The global financial cycle and macro-prudential policies

Articol publicat în World Commerce Review, septembrie 2014

Whmacro-prudential policies?

The current financial crisis has highlighted financial stability as a paramount objective  of economic  policy. Macro-prudential measures  (MPMs)as a recontemplated and, in some instances, already implemented by European national authorities, aim at enhancing financial stability.

These measures  range  from loan to value caps for mortgage lending   to   banks’  holding   bigger   capital   buffers  against various categories  of loans. While there  is a history of such measures  practiced    in   emerging    economies,   they    are, arguably, a novel(some would say a resuscitated)  tool in many advanced  economies, where a simplistic paradigm  dominated macroeconomic and  financial policies in recent  decades. But the ‘Great Recession’ has changed the conceptual framework substantially.

The purpose  of MPMsis, therefore, to diminish the dynamics that lead to boom and bust cycles while there  is wide acknowledgment that price stability is not sufficient for achieving financial stability. This objective is all the more important  at  a time  of still significant  injections  of liquidity in  global  financial  markets  which, against  the  backdrop  of investors’ intense  search  for yield, causes  considerable  over- valuation of financial assets.

In the US, Janet Yellen, the new chairman of the Fed has stressed that   macro-prudential  instruments,  rather   than   monetary policy,  are  the   means   for  dealing   with  macro-prudential, financial stability1. This view was also echoed  by ECB officials; the  ECB Vice  President   Vitor  Constancio  said  that   macro- prudential measures“…are more compatible and effective to deal with imbalances in asset markets”.2

Macro-prudential  policies can  have  diverse  effects  in highly integrated financial markets  and  spillover effects, which  do influence  their effectiveness,  need  to be  taken  into account. In Europe, although there  is market fragmentation under  way under the impact of the deep financial crisis, the single market for financial services is not a chimera for it has a concrete meaning and content. Moreover, the need for MPMs in the euro area is to be seen against the backdrop of limited macroeconomic policy instruments in its member countries.

One could even argue that the need for MPMs in this area gives more salience to its incompleteness as a monetary  union; that these  measures  are a substitute for capital controls, that  they are a suigeneris way of dealing  with the  ‘trilemma’of open macroeconomics (how to reconcile a free flow of capital with exchange   rate  stability  and  independent  monetary   policy). In the  European Union, spillover effects that  derive from the implementation  of  macro-prudential  measures   (MPMs) can entail positive as well as negative effects.

Making judgments on MPMs is to be seen from the need in the EU to:

a. coordinate policies for the  sake of achieving  common goals;


b. have a collective policy stance  wherever  it is suitable, which is clearly the case in an economic  area that aims at establishing  a banking union which would go beyond  the borders of the euro area;


c.  consider  the  linkages  between monetary  policy and financial stability policy, however much one would entrust each of them  with particular goals (fitting the Tinbergen assignment problem).


Thnature and drivers of the financial cycle matter

Implementing MPMs has to be seen within abroad conceptual framework,  which needs  to pay attention  to financial cycles. As Borio3   observes,  financial cycles cover  much  larger  time frames than business cycles and a reshaped  byself-reinforcing interactions   among   perceptions   of  value  and   risk,  which translate  into  booms  followed  by  busts4   can  be  seen  as  a precursor of this line of reasoning). This evolution is correlated with a big rise in debt (private) relative to income (GDP).

A key tenet  of the Financial Cycle paradigm, as propounded by Borio and  others  is that  financial liberalization enhances the amplitude  of financial cycles. Another tenet  is that a one-sided (focused exceedingly on inflation) monetary policy is inadequate since it does preclude the adoption of MPMs that could mitigate boom  and  bust  dynamics, resource  misallocation. Borio and Disyatat5  talk about  a ‘policy drift’ when there  is maintenance of low interest rates for too long. Such a drift would accentuate over-borrowing and debt over hang.

Regarding the  current  circumstances  in the  world economy, one  can  detect   a  clash  of views with  regard  to  the  policy effectiveness   a  central   bank  can  obtain   in  combining   its monetary stance with MPMs. While BIS experts seem to favour a monetary policy geared toward a sooner rather than later policy rate rise for the sake of weakening boom and bust dynamics in6, the Fed and the ECB would rather maintain a relaxed MP stance.

In Europe, the threat  of debt  deflation is judged  by not a few central bankers as quite menacing  and asking for a continued relaxed monetary  policy. And numbers  fuel this apprehension for a headline inflation rate of just 0.4% last July is much below the ECB target at a time when correction of public and private debts is still a very protracted process.

While the assessment of the various tools central banks have at their disposal in order to deal with macro-prudential concerns is of great  importance, another  key  issue pops up: the shape and  nature  of  financial cycles, and, especially, of the  ‘global financial cycle’.

