Macro Prudential Weapon

FERRIER INTERNATIONAL thanks Cees Bruggemans, Chief Economist of FNB for this article which we share with you.

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Macro Prudential Weapon

By Cees Bruggemans, Chief Economist FNB
13 January 2009

Charlie Bean, Deputy Governor of the Bank of England, has referred to it as a ‘macro prudential weapon’. Something deployed alongside the interest rate weapon.

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Be ready to welcome into our global midst sometime soon a new highly potent policy instrument to be deployed in the financial sphere and to be used judiciously and wisely.

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Macro policymakers are moving beyond the real economy’s ability to create instability, mainly through under or overheating and the inflation or deflation pressures this can create, directly in resource and product markets, and indirectly over the balance of payments via the currency.

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For the financial sphere has (again) shown its ability to live in its own world, and to become too roguish by far if unchecked.

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Financial markets are supposed to rationally discount future income streams to fairly valued present asset prices (equities, commodities, properties) using existing interest rates, by their presence and activities enhancing the functioning of the real economy.

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But with the irrepressible human spirit nearly constantly wandering off the rationality reservation, what we get too often for too long in the financial sphere are irrational attempts at co-opting the credit process and leverage. Alternatively we see total withdrawal into a whimpering state of deleveraging.

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Either way, emotion, be it exuberant hubris or anxious hubris (two sides of the same human medal) rule the roost for too much of the time.

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Thus we frequently get rising asset prices that beget more rises which ultimately get airborne on a cloud of positive thinking and leverage, sometimes so wild that we see mushrooming bubbles forming. Only to be followed by descents into the pits of hell as all belief is lost, leverage is unwound and plunging prices beget yet more plunging until assets are ridiculously undervalued, yet cannot find willing buyers.

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Such irrational deviations from fair value are damaging to the progress of the real economy, and far too frequently devastatingly so.

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The regularity of such episodic disconnect between human emotion and the cold rationality of long-term economic activity, its steadfast increasing cleverness and the income streams attached thereto should be a source of wonderment.

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For surely it is possible to do better, having recognized these problems? It is the ultimate optimization problem, reducing excessive fluctuations in economic and financial activity and the feedback loops existing between them.

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Both phenomena show up our ultimate limitations as biological specie, apparently equating to laws of nature, forming unbreakable barriers.

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Alan Greenspan, former Fed chairman and current non-person, now typified as a kind of failed New York Superman for having apparently single-handedly engineered all recent troubles (a terrible simplification, which is in the nature of all witch hunts), recognized both behaviours.

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But while the one law of nature was recognized explicitly the other was more taken as implicit. That’s a huge difference, one that Charlie Bean and others now want undone.

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According to Greenspan, 200 years of US capitalism has shown Americans, and by extension the world, capable of 2.5% annual increases in applied knowledge and its technical embodiment in increasing productivity of the labour force. That is, at the technological boundary. Different logic applies to catch-up stories.

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Anything less than 2.5% annually over time implies underperformance, probably for institutional rather than any inherent human reasons, something that can be rectified through judicious policy action.

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Unfortunately, anything over 2.5% sustained over time at the technological boundary doesn’t seem possible with our present genetic endowment. Our cleverness knows an absolute upper boundary.

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We would have to change the genetic endowment for it to be otherwise, something we naturally are working towards, such being the nature of our ultimate cleverness, but that’s another story.

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When it comes to recognizing madness in crowds, as much when they undervalue assets as when they overvalue them, Alan’s contribution to knowledge was to recognize that we know this for sure only after the event.

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While it is happening we can never be really sure what we are witnessing. A rational response to opportunity, new innovation, underutilization of resources? Or an irrational overreaction?

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It is a view of life that he will never be forgiven in this life, given the enormity of recent financial events that sprouted uncontrollably during his terms of office. Even so, only a few did see it coming and in the nature of mankind were outvoted, and ignored as minority views clearly not in tune with the times.

