Interview with Paul M.W. Tucker

Senior Fellow, Kennedy School of Government and Business School, Harvard University; former Deputy Governor at the Bank of England; former member G20 Financial Stability Board Steering Committee.

Has the experience of the crisis changed your view of the central bank policy tool kit?

Deputy Governor Tucker: It would be hard for it not to have made me think about many things. I identify three distinct dimensions: the first is about balance sheet policy, the second about the lender of last resort, and the third about macroprudential policy.

To my mind, balance sheet policy raises more important and interesting questions than does forward guidance. Policymakers already understood before the crisis that it is the whole expected path of future policy rates that affects economic outcomes, and that it is therefore important to reveal information that helps people understand how policymakers think while underlining that they don’t have a crystal ball.

The distinct thing about balance sheet policy is that there isn’t a consensus on the channels through which it works or on its legitimacy. It appears to have worked effectively in the United States and the United Kingdom, but we will learn more from experience in the euro area. I have thought that balance sheet policies work largely through the portfolio balance channel – plus a degree of signaling about future interest rates. But, up to a point, one can give credible signals without balance sheet policy. So in evaluating quantitative easing (QE), we need to know more about the effects of purchases on asset management behavior, and how induced changes in risk premia influence spending in the economy.

Balance sheet policy also raises a set of issues about what is legitimately within the realm of central banking. If we think of central banks as using their operations to change the liability structure and, potentially, the asset structure of the consolidated balance sheet of the state in pursuit of macro-stability, the question is what degrees of freedom they should be granted. One can see that in the European debate about QE over the past year. There was debate not only about whether or not nominal stimulus was needed to achieve their inflation target, which I thought it was, but more profoundly about whether it is legitimate for central banks to go into the market and buy government bonds. For me the answer to that specific question is simple: it is, so long as the central bank freely decides how much and when. But that was an easy conclusion in the United Kingdom because it was a tool that we had used already in the 1980s to help influence broad monetary and credit conditions. Whether it is OK for central banks to buy private sector paper is more nuanced, because of the default risk entailed and because it could be used to favor some borrowers or sectors over others.

We need to get that debate resolved, not least because the move to paying the policy rate of interest on reserves means that the question of asset purchases is not relevant just at the zero lower bound for nominal interest rates. In principle, central banks are going to be able to make separate choices on the policy rate, the size of their balance sheet, and the composition of their asset portfolio. This is all about elected politicians refining the convention that separates fiscal policy which they control themselves from monetary policy controlled by an independent authority.

The lender of last resort part of the central bank toolkit also has two components. The first is that some central banks have been accused of lending to irretrievably insolvent firms. Whether or not that was true, central banks do need to come up with a framework for credibly committing to not knowingly lending to irretrievably insolvent intermediaries. That’s really important in terms of the political economy of central banking.

The second thing here is that some central banks – including the Bank of England – conducted market maker of last resort operations. Quite successfully, I would say, in terms of helping to revive corporate bond markets via modestly sized operations. The question arises whether that should be in the tool kit; if so, how should it be framed; and if not, how central banks could commit never to do it again. For example, is it better to lend secured to shadow banks than to act as a back-stop dealer?  And, what are the implications for regulatory policy given moral hazard problems?

The third area is the most novel – macroprudential policy – which I am going to define as dynamically adjusting regulatory requirements to maintain a desired degree of resilience in the core of the financial system. If regulatory requirements are static and calibrated for a normal risk environment, the system will not be as resilient as desired when it gets into an exuberant phase. Now, this approach of dynamic policy is completely new. It was a key missing element of the tool kit available to the authorities before the crisis. The other reforms of financial policy amount to improving existing regimes, but this is new. No one had conceived before of regulatory requirements being adjusted according to cyclical conditions and threats to financial stability. If it proves effective, it frees monetary policy to remain dedicated to anchoring inflation and stabilizing the path of nominal demand.

Perhaps unsurprisingly, but a bit disturbingly, many of the bigger jurisdictions, including the United States and the euro area, still don’t have comprehensive, coherent macroprudential frameworks. There’s just an enormous amount of work to be done on that. It’s a bit of a revolution in terms of thinking about how the different elements of a stability-policy framework fit together.

Where should we be looking now for financial stability risks given this experience?

Deputy Governor Tucker: The obvious answer is: any large-scale development in the financial system where high leverage meets maturity mismatch meets exuberant credit supply, particularly if the credit is collateralized by illiquid property. Although that sounds obvious, it actually leads to a big point: because regulatory arbitrage is endemic, and because the banking system is being re-regulated to a significant degree, future risks to stability are quite likely to come from outside of the banking system. The financial system is a shape shifter. That means that the key threats are going to emanate from firms or funds or structures that are not under the jurisdiction of banking supervisors or central banks. So other financial regulators – particularly securities regulators – are going to need the mandate and the culture and the knowhow to tackle stability issues. If those conditions aren’t met, we’re in trouble. I am not convinced they are met yet.

I think one can identify current potential threats across a whole range of sectors and countries – because of regulatory arbitrage in some places, and in others because of the effects of a search for yield in an environment of persistently very low nominal interest rates.

What do we need to do to preserve the benefits of global finance?

Deputy Governor Tucker: First of all, we really must preserve the benefits of global finance. No one knows precisely how it supports openness in trade in goods and services. More research is needed on that. But there’s also an element of freedom here as well.

To make it safe, at least two things are needed. First, the core of the financial system must be safe. But as I’ve just said, the core of the financial system is not going to be well defined in the coming years. It is changing.

The other thing policymakers need to do is reduce stability-threatening contagion in the international monetary system. I don’t think that we are going to get to a position where we can be confident that the international monetary system will function with lower imbalances in the pattern of current account surpluses and deficits. The interests of different economic blocs around the world are just too entrenched for credible commitments to be made on more symmetric adjustment to big macro shocks. But more can be done by countries to protect themselves from the stability-threatening effects of hot money inflows, and that would be a breakthrough as contagion has plagued the current international system. We’ve seen policy responses of this kind in a number of emerging market economies in recent years.

The hazard here is that such “whole-economy macroprudential policies” could all too easily tip into a form of protectionism, where countries declare something to be “a temporary macroprudential policy measure to makes the system more resilient”, but in fact they are really managing their exchange rate in what amounts to a beggar thy neighbor policy. I am not yet convinced that the IMF, which has a vitally important role to play here, has grasped the nettle of that distinction and understands how to police it around the world. Put differently, I think there’s potential to make the international monetary system a lot less fragile, but at the risk of the world unnecessarily creeping back into protectionism, and that would be a terrible thing.