – that goals of reform and recovery could often be at odds with one another. Keynes even advanced these views in an open letter to Franklin Roosevelt, arguing:

“even wise and necessary reform may… impede and complicate recovery. For it will upset the confidence of the business world… before you have had time to put other motives in their place.”

In other words, even as nervous animal spirits had caused the boom and bust, reform could now push the “state of confidence” in the wrong direction. Reform might be needed, but not too soon, lest it impede renewed growth.

In this light, calls for the imposition of new controls on finance – on executive pay, capital requirements, or types of lending – would be muted over early 2009. Indeed, the problem in the early months of the crisis was not to discourage risk taking driven by unruly “animal spirits.” Instead, it was to encourage risk taking.

Money was being lent by governments to the banks, but the banks in turn were in danger of sitting on their hands. In this light, an important early move by the Geithner Treasury was to introduce “stress tests” which were designed – much like the Roosevelt bank holiday of March 1933 – to provide a means to revive risk taking.

Now, a half-decade out from the GFC, it’s clear what emerged is a gradual transition rather than a “Great Transformation”.

Managing micro risk at a macro level

Macro-level regulation worries less about the health of individual firms than the direction in which the overall economy is trending. Indeed, the oft-derided Geithner Treasury stress tests represented a macroprudential innovation, to the extent that they were meant to increase systemic risk at a time of market pessimism.

More formally, Federal Reserve Vice Chair Stanley Fischer has recently distinguished two meanings of macroprudential regulation. Fischer argues that macroprudential rules pertain to both “the supervision of the financial system as a whole” and “the use of regulatory or other non-interest-rate tools of policy to deal with problems arising from the behavior of asset prices.”

It is because of the second meaning of macroprudential regulation that macroprudential regulation has acquired increasing support since the GFC – particularly among central bankers. This reflects most importantly their institutional or bureaucratic interests, as they are loathe to risk financial instability, but equally unwilling to impose restraint where it threatens to undermine real growth or employment – and so prompt the sorts of political backlash that may jeopardise the ultimate value of policy independence itself.

First, while monetary policymakers might seek to limit inflation or financial instability, they are often hesitant to do so where this requires “taking away the punch bowl” and limiting economic policy growth.

Macroprudential instruments – Fischer’s “regulatory or other non-interest-rate tools” – may enable policymakers to keep a lid on asset or price pressures without raising interest rates and imposing real pain across the economy – and so incur calls for limiting monetary policy independence.

Secondly, where wage-price spirals or asset-price bubbles acquire a self-reinforcing momentum, this can render them resistant to conventional monetary restraint. In such contexts, central bankers often must impose a punishing degree of austerity across the wider economy to achieve “targeted” reductions in financial instability, labour market power driving wage-price pressures, or commodity price pressures.

Where they can employ regulatory mechanisms that contain such pressures “at the source,” policymakers can negate ostensible trade-offs between monetary stability and full employment, as controls can be used to “keep the lid” on financial or monetary instability, while expanding the space for fiscal or monetary easing to spur growth onwards.

Delivering stability and growth

Such benefits of macroprudential regulation have facilitated not simply the broad ideological support for change that marked the early post-GFC setting. They have also fueled a shift in institutional attitudes, as central bankers – most explicitly at the US Federal Reserve – have recognised institutional interests where macroprudential regulation might enable them to better thread the needle of reconciling stability and growth and provide an “alibi” that might limit political calls for restrictions on monetary policy autonomy.

In more historical terms, macroprudential concerns – albeit by other names – have been at the centre of policy debates for nearly a century. First, in the midst of the bull market of the 1920s, again by wartime economists in the 1940s in the form of wage and price controls to boost wartime production, and in the 1970s when Nixon-Ford Federal Reserve Chairman Arthur Burns argued that wage-price restraints could limit “stagflationary” excesses, holding down labour pressures for higher wages while enabling fiscal activism.

In the early 2000s, Federal Reserve Board Member Edward Gramlich urged more direct regulatory efforts to tamp down on subprime abuses, in advance of the acceleration of the subprime bubble itself.

And most recently, Federal Reserve Chair Janet Yellen has argued that:

“it is critical for regulators to complete their efforts at implementing a macroprudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability issues rather than on price stability and full employment.”

Taken as a whole, this analysis highlights the irony that the most substantial policy changes to emerge from the GFC have reflected less populist appeals or a neo-liberal critique so much as a shift in technocratic attitudes. In short, where bureaucrats “stand” depends not only on where they “sit” but also how they think.