Macroprudential regulation: policy dynamics and constraints

The Irish Central Bank is planning to impose macroprudential risk regulation on the domestic banking sector (see here). The general approach of the Irish Central Bank has been widely welcomed by economists, although the specifics of the proposals are controversial.

John Cotter (UCD) and I are planning a conference in September 2015 on macroprudential regulation, the fifth in our series of FMCC conferences on financial risk and regulation. Macroprudential regulation is fairly new, and there are many unanswered questions. Can macroprudential constraints on credit be reliably attuned with the business cycle and/or credit cycle? Are a-cyclical constraints on credit safer and more reliable than attempts at anti-cyclical ones? Should regulators take account of market imperfections, such as the poor performance of the Irish property development industry and the high costs of new housing construction in Ireland, in setting constraints on credit growth?

Macroprudential regulation has particular importance in Ireland, a small open economy buffeted by credit flows from bigger neighbours. The failure to impose macroprudential regulatory control on the Irish banking sector was a central cause of the Irish financial crisis of 2008-2011. During 2000-2007, within a flawed eurozone currency system, a politically-neutered Irish Central Bank ignored a runaway inflow of foreign credit into the Irish banking system. This massive credit inflow undermined the stability of the Irish financial system and led to the disastrous failure of the Irish domestic banking sector.

There is a varied range of views among economists on macroprudential regulation. This is clear in the responses to the Irish Central Bank’s policy discussion document. Three thoughtful responses come from David Duffy and Kieran McQuinn (both at ESRI) here, Ronan Lyons (TCD) here, and Karl Whelan (UCD) here. (For full disclosure, my own response to the Irish Central Bank discussion document is here.) Lyons recommends fixed, a-cyclical credit controls whereas Duffy and McQuinn argue for dynamic, anti-cyclical controls. Duffy and McQuinn stress the need for more new housing in light of fast Irish demographic growth, and the positive role of high housing prices (aided by bank credit growth) in eliciting an adequate supply response. Lyons argues that excessive bank credit growth should not be used as a hidden subsidy for a cost-inefficient building industry.

Lyons makes a case for no loan-to-income (LTI) constraint, instead relying only upon a loan-to-value (LTV) constraint for macroprudential credit control. This contrasts sharply with the view of Karl Whelan who argues for LTI-only macroprudential controls in the current Irish case. Duffy and McQuinn advocate for both controls. I share the view of Duffy and McQuinn. Lyons does not consider the importance of dual-trigger mortgage default in Ireland (that is, mortgage default which is triggered jointly by income stress and negative equity). The amount of Irish mortgage arrears is likely to remain large and volatile, and this is a key potential source of market instability. Both initial LTI and initial LTV ratios are linked to subsequent mortgage default probabilities, so both should be controlled.

There are certainly many points for discussion, which should make for an interesting conference! A formal Call for Papers will follow shortly – if there are particular themes or panels that we should include, feel free to mention them in the comments thread below.

Austerity Talk at Battle of Ideas in London

The ‘Battle of Ideas’ festival held at the Barbican in London last weekend included a panel session entitled ‘Piigs can’t fly: Democracy/Technocracy/Austerity’. I was invited to make a 7-minute presentation of my views as expressed at various crisis conferences over the years:

Back in 1986, long before most people imagined that the single currency would really come into being, Paul Krugman wrote of the potential fiscal co-ordination problem: a bias towards excessive restriction because each country ignores the impact of its actions on the exports of others. “Achieving co-ordination of fiscal policies is probably even harder politically than co-ordination of monetary policies. There is not even temporarily a natural central player whose actions can solve the co-ordination problem. None the less, in surveying the problems of European integration, it is hard to avoid the conclusion that this is the systemic change most needed in the near future”.

Without this problem ever having been addressed, the potential for exchange-rate realignment was locked down. As many US economists warned, the euro was a federalist project lacking in federalist foundations, whether minimalist (banking union or federalist insurance schemes) or maximalist (a Washington-style federal budget).

