Macroeconomic perspectives have been largely missing in the debate on how to prevent a re-run of the present crisis. In CEPR Policy Insight 36, I focus on the macroeconomic instabilities that the crisis has revealed.
The current crisis has brought to the forefront three main problems in the economy: the instability of the price level, the instability of the overall leverage in the financial system, and the increased connectivity of the network of financial institutions within a context of fuzzy boundaries of central bank responsibility.
Macroeconomics can provide important insights into these problems, but, in order to do so, it must move on from the assumption of free competitive markets and the negative feedback loops that ensure equilibrium reversion in those models. In fact, none of the above-mentioned problems can be modelled with such control dynamics.
For example, following the dot.com crash, the behaviour of the price level gave the Fed no clue that it was keeping the interest rate far too low for far too long. Cheap imports from countries with weak currencies kept American consumer goods prices in check during the economic recovery, leading policymakers to believe that the interest rate had been set at the “right” level.
Likewise, debt leverage can grow for years without corrections. When investors increase their leverage, asset prices rise and market participants book profits. These dynamics are reinforced by incentive structures of financial firms and financial analysts, as well as by regulation. In fact, in the recent boom-bust cycle, existing capital requirements have acted as macroeconomic amplifiers. The increase in asset prices opened up room for further expansion of the balance sheet. During the ensuing downturn, capital requirements made deleveraging even more imperative.
Diversification vs. connectivity
Not for the first time, economists have fallen into a fallacy of composition. For the individual bank, of course, the maxim holds true that it is best “not to put all your eggs into one basket.” It turns out, however, that when financial institutions to diversify in every direction they see fit, the nature of systemic risks changes.
As the connectivity of the network of financial agents increases, a disturbance arising somewhere in the system may percolate through the entirety of it. To be sure, whether a disturbance propagates or dissipates depends on several further properties of the network – e.g., leverage level of agents, volume and distribution of “toxic” assets in the economy, and existence of critical nodes in the network that cannot be allowed to fail – but from a macro-prudential standpoint, this means that all the eggs have ended up in the same basket. At the present time, we have on our hands one giant omelette that cannot easily be unscrambled. The challenge is how to structure a governable financial system for the future.
Tackling the systemic problems
There are no obvious, easy, or uncontroversial solutions to these three systemic problems. In my view, the solution to the instability of the price level and the instability of the overall leverage in the financial system lies in re-introducing effective reserve requirements as well as establishing countercyclical capital requirement. The lack of defined boundaries for the responsibilities of central banks, however, raises more difficult questions than can be answered.
A. The price level
Beyond difficulties with inflation targeting, serious inflationary pressures in a few years time may further confirm that the bank rate alone is too weak an instrument of monetary policy. Re-imposing effective reserve requirements would reinvigorate open market operations as a tool of monetary policy.
Reserve requirements would have to be extended in two directions. First, they should cover non-bank institutions that issue demand liabilities. Second, they should extend to the non-deposit short-term liabilities, such as repurchasing agreements and notes.
Monetary authorities should raise capital requirements above “normal” in periods when asset prices rise above the trend of consumer goods prices and reduce them, perhaps drastically, in episodes when deleveraging is the order of the day among financial institutions. The cyclical average should be set at probably no more than half of the leverage levels that the big investment banks reached in the recent boom.
The financial industry may not welcome such a development. A lid on leverage is a lid on the bank’s rate of return. Moreover, such a proposal would turn capital requirements into a tool of monetary policy, thus giving authorities discretionary power and introducing a new type of risk for banks. However, so long as counter-cyclical capital requirements reduce the likelihood of needing future Toxic Asset Relief Programs, governments may consider them a desirable option.
C. The financial system architecture of the future
Turning the clock backwards to replicate the regulatory approach prevailing during the Glass-Steagall days is almost certainly not feasible, and it is probably undesirable. Rather, we should consider establishing a two-tiered financial regulation system that distinguishes between “core” and “peripheral” financial institutions. While core institutions would be subject to stringent reserve and capital requirements and strict supervision, they would be eligible for central bank lender-of-last-resort assistance. “Peripheral” institutions would be less regulated and supervised but would be outside the umbrella of central bank protection.
Such a demarcation of central bank responsibilities would also require some degree insulation of core institutions from the high-risk activities permitted in the periphery.
An obvious problem with the core-periphery idea is that big international conglomerate banks cut across any such dividing line. Would it be feasible to achieve a “core-periphery” structure without infringing greatly on the present structure of the very big banks? If they are not to be broken up into smaller units that would not individually pose serious systemic risk, financial conglomerates must be closely regulated. In either case, their prospective profits are bound to be adversely affected. They will certainly resist any measures that would have that effect – and they have the resources to make their resistance politically effective.
It should nonetheless be possible at least to move in the direction of protecting the core from the periphery – and from itself. Lessons of recent history suggest some measures to consider:
- Force the banks to either bring off-balance sheet vehicles onto the balance sheet or divest themselves of them. Capital requirements might be used to give the banks incentives to rid themselves of these vehicles. (Citigroup lesson)
- Weight capital requirements on lending to hedge funds relatively heavily so as to raise the implicit cost to core banks of such lending. Hedge fund operations by the banks themselves should then be subject to the same capital requirements. (LTCM lesson)
- Forbid “naked” default swaps i.e., pure bets on default by parties who do not hold the bonds that are being insured by the contract. (AIG lesson)