Australia mustn’t jump the gun on macro-prudential policy

The Financial System Inquiry’s interim report recognised that the Reserve Bank and the Australian Prudential Regulatory Authority have considerable scope to manage risks to financial stability without greater reliance on so-called macro-prudential policies.

It noted that the effectiveness of such measures is not well established and that there are practical difficulties in their implementation. The inquiry largely echoes the views of the Reserve Bank and other Australian regulators on this issue.

At the same time, the report argued that household sector leverage and the financial system’s exposure to housing posed risks to financial stability. In Britain, New Zealand and some countries in Asia, these risks have seen the introduction of new macro-prudential policies.

These policies are partly based on a false narrative about the causes of the recent global financial crisis that fails to recognise the central role played by the politicisation of housing finance in the US as a causal factor. For financial institutions in Britain and much of the rest of the world, it was their exposure to a politicised credit allocation process in the US that caused problems, rather than home-grown excesses.

There are good reasons for Australia not to follow other countries in making greater use of counter-cyclical, macro-prudential policy instruments.

The term ‘macro-prudential’ regulation has its origins in the Bank for International Settlements in the late 1970s, although has assumed much greater prominence in the wake of the global financial crisis. It refers to regulation that has as its objective the stability of the financial system as a whole, as opposed to micro-prudential regulation, which is focused on the stability of individual financial institutions. This recognises that risks to financial stability can emerge at a macro level that might otherwise fall outside the scope of micro-prudential regulation.

While the term has only recently come into widespread use, there is nothing new in the policy instruments designed to give effect to macro-prudential policies. These tools have a long history, although their use mostly pre-dates the financial deregulation seen since the early 1980s. Macro-prudential policy instruments were part and parcel of the apparatus of financial repression used to regulate financial markets and credit allocation before deregulation, although often as permanent features of the financial system rather than counter-cyclical policies.

Policymakers have yet to establish how greater counter-cyclical use of quantitative controls over the supply and demand for credit based in part on macroeconomic conditions can be effectively reconciled with a more deregulated financial system in which financial market prices now play the dominate role in allocating capital.

In the wake of financial market deregulation, changes in official interest rates have been the main instrument through which authorities have sought to promote price stability and, at least indirectly, financial stability. This influence over the price of credit has always been partial in a deregulated environment, because the wholesale and retail interest rates at which people actually borrow are market-determined. This is especially true for a small, capital importing country like Australia, for which interest rates are determined in global markets.

Moreover, monetary policy is a blunt instrument, making it unsuitable for addressing what are seen to be excesses in credit growth tied to specific asset classes. Central banks have a poor track record when it comes to taking an activist approach to changes in asset prices. It was Milton Friedman who showed how the Great Depression had its origins in an all-too-successful attempt by the Federal Reserve to pop a stock price bubble, an assessment former Federal Reserve chairman Ben Bernanke subsequently endorsed.

The danger is that monetary policy becomes miscalibrated for the broader economy when central banks seek to manage prices in asset markets that are viewed as disconnected from economic fundamentals. That disconnect is itself a strong argument against such activism. When it comes to asset price booms and busts, central bankers can be divided into asset price ‘poppers’ and ‘moppers’, but the weight of historical experience strongly favours the mopping-up approach.

Macro-prudential policies are seen as providing policymakers with a more targeted set of policy instruments that might complement or even substitute for changes in official interest rates. However, these instruments also implicate policymakers in making much finer judgements about risks to financial stability as well as the more traditional concern of monetary policy with price stability.

A blunt instrument like monetary policy encourages caution in making such judgements. By contrast, more targeted counter-cyclical quantitative controls are a standing invitation to micro-manage credit allocation, but do not in themselves improve the ability of policymakers to make appropriate judgements about the implications of such policies. It can also create a false impression that a central bank’s price stability mandate has been subordinated to other objectives, such as house price inflation.

Macro-prudential policies are also more politically fraught than traditional monetary policy. Quantitative controls designed to be selective in impact are more likely to provoke opposition. In Britain, macro-prudential policies are at cross-purposes with the government’s ‘Help to Buy’ mortgage guarantee scheme. Macro-prudential regulation is often a second-best approach to dealing with the inflationary implications of supply-side rigidities in housing markets. It may also push borrowing and lending activities outside the regulatory perimeter altogether.

Dr Stephen Kirchner is a research fellow at The Centre for Independent Studies.