Central Banking, Asset Prices and Financial Fragility

Éric Tymoigne

• Publisher: Routledge
• Year: 2008
• ISBN:
  9781135976729
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The current literature on central banking contains two distinct branches. On the one side, research focuses on the impact of monetary policy on economic growth, unemployment, and output-price inflation, while ignoring financial aspects. On the other side, some scholars leave aside macroeconomics in order to study the narrow, but crucial, subjects of financial behaviours, and financial supervision and regulation. This book aims at merging both approaches by using macroeconomic analysis to show that financial considerations should be the main preoccupation of central banks. Eric Tymoigne shows how different views regarding the conception of asset pricing lead to different positions regarding the appropriate role of a central bank in the economy. In addition, Hyman P. Minsky's framework of analysis is used extensively and is combined with other elements of the Post Keynesian framework to study the role of a central bank.

Tymoigne argues that central banks should be included in a broad policy strategy that aims at achieving stable full employment. Their sole goal should be to promote financial stability, which is the best way they can contribute to price stability and full employment. Central banks should stop moving their policy rate frequently and widely because that creates inflation, speculation, and economic instability. Instead, Tymoigne considers a pro-active financial policy that does not allow financial innovations to enter the economy until they are certified to be safe and that focuses on analyzing systemic risk. He argues that central banks should be a guide and a reformer that allow a smooth financing and funding of asset positions, while making sure that financial fragility does not increase drastically over a period of expansion.

This book will be of interest to students and researchers engaged with central banking, macroeconomics, asset pricing and monetary economics.

1 Introduction

For most contemporary economists, the main goal of a central bank is to achieve price stability, that is, low and stable inflation. Financial management, regulation, and supervision are additional concerns that represent the prophetical element or “extension” of a central bank (Greenspan 1996). This position is rooted in a presupposition that goes back to the quantity theory of money, i.e. inflation has monetary origins and the central bank is the institution that controls the money supply. In the past, this view has been shared with more or less conviction by economists, but with the emergence of the New Neoclassical Synthesis, output-price stability has become the overriding goal of a central bank, which is supposed to promote robust economic growth and financial stability.

The position taken in this book is the opposite. Financial matters should be the primary preoccupation of a central bank, and other public institutions should deal with inflation. Central banks have been created to take care of financial matters, not price stabilization or the fine-tuning of economic activity, and it is only recently that their role has changed dramatically (Goodhart 1988). The problem becomes determining how a central bank can improve its current framework to deal with financial concerns. Indeed, one may wonder if the current supervisory and regulatory policies, together with the lender of last resort, are enough, and if focusing on financial matters substantially changes the way central banking should be practiced.

To provide an answer to these questions, this book uses a macroeconomic framework that emphasizes financial aspects. Most of the literature on central banking written by macroeconomists focuses on the impact of monetary policy on the production side of the economy (economic growth, unemployment, output-price inflation), while totally ignoring the financial implications. On the other side, some economists leave aside macroeconomic implications in order to concentrate on the narrow, but crucial, subjects of financial behaviors, and financial supervision and regulation. This book aims at bridging the gap by using macroeconomic arguments to show that financial considerations should be at the center of the preoccupation of central banks. By focusing on the financial side of the economy, this book shows that the current manipulation of interest rates in order to fine-tune the economy is inappropriate because its effects are weak and uncertain, and they may generate financial instability and speculation. Central banks would be much more effective in their management of the economic system if they concentrated their efforts on direct management of the financial positions and financial practices.

The book argues in favor of the creation of a highly developed proactive financial policy that takes into account both the actual and expectational sides of the financial frame. A Financial Oversight and Resolution Commission (FORC) should be created to monitor constantly developments in the financial sector, in the same way the FOMC monitors economic activity today. This Commission would approve financial innovations before they are used, and would foster research toward financial systems and instruments that promote financial stability and social welfare. The Commission would also aim at constantly improving its supervisory and regulatory framework by concentrating its research toward a better understanding of the aggregate, sectoral, and individual sensitivity of balance-sheet positions, cash-flow positions, and position-making sources, to changes in variables such as asset prices, income, and expectations. The goal would be to develop a cash-flow-oriented approach to systemic risk and to monitor financial innovations. The current focus on capital requirement is not enough, not only because the level of capital equity may have non-linear impacts on risk aversion, but also because capital requirements may reinforce financial instability. In addition, capital equity is not the appropriate variable to check financial fragility because equity is a residual variable, and a growing equity may not reflect economic success and a higher capacity to meet contractual and compulsory payments. Only present and future cash flows provide a good picture of the financial fragility of an economic unit.