It is useful here to distinguish between an ‘ordinary’ and what could be  named  a‘policy-drifted financial cycle’. The former would be an unavoidable  (endogenous) financial cycle, which is not  biased  by suboptimal  policies considerably. Whereas a derailed, drifted cycle would be heavily influenced  by drifted policies. In this context, the  role played by major economies, as‘market-makers’,  is to  be  highlighted.  Helene  Reyspeaks, in this context, about  a ‘dilemma’ instead  of the ‘trilemma’, in the sense  that  a global financial cycle, which is driven by the monetary policies of ‘centre countries’, sets the tone for the rest of the world irrespective of operating exchange rate regimes7.

Whether  a  ‘dilemma’, rather  than  a  ‘trilemma’,operates for policy-makers  is less  relevant  for  both  views  acknowledge that  well targeted capital  controls  can  play a useful  role in broadening national policy space8.As spillover effects of MPMs adopted by EU member states are so much more important  for the ECB, for the Union as a whole, the same logic can be applied to the global economy with regard to the policies of the central banks  that  provide  reserve  currencies. This is why what  the Feddoes is of enormous significance to the shaping of macro- prudential policies in Europe and elsewhere in the world.

Can MPMs be coordinated internationally?

A fundamental  question,  consequently,  arises:  what  is  the relationship  between national  macro-prudential policies and the financial cycle in the global economy, with the latter being so much under the impact of major central banks’ policies? QE (quantitativeeasing) comes to one’s mind in this regard, but not only. Policy coordination  between the Fed and the ECB (ESRB) would be welcome under such circumstances. But how much is it feasible in view of the policy mandates central banks have, and which focus, primarily,on domestic economic conditions? Several related  policy inferences  can be  made  following the observations  made above.

MPMs need to consider drivers of financial cycles, whether there are policy drifts that derail these cycles;


What drives the global financial cycle is critically important

“What is the relationship  between national macro-prudential policies and the financial cycle in the global economy,with the latter being  so much under  the impact of major central banks’ policies?”and, in this  context, the  role played  by market-makers’ policies; for what could appear a justified macro-prudential measure  to a major central  bank, may cause  tremors  in other markets;

There is, arguably, an optimal degree  of financial liberalization,   for   emerging    economies    in   particular (one reason  being  that  they cannot  borrow in their local currencies);

Targeted capital controls can play a useful role in underpinning  financial  stability  in  economies   that  can be  ravaged  by massive  flow reversals. This observation should  be examined  in conjunction  with the  risks posed by growing inter-connectedness in financial markets and, correspondingly, by an erosion of robustness and resilience of economic systems;

There  is need   to  think  about   and  try  to  shape   inter- connectedness(asuggestionmade  byAndrewHaldane andothers)9;

The reform of regulation  and supervision of financial markets and the change of business models in the financial industry could bring about more robust and resilient organizations and economic systems;

Rediscovering the logic of the Bretton Woods arrangements would bolster  the  resilience of the  international financial policy regime10;

Designing proper  regulatory  and supervision frameworks of finance in the ‘market-maker’ (big) economies is essential for dealing with negative spillover effects of their policies.

How can the  ECB coordinate its policies better  with the  FED and other major central banks, for the sake of mitigating boom and  bust  dynamics  in the  global  economy, has  to  be  given more clear answers. Is the Financial Stability Board an effective instrument to this end?What about G-20 in this regard? Can the IMF play a significant role in this respect? There is so much still to be figured out in order to make macro-prudential policies effective instruments.


1.Yellen,Janet,as quotedby Reutersin“Yellendriveswedgebetweenmonetarypolicy,financialbubbles”,7July,2014

2.Constancao,Vitor,as quotedby WallStreetJournal,“MoreECBstimulusisn’tlikelysoon?28July,2014

  1. Borio, Claudio,“Thefinancialcycleandmacroeconomics:whathavewelearned?”,BISWorkingPapers,no.395,December2012


5.BorioClaudioandPitiDisyatat,“Lowinterestratesandsecularstagnation:isdebta missinglink?”,Voxeu,25June2014



7. Rey,Helene:“DilemmanotTrilemma:theglobalfinancialcycleandmonetarypolicyindependence”,Voxeu,31August2013

8.Klein,MichaelandJayC. Shambaugh:“Istherea dilemmawiththetrilemma”,Voxeu,27Septeber,2013


10.Stiglitz,Joseph,“Riskandglobaleconomicarchitecture:  whyfullfinancialintegrationmaybeundesirable”,AmericanEconomicreview,Papersand

Proceedings, 100,May,388-392,2010