I firmly believe that the U.S. needs to use macroprudential tools as a way of reducing the harm from cycles in the financial system. The traditional options—monetary policy and standard safety and soundness regulation—have real weaknesses. Monetary policy is generally too blunt a tool, since forcing interest rates up or down for the whole economy is an inefficient way to deal with issues specific to the financial system. On the other hand, traditional financial regulation is so focused on each individual financial institution that it often misses larger trends in the system as a whole. Macroprudential tools have the corresponding advantages of operating on the financial system as a whole, but without doing unnecessary collateral damage to the rest of the economy.
The recent study that I did with Greg Feldberg and Andreas Lehnert solidifies my view that macroprudential policy is valuable, but that we also must be aware of its limits and of the need to develop a better framework for understanding the tools and how best to use them. Our comprehensive review strongly suggests that the macroprudential actions of American authorities over many decades achieved their purposes, at least in part. To be fair, the analysis shows a relatively weak effect and the results are not always statistically significant. However, this is the first study to provide such a comprehensive analysis and it is very likely that more refined approaches to analysing the data will find clearer results. We see promising ways to improve the analysis and doubtless other researchers will find even more. Our collective understanding of macroprudential theory is also much better now than it was a few decades ago, which should allow us to optimise our actions in ways that we did not do in the past.
While I’m confident that macroprudential policy is useful, it is critical not to overstate what it can achieve or the ease with which it can be implemented effectively. We are in the early days of macroprudential policy, akin perhaps to where monetary policy stood in the 1950s. We need more refined theory, better statistics, and, unfortunately, we will also need to learn by experimentation. The good news is that any moderately intelligent macroprudential policy is likely to be better than our de facto policy of recent decades, which was never to use these tools, effectively leaving their setting at “off” even in the midst of the biggest credit bubble in history.
Macroprudential policy may be particularly helpful in the next decade or two, because the other choice is likely to be the blunt application of monetary policy. Non-intervention will not be politically viable in the wake of the financial crisis. Some may argue that the quantitative easing belies this, with authorities deliberately creating a bubble, or at least risking one. Whatever one’s views of the value of QE, the current situation is a transitional one and there will be a need to counteract any credit boom, or to prepare for the consequences of its eventual reversal, whether that boom is in process now or is a future contingency.
American policymakers generally view macroprudential policy favorably, but we do not have a good governance structure for it and the resources being put into considering it are far less than those devoted to implementing Dodd-Frank, for understandable reasons. We do not need to instantly get the macroprudential policy framework right, but we should be shifting our attention increasingly to that topic. It may not be all that long before we have to choose whether and how to use macroprudential tools. The tools to be considered should include the core tools of counter-cyclical capital buffers, counter-cyclical liquidity buffers (after we settle on the base liquidity rules and have some experience of them), and limits on loan-to-value (LTV) ratios for mortgages or capital requirements that vary with LTV ratios. We may also wish to consider setting minimum collateral requirements or haircuts for transactions involving the repurchase agreements and securities lending.