Scott Sumner  


A Eulogy for Corneliu Mateescu... Exclusionary Inclusivity...

During the Great Recession, many prominent economists told us that we needed to go back to using fiscal policy, as if Congress were competent and powerful enough to steer the business cycle. It is neither. Monetary offset (in 2008, 2009, and 2013) has repeatedly prevented fiscal policy in the US from having the expected effect, and as for competence, Congress just embarked on unprecedented fiscal stimulus at a time of 4.1% unemployment. It's hard to see how any fair-minded observer could conclude that fiscal policy is effective.

Many experts also discussed the need for "macroprudential regulation" of the financial system. It wasn't enough to set a fix set of standards, such as a minimum capital ratio---the regulations needed to be tightened during booms and loosened during recessions. And in fairness, policymakers such as the Federal Reserve are not as incompetent as Congress.

Nonetheless, macroprudentiual regulation has failed almost as spectacularly as fiscal policy. As Kevin Erdmann has persuasively documented, the Great Recession led to a sort of "moral panic", which caused policymakers to crack down on banks. Now that the unemployment rate is down to 4.1%, the Fed has decided that it's a good time to "fill up the punchbowl", and it recently announced new regulations to spur lending:

Federal Reserve policy makers seem to be working at cross purposes.

In laying out plans to ease some constraints imposed on banks after the financial crisis, the Fed is moving to free up tens of billions of dollars for financial institutions to lend to promote faster economic growth.

At the same time it is reducing its balance sheet and gradually raising interest rates to restrain credit creation and keep the economy in check.

"The timing is not the most opportune" for relaxing the banking rules, said Mark Zandi, chief economist at Moody's Analytics Inc. in West Chester, Pennsylvania.

This is the exact opposite of what macroprudential regulation is supposed to look like.

I've also frequently discussed the procyclical nature of monetary policy, with the Fed often (not always) running inflation above target when unemployment is low, and below target when it is high. This violates the dual mandate.

Milton Friedman was right about discretionary policies often ending up being procyclical, and indeed to some extent contributing to the business cycle. But in the case of macroprudential regulations, the problem is not exactly the same as with fiscal and monetary policy.

This is just speculation, but perhaps the problem is a sort of knee jerk "this hasn't been working" mentality. Policy continues under a certain regime for an extended period of time. Then problems develop, and regulators conclude that "this hasn't been working". The problem here is that the regulatory regime was inappropriate for the period before the problems developed. Thus in 2009 there was a general sense that tighter regulation was needed. But you can make a good case that it was needed in 2004, not 2009. Similarly, the slow recovery has created a sense that regulations have been too tight. But arguably they were too tight in 2009, not 2018. Policymakers always seem to end up like generals fighting the previous war.

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COMMENTS (7 to date)
Kevin Erdmann writes:

It is true that once the patient is recovered from pneumonia, it makes sense to remove the oxygen tubes rather than to insert new ones. On the other hand, if your reaction to the pneumonia was to stuff a pillow in the patient's face, it is probably prudent to remove the pillow, even if they managed to recover in the meantime.

db writes:

Pilot (or Operator) Induced Oscillation is a well known phenomenon in aviation and industrial process control that leads to all manner of inefficiency and in extreme cases, disaster. Even operators who are aware of, and attempting to compensate for, their own tendency to induce oscillation find it difficult to do so.

Removing the human element from the control loop usually helps. Sometimes the best solution is just to let go of the controls and allow the system to straighten itself out, if it is known to have sufficient inherent stability. Then once stable operation has been achieved, efforts at returning it to a desired setpoint can be resumed.

But as we all should know here, an economy is far too complicated to be "controlled" as a chemical process can be. Before control can be attempted, the system must be understood and its important parameters accurately measured, and its key control elements identified. We really aren't there yet and probably never will be. The economy is made up of trillions of decisions made by billions of individuals and firms, constantly learning and updating their models of reality. Imposing one model of control on all of that is an act of fatal hubris that, sadly, we keep attempting.

D. F. Linton writes:

Maybe the real-world public choice incentives coupled with the inevitable information deficiencies make counter-cyclical monetary, fiscal, or regulatory policies simply impossible.

The historical record would support the harsher judgement that any such policy however started ends up being pro-cyclical with the rare exceptions down in the noise.

Quite Likely writes:

This has some good arguments for the "automatic stabilizers" side of the debate about how to implement counter-cyclical fiscal policy, but not much for monetary policy over fiscal policy. If we had an entity like the Fed deciding salaries at a job guarantee program or UBI levels or what have you and Congress trying to manage interest rates by passing legislation the situation would be reversed.

TMC writes:

There seems to be enough evidence that an overreach in banking regulation has hurt small businesses, so reform is good. Add the tightening to balance it out as we do not need stimulus. Makes sense.

Alan Goldhammer writes:

TMC writes,

"There seems to be enough evidence that an overreach in banking regulation has hurt small businesses, so reform is good."
This is a false argument as surveys over the past several years have shown that access to capital is not a constraining factor on small business growth.

Straight from the horses mouth (courtesy of the National Federation of Independent Businesses; the key lobbying group in DC):

Three percent of owners reported that all their borrowing needs were not satisfied, down 1 point and historically very low. Thirty-one percent
reported all credit needs met (up 4 points) and 51 percent explicitly said they were not interested in a loan, down 3 points. Including those who did
not answer the question, 66 percent of owners have no interest in borrowing. Only 2 percent reported that financing was their top business problem compared to 21 percent citing taxes, 16 percent citing regulations and red tape, and 19 percent the availability of qualified labor. Thirty
percent of all owners reported borrowing on a regular basis.

Let's not use small business loans as a reason to gut the banking regulations.

Scott Sumner writes:

TMC, Even if true, your point does not address this post, which is about macroprudential regulation.

And while I agree that reforms can be good, and indeed are needed, this is not the sort of reform that is appropriate. We need to reduce the moral hazard in the system.


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