Charles Plosser, former President, Federal Reserve Bank of Philadelphia; former Dean, Graduate School of Business Administration, University of Rochester.
Has the experience of the crisis changed your view of the central bank policy tool kit?
Former President Plosser: I would say that the tool kit has not changed so much but the willingness to exploit it has expanded. Central banks have long had a great deal of power to intervene in financial markets in the conduct of monetary policy. Wide differences, however, have prevailed in central banks’ regulatory and supervisory responsibilities over the financial sector. It is worth remembering that whether a central bank was responsible for financial supervision or not made little difference in the ability of policymakers to anticipate the crisis or the resilience of the financial sector to the ensuing turmoil.
On the monetary policy side central banks have clearly pushed the envelope in an effort to stabilize and then promote real economic growth. The pressure to do so has come from inside and outside the central banks. These actions have raised expectations of what the central bank can do. For the last three or four decades, it has been widely accepted among academics and central bankers that monetary policy is primarily responsible for anchoring inflation and inflation expectations at some low level. In the United States, where the Fed operates under the so-called dual mandate to promote both price stability and maximum employment, monetary policy has also attempted to stabilize economic growth and employment. Yet it has also been widely accepted that monetary policy’s impact on real variables was limited and temporary, thus in the long-run changes in money were neutral for real variables.
The behavior of central banks during the crisis and subsequent recession has turned much of this conventional wisdom on its head. It is not clear that this is wise or prudent. Many have come to fear that without substantial support from monetary policy our economies will slump into stagnation. This would seem to fly in the face of nearly two centuries of economic thinking. More broadly, central banks seem to have tacitly accepted the idea that financial stability, whatever that may mean, is now their primary purpose. Shifting goals and objectives in such a manner is fraught with risks.
The authority of monetary policymakers to intervene in financial markets has come to be accepted and expected. Whether the purpose is to change the relative price of various assets, such as long vs. short dated Treasuries, or to alter the allocation of credit, such as Treasuries vs. mortgage-backed securities, the result has been a much more interventionist central bank. The belief is, of course, that central bankers know enough to control relative asset prices with sufficient precision and that the transmission mechanisms and consequences are sufficiently predictable that policymakers can better control real economic growth and employment, and now, financial stability.
I find this a dubious proposition at best. For central banks to act as if these conditions exist suggests to the public that monetary policy has great ability to fine tune economic outcomes. That means monetary policy makers may well be accepting more responsibility for managing economic outcomes than they, in fact, can deliver. This is a recipe for failure and can undermine the public’s trust and confidence in the central bank. So maybe a little more humility on the part of central bankers and the public regarding what they monetary policy can accomplish is in order and a little less intervening just because it can, or has the power or authority, may be prudent. Monetary policy simply cannot solve all economic problems that may ail our economies.
Where should we be looking for financial stability risks given this experience?
Former President Plosser: That is a very hard question. As I mentioned, no regulatory authority anywhere in the world, no central bank no financial supervisory agency, saw the crisis coming. What makes us think we will spot the next one? Whenever it arises it will surely come from somewhere the authorities were not looking.
We face a number of challenges. First we have the problem of defining financial stability. I know of no good definition. Without a definition how do we know if we have succeeded? How do we know if we have over compensated and reduced risks too much without some metric that tells us of the trade-offs? Implicit in the Dodd-Frank legislation is the view that if only we could write enough rules and prohibitions on the financial sector we could solve the problem. I believe this is a bit like the dog chasing its tail, and equally futile.
Second we should acknowledge that stability risks can move around. Where regulators look, those risks are unlikely to be found. The challenge is figuring out where they will show up next. Financial markets are adept at packaging and repackaging risks in forms that the market will buy. There is nothing inherently wrong with this except regulators will always be behind the market developments.
Finally, the central bank should be particularly vigilant in not artificially encouraging financial imbalances or stability risks through its monetary policy actions. Unfortunately, this may bring financial stability and the goals of monetary policy into stark conflict. There is an ongoing and important debate on this issue. That is, should monetary policy be used to address financial stability risks or not; what if it’s a source of the risks?
Today the stated goal of the interventions undertaken by the Fed such as the asset purchases or the maturity extension program have been intended to encourage risking-taking and alter the portfolio balances of economic agents. If successful, these actions distort market prices. One stability risk worth considering is: What happens when the Fed stops distorting prices?
What do we need to do to preserve the benefits of global finance?
Former President Plosser: The financial sector is important and global finance has lowered the cost of international trade and enhanced the movement of capital around the globe. We should be careful not to condemn all of financial engineering as bad.
One of the big challenges facing global financial firms is regulation. The regulations governing financial institutions are very complex, even for domestic firms. For international firms it is even worse because the rules can differ significantly across countries. A greater degree of harmonization of regulations would tend to help make global finance more efficient.
One approach to promoting more uniform treatment of financial regulation is simplicity. Much of the strategy of regulation is to control the products and activities of financial institutions. Yet the history of regulatory arbitrage is that these financial institutions are creative and can find ways around the regulations. Thus products morph into new products that have to be regulated and the regulations always lag and just pile up.
One thing we have learned is that capital is an important buffer for financial institutions. The more capital they have the better able they are to withstand financial shocks and thus the more stable the financial system. I think that substituting larger capital requirements for much of the current micro-regulation of these institutions would be beneficial. It would simplify both compliance and enforcement. It would make it easier for markets to assess the soundness of the institutions as well as the regulators. For example, I would support the substitution of simple leverage ratios for ratios based on the Basel risk weighting of assets.
In the same vein, regulators should seek to use market forces effectively in monitoring the health of these institutions rather than regulator judgement and discretion. In other words devise methods that allow the markets to do the work of regulators. This, in part, is the idea behind the issuance of contingent claims that can be converted to equity if market prices suggest an undercapitalized institution.
Finally I would mention the “too big to fail” issue. Increasing the odds that large financial firms will not fail is useful, but may lead to over regulation, that is, to too few firms failing. Failure is necessary for a market-based system to provide the benefits it is capable of bringing to the table. Thus there must be a mechanism that allows these large firms to fail without bringing down the entire system. From an international perspective this is a very difficult problem. That doesn’t mean it is impossible but by simplifying the regulations this may become easier to accomplish.