Must-Read: Barry Eichengreen: The Promise and Peril of Macroprudential Policy
Must-Read: As I sometimes say: Perhaps 5% of the things I say that are smart and worth saying our simple borrowings from the extremely learned in a very sharp Barry Eichengreen three doors down the hall. And another 5% are generated by the sub-Turing instantiation of Barry Eichengreen’s mind I have running on my wetware–the thing that answers me when I ask myself: “What would Barry think?” (He would say that those are, in turn, simple borrowings from the late Charles Kindleberger.)
Thus it is with some pain that I think this morning that Barry has gone squishy and optimistic in his flirtation with the idea that perhaps, when asset prices are bubbly, central banks should raise interest rates about levels appropriate for optimal control based on current unemployment-and-inflation conditions. It has always seemed to me that raising interest rates knocks down asset prices by knocking down their fundamental values. It thus affects a bubbly asset price only to the extent that the marginal investor has a good sense of fundamentals on top of which he or she layers a bubble premium. I suspect that model of the marginal investor in a bubble is rarely right.
I am still much more of the quantity-and-collateral-controls view. I remember Bill Janeway’s line: “When you give a banker credit during a bubble, you know what they are going to do, you just do not know what wall they are going to do it against”.
: The Promise and Peril of Macroprudential Policy: “Central bankers continue to fret about frothy asset markets–as well they should…
…What, if anything, should be done to minimize the risks of a rapid and sharp asset-price reversal? For many years, this question was framed according to… ‘lean versus clean’…. Should central banks ‘lean’ against bubbles… or just clean up the mess after bubbles burst?… 2008-2009… demonstrated [that] merely cleaning up after the bubbles burst is very costly…. So what should central bankers do instead?…
Specially tailored financial tools… raising banks’ capital requirements when credit is booming… [to] restrain lending and strengthen banks’ cushion… setting ceilings on loan-to-value ratios…. Unlike such tools, interest-rate policy is a blunt instrument… [and] interfere[s] with the central bank’s primary objective of keeping inflation near target. Unfortunately, the development and use of macroprudential tools faces considerable economic and political obstacles…. Once a mania gets underway, the temptation to join is simply too strong…. [Where] homeownership [becomes] virtually an entitlement, measures making it more difficult would whip up a political firestorm….
Policymakers should respond to these challenges by working hard not only to develop effective macroprudential tools, but also to demonstrate that they can be deployed evenhandedly… the process will take time. In the meantime, situations may arise in which the interest rate is the only instrument available…