In the face of this existing (anti-Keynesian?; pre-Keynesian?; antediluvian?) institutional structure, Ireland had no choice but to impose austerity (which would have been required even in the absence of the disastrous bank guarantee of 2008). The large primary budget deficits – which meant that government spending would still far exceed tax revenues even if interest payments ceased – precluded debt default.

The actions of the ECB in 2010 in forcing us to pay off remaining unsecured bank bonds (by threatening to cut off liquidity) appear to have been beyond its mandate and it is difficult to think of any reason not to support economist Colm McCarthy’s call for this to be brought to the ECJ. But, as he notes, the need for  retrenchment would have remained.

The Irish experience under austerity has been distinguished by remarkable industrial peace. Paddy Teahon, the chief civil servant behind social partnership, argued that the process had promoted a shared understanding among unions, employers and the government of the key mechanisms and relationships that drive the economy. I wrote back in 2009 that “the Teahon view will be seen to be of validity if some agreement can be reached to reduce public-sector pay until the current crisis is overcome”.

As to whether austerity has worked, it has achieved what it was supposed to achieve, which was to close the deficit and slow the accelerating debt ratio. It was never supposed on its own to get the economy back to work, but rather to position the economy well for when markets rebounded. The flexibility of the labour market makes it easier for Ireland to bounce back from austerity than is the case for Greece for example. So does the openness of the economy, as long as export markets recover.

[All of the other panellists having been hostile to ‘the displacement of democracy by technocracy’, I suggested that:] Many or most economists of my acquaintance in Ireland were content enough with the policies espoused by, and implemented at the behest of, the troika. Technocracy can be viewed as an advantageous buffer between government and – on the other hand – purveyors of snake oil and the representatives of powerful entrenched interests (though technocrats too are not immune, of course, from regulatory capture).

Sinking, fast and slow

For well over a year now some of us have been pointing out that the Eurozone crisis was entering a very dangerous phase, in which slowly increasing unemployment would eat away at the foundations of Europe’s societies, while short-sighted politicians and excitable journalists proclaimed that the Euro was saved. The invaluable Eurointelligence has been doing a great job recently tracking the apparently inexorable deterioration in the economic fundamentals of the Eurozone, with Germany itself now apparently affected. But for both political and personal reasons I find myself worrying most about France.

Twiddling their thumbs and hoping that something (the economy) will turn up, flawed macroeconomic policy notwithstanding, seems to have been the French government’s master plan up till now. As a result it is hard to see Francois “Say” Hollande, or any other Socialist for that matter, getting through to the second round in 2017.

You may think that Paul Krugman is being too alarmist when he raises the possibility of President Le Pen, and I hope you are right. But Sarokozy’s apparent return to the political fray does worry me. Of course, you may think that if he wins the UMP nomination, the Left will rally round and vote for him when it comes to the second round.

How confident are you about that?

The Irish Case for LTV and LTI Caps on New Mortgage Lending

The Irish Central Bank discussion paper on macro-prudential policy tools published yesterday seems to be a trial balloon for possible caps on Loan-to-Income (LTI) and Loan-to-Value (LTV) ratios for new residential property mortgages in Ireland. The general theory behind imposing these limits is laid out clearly in that document; there is no reason to repeat it here. I want to discuss some notable features of the Irish environment which strengthen the case for these caps (but do not make the decision easy).

Continue reading “The Irish Case for LTV and LTI Caps on New Mortgage Lending”

Balanced budget tax cuts

In his press conference yesterday, Mario Draghi said the following:

Within the Stability and Growth Pact, one could do things that are growth-friendly and also would contribute to budget consolidation, and I gave an example of a balanced budget tax cut. Reducing taxes that are especially distortionary, where the short-term multipliers could be higher, and cutting expenditure in the most unproductive parts, so mostly, actually not mostly, entirely, current government expenditure.

There are at least three possible interpretations of this statement.

1. Draghi genuinely thinks that balanced budget multipliers are negative, which I find hard to believe. A balanced budget tax cut under current circumstances would be contractionary, not expansionary; at least, that is what we teach our students.

2. Draghi genuinely thinks that the Eurozone’s problems right now are on the supply side, and that tax cuts will help address these problems. I also find that hard to believe. The major problems facing the Eurozone right now are pretty clearly on the demand side.

