The Limits of Macroprudential Policy: Hardly a magic cure for the credit cycle.

• Author: White, William R.

The global economic crisis that began in 2008 had its roots in excessive and imprudent credit creation and the associated rise in debt levels. Similar "boom-bust" cycles have been seen throughout history, although with increasing frequency and magnitude in recent years. The same history teaches us that problems can emerge in the financial sector and spread to the real economy, but that problems in the real sector can also feed through to weaken the financial sector. The central policy conclusion to draw from this is that, while stability in the financial sector and price stability are both desirable, they are not sufficient to ensure macroeconomic stability. That is unfortunate in that policymakers have been focusing narrowly on those objectives in recent years.

This insufficiency is being recognized in the form of growing concerns about global economic prospects. In particular, the almost total reliance on monetary policy to stimulate aggregate demand in recent years has encouraged a further, sharp rise in global debt ratios. As well, there has been a decline in the quality of that debt, especially with respect to corporations. Given pressure on profits in many jurisdictions, the global financial system also remains vulnerable in spite of many improvements to financial regulation.

To the limited extent that policymakers have recognized the dangers posed by the credit cycle, they seem to have taken comfort in the possible use of "macroprudential" regulatory policies to improve both crisis prevention and crisis management. Such comfort also implies that other, potentially more painful but more effective solutions, need not be envisaged. Again, this is unfortunate since macroprudential policies not only have inherent shortcomings, but are being increasingly applied in ways that are totally inconsistent with how their use was originally envisaged. Indeed, they might now actually be raising the expected costs of future macroeconomic instability rather than reducing them.

A BROADER FRAMEWORK

We are all familiar with traditional microprudential policies (such as those of Basel I and Basel II) directed to improving the health of individual financial institutions. Such policies are essentially static in nature. Macroprudential policies were originally envisaged as financial regulatory policies directed to improving the health of the economic system in general and the financial system in particular. These policies have both a cross-section (static) dimension and a time-varying (dynamic) component. The former emphasizes the systemic threat posed by individual institutions that are "too big/complex" to be allowed to fail, as well as the threats posed by interdependencies within the system. The latter recognizes that risks ebb and flow over the cycle and focuses on...