CAMELS supervision (supervision of Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk) is a good supervisory tool, but it should be developed much further, should be generalized to all financial institutions without exceptions, and should include all off-balance sheet items. In addition, by staying at the level of individual banks, and by applying a reactive financial policy that waits until catastrophes unfold to decide what to do about financial innovations (which are validated ex post because of the fear of weakening further the economy), central banks impair the efficacy of their lender of last resort interventions and supervisory activities. Indeed, the profit motive that drives economic units, combined with the social rationality that they use to justify their decisions, leads private agents to believe that the lender of last resort will guarantee a privatization of economic gains and a socialization of economic losses. This behavior endangers the long-term financial stability of the economic system and the capacity of the central bank to maintain short-term and long-term financial stability.

Institutions similar to the FORC already exist in other parts of the economic system. For example, the Food and Drug Administration approves new drugs and the National Highway Traffic Safety Administration defines and monitors safety standards for vehicles while promoting further safety improvements. Those institutions exist because of the potential health hazard of medical treatments and of driving motored vehicles. Financial activities may also have substantial adverse impacts on the well-being of the population, and so financial innovations should be tested extensively in a controlled setting before they are used in daily transactions.

Another conclusion of the book is that constant interest-rate manipulations are not an appropriate policy, whatever the rule followed. The central bank has a role of contrarian, which was well illustrated by the two colorful expressions of William McChesney Martin that the role of the Federal Reserve is “to take away the punch bowl just when the party gets going” or “to lean against the wind.” However, the main way this should be done is not by fine-tuning the economy with interest rates, a rather ineffective tool because of its passivity, cumulative effects, and ex post response to problems, but by intervening dynamically in the credit and placement policies, as well as refinancing practices, of financial institutions.

The book contains five core chapters. Chapter 2 reviews the literature in the New Consensus and Post-Keynesian schools regarding the role of asset prices and financial fragility for central banking. Because the frame of thought used by each school is central to understanding their respective views, the chapter spends some time presenting some of the characteristics of each view. The New Neoclassical Synthesis relies extensively on the work of Fisher and Wicksell and assumes that the framework of a barter economy patched with money provides a good understanding of a capitalist economy. In this type of framework, money is neutral, at least in the long run, and market imperfections are essential to explain government intervention and the importance of financial aspects. The Post-Keynesian framework relies on the work of Keynes, Sraffa, Kalecki, Marx, and others, and argues that a capitalist economy is a monetary production economy. In the latter, people care about nominal values, money is never neutral, and financial instability is intrinsic. Contrary to the New Consensus, the importance of money and financial institutions is integrated from the very beginning because monetary accumulation, not physical accumulation, drives economic decisions. Since the bubble of the 1990s, there has been an increasing debate in the New Consensus about the role of financial matters in the decisions of a central bank. This debate has been intense and has concerned several subjects, from the relation between financial stability and price stability to the importance of asset prices for monetary-policy decisions and central banking. The debate among Post-Keynesians has been much less intense because there is a broad consensus about the importance of financial matters for central banking. Discussions of the relationship between financial stability, price stability, and full employment have been settled. The debate focuses more on the appropriate goal and interest-rate rule for a central bank. Overall, the chapter concludes that financial matters are an important element that central banks should consider in their daily preoccupations. More precisely, central banks should pay much more attention to the financial imbalances that accumulate in the economic system. The role of a central bank is not to determine if assets are well priced, nor to figure out how to use them to improve inflation targeting, but to understand the implications of changes in asset prices on financial positions.