3. Despite its nominal independence, the ECB is in fact the most politically constrained of the major central banks. If Draghi is going to push the ECB towards QE, and question the overall fiscal stance of the Eurozone, he has to come out with this sort of stuff from time to time, to appease the Germans.

I find the last of these three explanations entirely plausible, and it helps explain the ECB’s poor performance in the crisis to date. But why should a nominally independent central bank feel that its hand are tied in this way? Ultimately, perhaps, because the Eurozone is not a political union, and because democratic legitimacy resides at the level of the member states. This means that exit from the Eurozone is always an option, even if it is not openly acknowledged.

Another reason to think that monetary union without political union is a bad idea.


Paul Krugman asks whether anyone thinks that Hollande has the faintest idea about how austerity is going to fix the French economy, in a context where France is clearly facing a huge demand-side problem.

I guess this is the latest statement of what the French are thinking. They recognise that there is a demand side problem in Europe, and hope that someone else (the ECB, and European institutions who might promote European investment) will address this. And they hope that if they do things that the Europeans like, then this will lead not only to saner European macroeconomic policy, but to investment by French companies as well:

“Je souhaite… que chacun prenne ses responsabilités”, poursuit Michel Sapin. “Le gouvernement a pris les siennes, je souhaite que l’Europe le fasse aussi. Mais il faut que les entreprises prennent les leurs.”

I sort of understand what is going on politically. One thing that strikes you about France is how partisan the politics there are. There are some — typically on the left — who think that demand is all that ever matters, and others — by no means all on the right, since VSP’s are to be found right across the spectrum — who think that supply is all that matters. So the government is trying to say that both demand and supply matter, and is describing this in terms of a bargain: if we are tough on spending and all the rest, then the French private sector and “Europe” should do their part, and invest.

But what if, as appears to be the case, the big reason that French companies are not investing is a lack of demand? And what if the Germans simply refuse to budge on macroeconomic policy, as seems likely? Is French policy simply going to consist of saying “pretty please”, or do they have a credible threat to move things along?

Threatening to leave the euro if things keep going the way they are might just do it (what would be the political point of the euro without France?), but does anyone see Hollande credibly threatening that? Does anyone see him credibly threatening anything? And what is his Plan B if Eurozone macroeconomic policy remains essentially unchanged? Does he even have one?

In the mean time, austerity in France will continue to hurt the French economy. How high in the polls does the FN have to rise before Hollande realises that what he is doing is neither prudent nor responsible, but incredibly dangerous?

And how long before the French political system is willing to acknowledge, publicly, that Montebourg’s warnings do not reflect a particularly “left wing” view of economics, but would be regarded as plain common sense by most macroeconomists?



Just gimme some choice

The Irish Times this morning describes the increased vote for independents as an expression of anti-politics sentiment.

Anti-establishment-politician sentiment, certainly, but anti-politics? That depends on how you define politics.

My definition of “politics” is all about choice over policies: citizens in a democracy can choose to fundamentally change their country’s economic and social policies, if that is what they want to do. In 2011 Irish voters voted for change, and got none: the new government faithfully implemented the Troika programme, just as the previous government had done, and presumably would have continued to do had they been re-elected. (And now that they have been let off the leash they are coming up with bubble-era proposals to increase mortgage lending. Not much change there either. And consequently not much real choice.)

Democracy without choice is not democracy. Politics without choice is not politics.

A lot of people in this country, and right across Europe, want real change. Some in Ireland voted for Sinn Féin, the big winner in the election. Some voted Independent. This isn’t anti-politics. It’s anti-anti-politics.

The FT is on a roll

In an otherwise unremarkable editorial about the upshot of the elections, the FT comes up with this quite remarkable statement:

The only viable path for France is to press ahead with tax cuts and spending reductions that can sustain growth.

Is the FT really saying that in a Keynesian short run, such as we find ourselves in just now, the balanced budget multiplier is negative? Really? Or that the spending multiplier is negative? Or is it perhaps denying that the Eurozone currently finds itself in such a Keynesian short run, in which a lack of demand is the key constraint on growth? (Let’s not even get into the debate about the long run relationship between growth and the size of the state in Europe, although I can’t help writing down one word: Scandinavia.)

