Mojmír Hampl (Central Banking Publications 20.1.2011)
The turmoil has left our profession facing some uncomfortable truths, Mojmír Hampl notes.
What exactly caused the recent financial crisis? This question will be the subject of heated debate for a long time to come. Academics have something to keep them busy for many years ahead. In time, Nobel prizes will be awarded for convincing answers and ensuing recommendations. However, some central banks have already intuited that they are going to have to make some changes in at least two areas – monetary policymaking and the currently little-researched area of so-called financial stability. What is more, these two areas may have more in common than first appears.
Central banks in many advanced countries operate under the well-established inflation targeting system. Before the financial crisis, these inflation targeters had reached a simple consensus supported by numerous theoretical studies and by the practical experience of many countries. Monetary policymakers broadly agreed that monetary policy would be most beneficial (or least damaging) to the economy if it was focused on delivering stable and negligible growth in consumer prices.
This objective was successfully pursued for many years before the crisis. It looked like we had the game won. We began to refer to the entire decade with pride as the Great Moderation. But as so often in the past, pride came before a fall. True, there had been a moderation, but it was also something of an optical illusion. The focus on consumer prices meant, for example, that rapid credit growth and soaring prices of property and many financial assets slipped under central banks’ radar. In short, stabilising this growth was outside central banks’ defined objective. The subsequent crisis demonstrated yet again that the schools of economic thought that emphasise just how important it is to keep track of these variables were right on the money.
Back in 1978, the US economic historian Charles Kindleberger in his now classic book Manias, Panics, and Crashes: A History of Financial Crises pointed out that in history financial crises had almost always been preceded by credit and property price booms. The bad news for monetary policy, however, is that credit booms have not always led to crisis. In other words, we still lack a rule of thumb for the future.
The basic proposition about the importance of credit, asset prices and the extent of financial intermediation in the economy is slowly establishing itself in central bankers’ post-crisis thoughts – although so far only at the general intuitive level described above. As soon as we start to ask specifically when exactly, and at what level, does the rate of growth of credit aggregates or asset prices start to be risky, or how large a leverage ratio and how high a risk mark-up are sustainable, there are no clear answers. Moreover, we are frequently asking fundamental questions which we thought we had answered: What prices should we actually target? How should we define new price indexes? Hacking at the foundations like this is painful in any field of study. Try asking a monetary expert for a precise definition of money. Where does money start and end? The layman may be surprised to learn that the answer is not necessarily clear cut.
Furthermore, if this line of thinking is correct, it will require central bankers to change their view of the world. They will have to accept the previously rejected view that house purchases are a normal consumer expenditure and therefore we should stop drawing a sharp dividing line between property (and perhaps certain other) prices and prices of consumption goods and services.
However, there is no need to panic yet. Revolution is not on the cards. We are not turning all the existing knowledge on its head. No one is saying, for example, that high or higher inflation would be a good thing. Mercifully, IMF chief economist Oliver Blanchard’s suggestion in that direction disappeared as quickly as it appeared. Inflation targeting, it seems, will be modified rather than abandoned.
Similarly important questions with no clear answers are arising in the currently fashionable area of so-called financial stability. Again, the public may be surprised to hear that we still have no fixed definition of exactly what financial stability is. We know all too well what financial instability is, but we don’t know how to define the opposite of it in elegant and understandable terms. And we are even less able to define the tools for achieving this coveted goal of financial stability. Again, wherever one looks one sees new and unexplored worlds.
Nothing is certain, but academics and monetary policymakers in many countries around the world will be thinking along the lines described above. In my view, this thinking will be much more relevant and important in the long term than the torrent of malignant ideas for regulatory micromanagement of specific markets and financial institutions that has been pouring out since the crisis erupted, especially in the European Union and the United States. We may be – and probably are – making far greater mistakes on the questions described above. However, it is of course more difficult to make noise about them than about bankers’ pay or hedge fund regulation.
The above-mentioned questions concerning central banks’ future role, behaviour and objectives pose a challenge to academics and talented students all over the world. In the language of economics, the market for these ideas is unsaturated, hungry and full of promise. It offers good long-term returns on both the national and international level, as no one has so far established a clear lead in answering them. If any revolutionary papers come out in this area, I’d be grateful if you could forward them also to my central bank.