Chapter 3 narrows the discussion by reviewing three views regarding asset pricing and their implications for central banking. Indeed, views about the way assets are priced have a strong impact on the position taken regarding the role of central banks in the economy. The rational approach assumes that there is an a priori fundamental value toward which the market price converges. The convergence process is more or less fast, depending on the efficiency of financial markets and the rationality of individuals. Speculation is possible, but can persist only as a correcting force that accelerates the convergence process. In this approach, bubbles and crashes are mainly the result of informational problems. In terms of central banking, the essential conclusion of the rational approach is that central banks are not qualified to enter directly in the pricing mechanisms of assets. However, central banks should promote fundamental pricing by contributing to the formation of equity analysts, accountants, and other agents necessary to price assets properly. The irrational approach aims at showing that, contrary to the claim of the rational approach, disruptive speculation may prevail and be permanent in financial markets. This approach focuses on both microeconomic factors (behavioral finance) and macroeconomic factors that promote “irrational exuberance,” and shows that bubbles are not necessarily the result of informational problems. Behavioral “biases” or “anomalies,” relative to the homo-economicus standard, can be explained by psychological, institutional, and social factors. In this context, a self-justification process may exist in which it is the fundamental value that converges toward the market price. The role of the central bank is to help educate people in order to eliminate behavioral anomalies, to help create institutions that promote fundamentalist behaviors, and, when appropriate, to use either moral suasion or margin requirements to constrain the growth of asset prices. The convention approach states that rationality is not hedonistic but social, which implies that most behaviors in financial markets are assumed to be reasonable, given the existing institutional and socio-economic setup. Liquid financial markets, by their nature, promote speculation, and so, contrary to the irrational approach, speculative behaviors are not seen as anomalies and providing all the information necessary will not eliminate speculation. In this context, asset prices are subject to a self-justification process like in the irrational approach but, contrary to the latter, this self-justification process is not necessarily doomed. The structure of the economy may change and may provide solid foundations to the prevailing convention. In the end, what matters is not how well priced assets are, but the sensitivity of balance-sheet positions, cash-flow positions, and position-making activities to changes in asset prices. The central bank should focus its attention on the financial implications of a change in asset-price configurations, and not on the asset-price level per se. Thus, preoccupations about the correctness of the level of asset prices are irrelevant and can be dangerous. Even if there is no bubble, checking asset prices is still central to the formulation of a good financial policy.

Chapter 4 explains why interest-rate-based policies are not a good practice in central banking; this is especially the case for rules that aim at targeting a real interest rate. It is argued that the best monetary policy a central bank can have is to set permanently at zero the overnight nominal policy rate on central bank advances. By using theoretical and empirical arguments, the first part of the chapter provides a critique of the notion of real interest rate. It is claimed that the notion of real interest rate is flawed and that Fisher’s theory of interest rates cannot provide a good justification for interest-rate policies. Financial market participants may care about purchasing power considerations but, contrary to Fisher, the latter are included in portfolio strategies that include preoccupations regarding liquidity and solvency. In addition, many empirical studies have shown that interest rates have failed consistently to adjust for expected inflation until the mid-1950s in the United States. It is argued that the reason interest rates have responded more strongly (but not fully) to inflation after 1953 is because the Federal Reserve, not financial market participants, has become more Fisherian. The second part of the chapter focuses on interest-rate rules that aim at managing nominal interest rates. It is claimed that the liquidity preference theory has to be understood in the broader context of financial market configurations, and that under specific configurations interest-rate policy creates more volatility than stability. All this provides a foundation to critique the alternative interest-rate rules provided by some Post-Keynesians. Indeed, some of them are for an active interest-rate policy, even though for different goals than the New Consensus. The chapter concludes by providing some arguments for the idea that economic stability is promoted by setting forever at zero the central bank rate on overnight advances. Constantly moving interest rates may promote output-price instability, financial speculation, and lower economic growth.