And is the FT really claiming that continuing with this programme would make all those FN voters switch to the socialists and UMP?


Canaries in the coal mine

The European election results are coming in, and in France they are catastrophic.

There are two obvious points to be made which work in opposite directions.

First, the vote for the FN and similar parties is an under-estimate of eurosceptic opinion, since these parties come with so much baggage that many voters who hate what Europe has become would never, ever dream of voting for them. And quite right too.

Second, it may well be that these parties would have done less well if there had been national elections last weekend: voting for the EP is one thing, voting for national governments another. (But who really knows.)

Expect many mainstream commentators to point out that the centre has held, that the EPP have won, that Juncker is the people’s choice for EC President, and all the rest of it. This strikes me as exactly the wrong response.

My big worry this Monday morning is that Hollande and others (but I am mainly thinking of Hollande) will continue with their current economic strategy, which as far as I can see consists of crossing their fingers and hoping that something will turn up. Yes, some day this recession will end, since all recessions do, but the timing of this will depend (probabilistically, since life is uncertain) on policies: monetary and fiscal policies, obviously, but also policies to fix the European banking sector. Right now, given Europe’s policy choices, there is no good reason for the French government, or any other government, to expect that the real Eurozone economic crisis (which has to do with growth and unemployment, not yields on government paper) is going to end any time soon. And certainly not by 2017.

M. Hollande and his like may believe that sticking to the programme is their only option, and that any other course of action would be far too risky. They should ask themselves what the political landscape will look like if the Eurozone crisis continues for another 3, 5 or 10 years. It’s not impossible. Perhaps something will turn up, and perhaps the status quo merchants will get away with it. But perhaps it won’t, and perhaps they won’t.

People who argue that there is no alternative presumably see themselves as prudent and responsible. But you could just as easily regard them as drunken gamblers on a losing streak, forever doubling up.

The eurozone recovery: still just around the corner

Paul Krugman is quite right: the most recent Eurozone GDP numbers are really disappointing. But hardly surprising, given current policies, unless you’re the sort of person who thinks that peripheral yields are the only thing that matters. (Not a great metric of success you would think, if they have been falling in Greece, but there you go.)

I recently read someone (can’t remember where, perhaps you can) saying — based on the yields —  that the eurozone crisis was now over economically speaking, and that the only thing that might derail things now was the politics. Which made me think two things:

1. It is surely unacceptable intellectually to regard the predictable political consequences of lousy economic policy as being somehow ‘exogenous’ and none of our business as economists.

2 If the politics of the eurozone crisis eventually turns sour, won’t this show up in various financial spreads , and wasn’t this the whole point of the ‘second generation’ crisis models we all starting teaching our students in the early 1990s?

Even if it’s cancer that kills you, death coincides with cardiac arrest.

Problematic Calibration of the EU Banking Sector Stress Test for Ireland

The details for the calibration of the EU-wide bank stress test are now available. Looking only at Ireland, and only at one of the key variables in the stress test, the calibration looks problematic. It may be coincidental that the Irish adverse scenario has been badly chosen; it might be that all the other member countries have reasonable calibrations.  If the others are as problematic as in the Irish case, this is not a reliable EU banking sector stress test.

Under the adverse scenario, Irish property prices are assumed to suffer a cumulative three-year drop of 3.03%; equivalent to a decline of 1.02% each year for three years in a row. Over the period covered by CSO data, 2005-2013, Irish residential property prices had an annual sample volatility of 11.7%. This in turn implies (under reasonable assumptions) a three-year volatility of 20.27%. In risk analysis it is conventional analytical shorthand to measure adverse outcomes in “x-sigma” units defined as the outcome as a multiple of the standard deviation. For an adverse scenario calibration, the assumed outcome is usually roughly a two-sigma or three-sigma event. Using a four-sigma shock would not be unusual (due to fat tails in some probability distributions). The EBA has calibrated the adverse price shock as a 0.1492-sigma event. That is not credible as an adverse scenario in a stress test.

