The imprudence of macroprudential policy.

• Author: Salter, Alexander William
• Position: Essay

In the aftermath of the 2007-2009 financial crisis, many academic economists have taken stock of existing theories in search of an explanatory framework. Of particular interest is the attention mainstream economists are paying to the business-cycle theories of Ludwig von Mises and Friedrich Hayek. Several studies have argued that Mises's and Hayek's ideas concerning monetary theory and the trade cycle provide a way forward for understanding the crisis (Diamond and Rajan 2009b; Leijonhufvud 2009; Caballero 2010; Borio and Disyatat 2011; Koppl and Luther 2012; Calvo 2013). Others, although less explicit, nonetheless espouse views that fit nicely into the framework of price-theoretic economics more generally (Diamond and Rajan 2009a; Meltzer 2009; Schwartz 2009; Taylor 2009; McKinnon 2010; Ohanian 2010). This development is heartening because it subjects to critical analysis the narrative that the crisis was the result of financial instability that naturally occurs in capitalist systems. It instead puts forth an explanation for the crisis grounded in price-theoretic economics, rooted in the analysis of how the relative prices of consumers' goods and producers' goods change in response to deviations in the market interest rate from its natural (Wicksellian) rate. (1)

However, much of the scholarship since the financial crisis is implicitly at odds with this line of thought. Perhaps the most obvious example is the literature on "macroprudential" financial regulation (Clement 2010; Bernanke 2011; Hanson, Kashyap, and Stein 2011; de la Torre and Ize 2013; Galati and Moessner 2013). According to Ben Bernanke, "Ultimately, the goal of macroprudential supervision and regulation is to minimize the risk of financial disruptions that are sufficiently severe to inflict significant damage on the broader economy. The systemic orientation of the macroprudential approach may be contrasted with that of the traditional, or 'microprudential,' approach to regulation and supervision, which is concerned primarily with the safety and soundness of individual institutions, markets, or infrastructures" (2011, 3). Bernanke's remarks make it clear that macroprudential policy is aimed at stabilizing the financial system as a whole, with special emphasis on the risks and costs associated with systemic crises. Before the crisis, regulators believed the best way to prevent such events was regulation at the level of the individual financial organization--that is, monitoring a firm's capital-to-assets ratio or the degree to which this ratio relies on short-term funding (Bernanke 2011, 4). The "tool kit" of macroprudential policy, in contrast, would involve time-variant countercyclical capital requirements (including capital-quality requirements), regulation of debt maturity, and the extension of already-existing regulation to the shadow-banking system (Hanson, Kashyap, and Stein 2011; Galati and Moessner 2013). (2) Ideally, these tools will be put to use by regulators who judiciously manage systemic risk in the financial systems they oversee in an attempt to minimize the probability of enduring another severe financial crisis.

Why is such regulation necessary? Samuel Hanson, Anil Kashyap, and Jeremy Stein point to external costs associated with firms attempting to divest themselves of assets they believe will lose their value: "[O]ne can characterize the macroprudential approach to financial regulation as an effort to control the social costs associated with excessive balance-sheet shrinkage on the part of multiple financial institutions hit with a common shock" (2011, 5, emphasis in original). Because financial firms during times of trouble (a) attempt to shrink assets, which might result in fire sales and credit crunches, and (b) operate with "too thin capital buffers" to weather the resulting balance-sheet effects, firms' ordinary profit-seeking behavior results in external costs that increase the probability of a financial panic (Hanson, Kashyap, and Stein 2011, 8).

In this essay, I argue that the macroprudential policy literature does not consider whether their policy recommendations are information and incentive compatible. As such, it is unlikely to deliver on its promises. To be more specific, the literature on macroprudential policy has not made any reference to or shown in any way that it has addressed the issues raised by the knowledge problems associated with nonmarket resource allocation. In a similar vein, it has not addressed the problem of how regulators armed with macroprudential tools can be trusted to use those tools in the limited sense ascribed to them. And even if these objections are brushed aside, an argument can be made that the macroprudential policy literature has failed to meet its prima facie case of demonstrating the instability of advanced capitalist financial systems. The admirable goals of macroprudential policy are unlikely to be achieved by enlightened discretionary regulation. Instead, I argue that future research should focus on potential improvements to the institutional framework within which economic agents act.

No Knowledge of Knowledge Problems

The macroprudential policy literature has not addressed the positive statements regarding the information-generating role of the unhampered market economy developed by Mises ([1949] 2008) and Hayek ([1948] 1980) and refined by Israel Kirzner (1973) and Murray Rothbard ([1962] 2009). I do not mean that the literature has merely neglected to cite these works. Beyond occasional tangential references to the necessities of developing more "complex analytic frameworks" (e.g., Bernanke 2011, 3), the works in the literature have not attempted to cope with the problems inherent in centrally managing a significant portion of the capital market. Lest the reader suspect I exaggerate the imagined scope of macroprudential policies, Bernanke spells out the expansiveness of their perceived mission: "[B]ecause of the highly interconnected nature of our financial system, macroprudential oversight must be concerned with all major segments of the financial sector, including financial institutions, markets, and infrastructures; it must also place particular emphasis on understanding the complex linkages and interdependencies among institutions and markets, as these linkages determine how instability may be propagated throughout the system" (2011, 3). He goes on to describe the various regulatory agencies that will operate in the United States (the Financial Stability Oversight Council, created by Dodd-Frank, and the Office of Financial Research, which operates within the Treasury Department) and the European Union (the European Systemic Risk Board) to manage systemic risk, primarily through the analysis of data that purport to show the degree of systemic risk and the ability to curb excessive risk taking (1-4). (3) Moreover, the Federal Reserve will be taking on additional roles, including "the supervision of thrift holding companies as well as oversight of nonbank financial firms and certain payment, clearing, and settlement utilities that the [Financial Stability Oversight] [C]ouncil designates as systemically important," and mandating capital and liquidity requirements for large financial organizations deemed "systemically important" (9).

Putting macroprudential policy into operation necessarily entails a significantly larger share of market activity being decided by nonmarket actors. It is important to note that the knowledge and information burdens facing regulators are not the same as in the classic statement of the knowledge problem, which refers to the impossibility of rational resource allocation absent private property in the factors of production (Mises [1922] 1951). However, there are several parallels to the problem first pointed out by Mises, and they are thematically similar enough collectively to deserve the label knowledge problems.

The first problem in this macroprudential approach to promoting financial stability is its conflation of risk with uncertainty. Ever since Frank Knight (1921), economists have paid lip service to the distinction, but the understanding has scarcely...