The disastrous financial crisis of 2007-2009 underlined the serious damage our economy suffers from booms and busts in the financial system. The harm from busts is obvious, with credit crunches inhibiting business investment and consumer purchases while falling asset values destroy confidence and lead to further cutbacks. As a result, serious financial busts produce severe recessions. The excesses of boom times do harm as well, mostly by setting up the inevitable bust, but also by encouraging activities that are a poor use of resources, simply because money is so cheap and readily available. Think about the vast waste during the "Dot Com" bubble for what can happen when silly money floods into a sector of the economy. The housing bubble that helped lead to the recent financial crisis was less silly, but ultimately more harmful.
There is more that the Federal Reserve and financial regulators can do to moderate the financial cycle. It will never be possible to eliminate the cycles, which stem from multiple causes, including the basic human tendencies towards "group think" and extremes of optimism and pessimism. However, authorities do have the ability to change incentives to discourage excesses during boom times and encourage sound economic activity when pessimism reigns.
Academics, think tankers, and policymakers around the world are increasingly interested in an approach that has been dubbed "macroprudential" policy. This ugly word refers to an approach which focuses on fundamental factors that run across the financial system, rather than simply looking at each financial institution on a stand-alone basis. Policies can be designed to spur financial activity during busts and rein it in during booms. For example, there is now an agreement at the global level that bank capital requirements should be toughened during boom times by requiring an additional amount to be held, known as a "counter-cyclical buffer." This is intended to push banks to slow down their growth when speculative excesses exist while also building their margin of error to handle the bust that is likely to follow. Had regulators pursued such a strategy in the boom years preceding the financial crisis of 2007-9, the excesses might have been less and there would certainly have been more resilience in the banking system to cope with the fall-out when it all collapsed, which would have considerably reduced the damage to the wider economy.
The US needs to do more to build a base of infrastructure and political support for such policies. Regulators already have the legal basis to use many of the macroprudential tools, including countercyclical capital buffers. But, implementing the massive changes to financial regulation stemming from the Dodd-Frank Act has left little time and energy available to focus on the practicalities of macroprudential policy. Now is a good time to start taking this more seriously. The UK has already established a workable macroprudential framework and has begun to take concrete actions to deal with risks in their housing system. We are years away from being able to take actions similar to this. Key principles need to be decided, many practical issues have to be thought through, and a base of political and bureaucratic support needs to be built. These will take years and we do not want to rush this thinking if dangerous conditions start to build unexpectedly.
One essential step is to create a consensus across our fragmented financial regulatory system and among key members of Congress and the Administration about such policies. Many in Congress, for example, are presumably skeptical about the ability of regulatory authorities to spot bubbles that the private sector has missed and to respond appropriately. This is a fair concern, but the incentives for a macroprudential authority to respond to increased risks in the system are much higher than for Wall Street or investors to give up on seemingly easy money during a boom time. The authorities could act to increase safety margins and reduce excess risk without having to know that bubble conditions were prevailing. They could judge based on probabilities and risks rather than certainty. There were plenty of signs in 2005 and 2006 that we might be in a bubble. We should have taken measures to reduce the attendant risks, even without certainty. Better to have taken a chance on a modest pullback of growth rather than to allow inaction to feed the disaster that in fact ensued.
Other skeptics will argue that the political pressures will be too great for any authority to act meaningfully. There are two answers to this. First, would it not be worth trying, if the only downside is that we effectively have the same approach of inaction that we do now? Second, there is actually a long history of such actions in the US prior to 1980, about which I have written. We took analogous actions, although we did not call them macroprudential, under governments of both parties and in quite different ideological environments. So, the political constraints are not as large as often claimed.
Using macroprudential policy to counter dangerous booms and busts is a good idea and has strong support from academics and policymakers. But, we need to push forward if we want to have the abilities in place when they may be needed.