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May 22, 2014 6:08 pm
Sartorial fashion is cyclical. Every few years, certain trends that had dropped out of style become hot on the catwalk again – meaning that ideas are constantly recycled.
Something similar may be under way in central banking too. Five decades ago, central bankers assumed that it was sometimes sensible to use targeted regulatory controls to create a healthy economy and financial system.
But then, from the 1980s, it became fashionable to presume that macroeconomic management sat in a different silo from financial regulation: the former was dominated by debates about inflation targets and interest rates; the latter focused on bank supervision.
Now the pendulum is swinging again. This week, Mark Carney, governor of the Bank of England, warned that the rapid pace of UK house price rises could threaten the British recovery, prompting speculation that the BoE will begin to tighten policy before long.
But if so, it is unlikely to rely exclusively on the tools it has used in the past decade – namely its power to set interest rates or to influence the rate at which money is created. Instead, the bank’s Financial Policy Committee might well turn to so-called macroprudential measures, which are intended to prevent financial excess. For example, it could impose loan-to-value caps for mortgage lending, or require banks to hold bigger capital buffers against certain types of loan.
Such regulatory meddling fell out of favour in the late 20th century. But since the 2008 financial crisis policy makers have discovered what they once knew but seemed to have forgotten: that macroeconomics cannot be divorced from finance and that it is sometimes difficult to steer the economy through interest rates alone.
Thus, when emerging market countries such as South Korea introduced measures to prevent excessive “hot money” investment inflows a couple of years ago, they labelled these “macroprudential” measures, where previously they might have called them “capital controls”.
Then, last year, countries such as New Zealand, Norway and Switzerland borrowed the label, too, to describe moves they were taking to combat domestic credit bubbles. Now big western countries are catching the wave and linking financial regulation to macroeconomic management: aside from the BoE, the European Central Bank is promoting macroprudential measures, too, and the idea is being debated at the US Federal Reserve.
What should investors make of this? One obvious lesson is that progress in policy making tends to follow the pattern of a Hegelian dialectic; ideas that seem terribly old-fashioned to one generation have a habit of being reborn with subtly fresh twists.
Another lesson is that these paradigm shifts do not always start with economists – or big central banks.
Think, for example, about how the last great shift occurred in relation to inflation targeting. Back in the late 1980s, the central banks of New Zealand and Sweden started experimenting with this out of frustration with the shortcomings of the previous central bank paradigm of targeting money supply. It was only later that the concept spread to countries such as the UK, at which point academic economists created an intellectual framework to justify this new mantra.
As Paul Tucker, former deputy governor of the BoE, recently observed, this pattern is playing out again: ideas that started in places such as New Zealand are spreading, and academics are scrambling to catch up. For what is striking about the new macroprudential fashion is that there is still relatively little intellectual scaffolding surrounding it, although groups such as the International Monetary Fund are now trying to put one together.
A third point to note is that central banks (and economists) would do well to be a little humble about their ideas. It is clear that policies such as inflation targeting, money targeting or macroprudential management can all be useful. But they all have potential shortcomings. Setting policy purely to target consumer price inflation does not work well if the biggest danger is an asset price bubble; but meddling in financial markets is not always as effective as raising interest rates to curb bubbles either. What limited evidence there is suggests that earlier experiments with macroprudential policy have produced mixed results
The one thing that is clear is that, whenever there is blind faith in any single paradigm, that paradigm will eventually fail. The fact that the BoE and others are relearning that finance and macroeconomics need to be analysed together is welcome, if long overdue.
But do not expect this new macroprudential paradigm to be a magic wand. Just remember the history of inflation targeting; or think of flares.
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