Chapter 5 studies in detail Minsky’s Financial Instability Hypothesis and uses System Dynamics within a stock-flow-consistent framework to model some insights of the Minskian analysis. It is shown that the dynamics of the analysis are complex, and that the instability of capitalist economies does not rest on arguments based on irrationality, the loanable funds theory, asymmetric information, or fallacies of composition. There are psychological, social, economic, institutional, and policy reasons that promote instability. The chapter goes on to argue that the best way to model the Minskian framework is to use models that emphasize the preeminence of nominal cash-flow considerations and in which shifting parameters and the model structure, not ad hoc non-linear equations, explain the dynamics of the system. The chapter also provides suggestions for empirically testing the Minskian framework. Overall, this is an important chapter because it lays out a framework that is very helpful to drawing some implications for central banking. Central banks should develop regulatory and supervisory tools that emphasize cash-flow aspects rather than capital requirements. Capital-equity requirement may help constrain the growth of credit by setting minimum standards in terms of collaterals. However, the concept of capital equity has important limitations in terms of preventing risky behaviors, of promoting financial stability in periods of instability, and in understanding how financially sound a financial institution is. Present cash flows and cash balance (liquidity) and future cash flows (solvency) should be the focus of attention of a central bank. Unfortunately, today, there is no macroeconomic accounting framework that focuses exclusively on cash-flow relationships. It is suggested that the stock-flow-consistent framework might be a fruitful tool to develop, in order to help central banks to manage systemic risk and to understand macroeconomic cash-flow implications. However, a large amount of research needs to be devoted to those very important problems in terms of both data availability and conceptual framework. The central bank should also manage financial innovations and should direct financial market participants toward non-speculative financing practices.

Chapter 6 uses the insights obtained in previous chapters to study how the members of the FOMC took into account financial matters in their decision-making process, and how the economic model that they have used to analyze the economy has been challenged. The analysis relies extensively on the FOMC transcripts available at the website of the Federal Reserve System. In the first section of the chapter, it is argued that financial matters have usually been a secondary consideration when setting interest rates. The emphasis is first and foremost on inflation, and most FOMC members do not have a frame of thought that incorporates financial considerations well. The latter are only emphasized in time of financial instability rather than over the whole business cycle. Consequently, FOMC members have been reactive rather than proactive in their management of financial problems. The second section studies how successful FOMC members have been in their analysis of the economic system. It is shown that most of the beliefs of FOMC members have been challenged, from the capacity of the central bank to control the money supply, the determinants of interest rates, the monetary origins of inflation, to the capacity of the central bank to manage inflation. Overall, it is shown that the Post-Keynesian framework would have provided some valuable insights to FOMC members. It is also shown that political considerations are an important determinant in the decisions of the FOMC members. For example, the shift to Monetarism was not based exclusively, or even mainly, on economic arguments. Several, if not a majority of, FOMC members were skeptical about Monetarism and knew that it was impractical in terms of policy. In addition, the Federal Reserve has been reluctant to implement strongly its regulatory framework because of political pressures to leave alone major financial institutions and financial market participants. All this provides some support for a central banking framework that emphasizes financial stability and leaves the management of inflation, economic growth, and income distribution to other government institutions.

2 Central banking, asset prices, and financial fragility

Today, a majority of economists and most central bankers assume that the main goal of a central bank should be to promote price stability, i.e. a stable and low rate of inflation. This goal is considered as the only reasonable objective that can be attributed to a central bank, all other objectives “having failed.” Recently, however, an intense debate has taken place among economists about the role that should be given to asset prices and other financial considerations in central bank operations. Most economists have concluded that financial matters have no role in usual policy-making unless they help to improve inflation targeting. However, not all economists agree and some of them would like central banks to put more focus on the management of financial imbalances.

This chapter reviews the literature concerning the role of asset prices and financial fragility within central bank operations by studying the views of the New Consensus (also called New Neoclassical Synthesis) and the Post-Keynesian schools of thought. Other approaches may have dealt with this subject but will not be presented here. It is shown that all authors recognize that financial aspects are important. However, they have different ways of dealing with them and including them into their analysis. Some authors think that price stability will guarantee financial stability and others want a more direct consideration of financial factors in the daily activities of central banks. To get a good grasp of the position of each school, this chapter also presents the main hypotheses that sustain their analysis. It is argued that the Post-Keynesian framework provides a better starting point to understand the inner working of capitalist economies.

Asset prices, financial fragility, and central banking in the new consensus

What is the New Consensus?

The New Consensus finds its roots in Monetarism and in the debate that occurred during the 1970s and 1980s between New Classical, New Keynesian, and Real Business Cycle theorists. The period of stagflation of the mid-1970s led to a rejection of the Neoclassical Synthesis that favored counter-cyclical policies in order to promote high stable economic growth. Several authors provided an explanation of the stagflation period. Friedman (1968) put forward a fooling-and-lag argument, while Weintraub (1978), Lerner (1961, 1979), and Davidson (1978) showed that stagflation could be explained by using Keynes’s framework; however, because the rejection of the Neoclassical Synthesis led to a r...