Speech: National Balance Sheets and Macro Policy: Lessons from the Past

Date Published 3/2/2012
Author Paul Tucker
Country United Kingdom

February 28, London

Speech by Paul Tucker, Deputy Governor Financial Stability, Bank of England, looks at lessons learned from the financial crisis for macro-prudential policy

In an important speech, yesterday, Paul Tucker – Deputy Governor Financial Stability of the Bank of England, Member of the Monetary Policy Committee and Member of the Financial Policy Committee – discussed some important lessons learned from the financial crisis in the area of the macro-economic policy. He looks at the over-stretched and vulnerable balance sheets of households, firms, banks and governments across the Western world prior to the crisis and stresses that it is insufficient to look only at current account imbalances for warning signs, but that gross capital flows, in particular cross-border banking flows, deserve much more detailed attention in the macro-economic policy framework.

Mr. Tucker highlights two possible international macroeconomic explanations for the period of pronounced credit growth and asset price appreciation prior to the crisis. “First, a fall in the world safe real rate, due to excess savings in the East; Second, increasing global liquidity, transmitted through expansive cross-border lending, kicked off by prolonged accommodative monetary policy.” Both of these, he notes, “…involve shifts in risk premia driven by changes in the supply and demand for financial assets.” These changes in risk premia can be key drivers of fluctuations in asset prices, and probably have substantial influence over macroeconomic fluctuations.

He suggests the following lessons in terms of the policy framework:
    • “We must not rely entirely on central banks ‘mopping up’ after financial crises. Not only does it strain our capabilities ex post, it is counterproductive ex ante. If central banks are perceived as writing deep-out-of-the-money put options, then the market, believing it is protected by those tail-risk puts, will itself take more risks than otherwise. We need overall macro regimes that aim to make chronic imbalances and over-indebtedness less likely and less threatening.
    • The transmission of monetary policy can be affected by risk appetite, and can itself affect risk-taking behaviour, domestically and globally. We need to be alive to that in forecasting the path of nominal demand, and in assessing global liquidity conditions.
    • We also, therefore, need macroprudential regimes to ensure that these mechanisms do not lead to stability threatening indebtedness or otherwise endanger the resilience of the financial system. We need, in particular, to be ready to contain private sector liquidity creation even when it is not driving excess nominal demand growth. That will amount to arresting occasionally the expansion or leverage of the banking system and shadow banking sectors.
    • Given its special role in international finance, the UK owes a special responsibility to the rest of the world to maintain the safety and soundness of the UK-resident financial system. It is therefore very welcome that the IMF has reached precisely that view in its new work on Spillovers. The Fund must ensure that we stick at it.
    • Reciprocally, the Fund needs to go back to the Draghi Report and incorporate its lessons into Article IV and FSAP reports.
    • As the Draghi Report stressed, we must try to identify and remove microeconomic incentives that distort risk-taking behaviour into dangerous channels. And given the interconnectedness of global finance, we – especially in the UK – must be alert even to such distortions elsewhere. US housing finance was a domestic system whose structure led to problems with global spillovers.
    • The public finances should be managed with an eye to the nature and extent of risk exposures elsewhere in the economy.
    • It is the precise pattern of capital flows, and the resulting composition of the resulting balance sheets, that matter to the stability of the financial system. All macro policymakers – monetary, macro-prudential and fiscal – should, therefore, pay attention to the national balance sheet; and to the pattern of gross as well as net capital flows.
    • But, in doing so, we and our peers must avoid financial protectionism just as a previous generation learned to oppose trade protectionism. And we must not leave anyone thinking that we can eradicate economic problems.”

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