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An old problem, that. How to honour the whistleblower. The deviant. The problem child. The social miscreant. Social groupings turf such non-conformers out along with the daily rubbish. And then reap the whirlwind.

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So here comes Charlie Bean and many others now saying we need more policy instruments to address these bouts of financial irrationality in an attempt to control more adequately this source of economic instability.

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Interest rate management and fiscal containment are two important macro economic stabilizers, as proven in the past. But something else is needed as supplement in the financial sphere specifically.

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There has traditionally been the suggestion that interest rate policy need be more anti-cyclical, raising rates as good times heat up, heading off excessive exuberance and destructive speculative behaviour.

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But there’s a rub. Interest rates get internalized in any hubris story. Short of genuine killing levels, in the process killing off the high performing economy as well, interest rates have their limitations.

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If economic performance will get killed off by 15% interest rate levels, but financial gains are potentially well in excess thereof, a problem exists. How to contain the episodic financial exuberance without having to kill off the economy by crushing levels of interest rates?

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Having sensible, disciplined regulations is one answer, but even when playing by the rules one finds human emotion capable of transcending the rational boundaries.

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So what’s the real problem? Greed, confidence tricks, consenting behaviour of crowds?

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Given a period of strong economic behaviour and lifting spirits, even a good regulatory frame and anti-cyclical policy stances won’t be enough to contain the human inclination to excess, wishing to be set free and roam where its imagination wants to take it.

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So what’s the answer?

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Probably still regulation, with an anti-cyclical bend, in effect allowing the human spirit to roam free as much as what it likes, but hampered by a simple leash preventing it to soar like eagles on credit leverage.

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This reminds me of my mother on the beach when we were toddlers, with a 20 meter rope attached to her one leg, and a forever exploring baby on the other end, happily wandering off among all the closely packed beachgoers and never getting lost, always remaining teetered to mother, to general hilarity.

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One can do that by manipulating bank capital. Banks effectively lend out multiples of their available capital. But instead of this being a constant, one often finds in good times erosion of the boundaries. Banks’ own leverage tends to rise, as do those of their clients, again illustrated by the recent global episode. In the process, enormous credit juggernauts can get underway.

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It is suggested to raise bank capital ratio requirements in good times, and lower them in underperforming times (when banks in any case tend to become cautious), effectively targeting general leverage.

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It isn’t yet clear who should wield such power, central banks or financial services boards. Each country will solve this problem differently.

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But if you can’t directly address greed without hampering unduly the creativeness of the economic process, nor completely eradicate confidence tricks through regulatory corsets nor fully contain untested financial innovations, nor will want to destroy performance through excessively high interest rates, there remains one possibility.

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Directly contain leverage. Don’t let sources of credit in the economy to mushroom uncontrollably, fueling excessive leverage.

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It would require human intervention in market processes, where we cannot be sure about the expertise required to minimize the damage to sustainable economic progress while trying to limit financial excesses.

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It is something Alan Greenspan was quite outspoken about, claiming not to know when enough was enough, qualifying as financial excess and potentially damaging to the economic outlook.

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But given recent experiences there are enough people around the world now prepared to differ. If it looks excessive, sounds excessive, smells excessive, you can bet your bottom Dollar it is excessive, with a price to pay eventually. Prevention being better than cure (at least in the present episode of financial disruption), opinion favours the creation of a new weapon, most probably some kind of cyclical variability in tightly controlled bank capital ratio requirements.

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And of course yet more transparency in financial affairs.

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As with the level of interest rates, the judgement required over time where to pitch things will decide the difference between promoting optimal performance outcomes as compared to causing underperformance.

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But too much damage has been incurred, too much systemic risk absorbed for it to be different. By living extremely dangerously for a while, incurring grotesque penalties, the world is ready for its next policy innovation.

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Charlie referred to it as a Macro Prudential Weapon. We could call it Prude for short. Keeps you short when you want to go long.-?-? -?-?-?-?-?-?-?-?-?-?-?-?-?

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Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics

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