Keep in mind that the stress test is meant to reassure market participants that even in an adverse scenario the Irish banks are sound. This test reassures us that if property prices fall by as much as one percent a year over the next three years, the banks have enough capital. In the case of a two-percent fall, there are no promises.

As a caveat, this does not mean that the Irish banks need equity capital. They have already had a credible stress test (in 2011) and a big capital injection. Also, the Irish property market although very volatile has a maximum likelihood price change which is positive over the next three years. However the asset class also has considerable “downside” potential and continued high volatility. Conventionally, at least in the case of portfolio risk analysis, the unconditional mean of a stressed variable is set equal to zero for risk analysis purposes. The EBA has chosen to build in a big positive benchmark price rise for Irish property assets, and this is part of the reason that the adverse scenario is unacceptably mild. In any case, this calibration is extremely mild as an adverse scenario and not reassuring for the EU-wide test.

Gosh, isn’t that exciting!

In a recent post, we read that

With the Social Democrats (S&D) and the conservatives (EPP) neck-and-neck in ever more refined EU wide opinion pools, the lead up to the European elections has never been more exciting. It’s down to one seat whether the next Commission president is Social Democrat or Conservative.

I am sure that there are some in Brussels who think that giving voters an indirect say in who becomes Commission President is exactly what we need to boost interest in the forthcoming European elections, and give the European project some democratic legitimacy.

By the way, does anyone know what the EPP or Social Democratic position on the Eurozone crisis is? (I think I know what Marine Le Pen wants.)

I have another proposal to enhance the democratic legitimacy of the project: allow voters to fundamentally change the direction of policy, should they so choose. Reverse the “treaty-isation” of particular economic policies. Stop trying to make the commitment to austerity democracy-proof.

Any takers?

The future of the euro

I have a piece on the subject in the most recent issue of Finance and Development, available here.

Production lags being what they are, I wrote the article in mid-December. Since then, Wolfgang Münchau has declared the Eurozone policy debate over (and not in a  good way); the German Constitutional Court has issued a ruling on OMT that is potentially much less benign than is commonly assumed; and Italy has installed its third non-elected Prime Minister in a row, with a notorious multiplier denier as Finance Minister thrown in for good measure. None of this has cheered me up.

Class divides and European integration, yet again

This morning’s Eurointelligence briefing put me on to this article in Les Echos, which in turn led me to this Ipsos opinion poll. It contains several sobering findings, notably with respect to foreigners. But the finding that struck me most — since this is something I have been writing about for years now — is that a majority of French working class voters now want to leave the Euro. Indeed, only 34% of French workers think that EU membership is a good thing.

Isn’t it amazing how short run blips in various economic indicators can lead powerful people to assume that all is well with the EMU project? It is slow moving variables — long term unemployment, gradual shifts in public opinion, and so on — that pose the greatest threat to the Euro’s survival. If the far right does as well as people now seem to think it will in the European elections, this will presumably be presented in the media as a “shock” to the system, but has it not been obvious since 2010 at the latest that something like this was likely, given Eurozone macroeconomic policies? And has it not been obvious for years that actually existing EMU is harming the broader European project?

Europe’s political leaders should remember what Ernest Hemingway said about bankruptcy.

The Eiffel group: for a Euro community


I dare say it will strike most people as pie in the sky, but it makes sense that people who want to preserve the Euro start formulating proposals such as this. Two reasonable conditions attaching to any such proposal seem to me to be that: (a) entry to any such community be decided by popular referenda in each country; and (b) that there be some sort of Connecticut compromise in place so that the rights of small states are protected.

‘Hardball’ v ‘Equity Sale’

The Irish Times today features two contrasting strategies for dealing with the debt legacy created by the Irish bank bailout.

An interview RTE’s Sean Whelan did with Willem Buiter is available here.

L’offre crée même la demande.

I can’t quite believe that he said it, but he apparently did. Go tell it to the small businesses in my favourite French village who have had to close since 2008.

Arguing against Say at a time like this is like shooting fish in a barrel, so let’s not even bother. The more alarming point is what this tells us about the European left: to all intents and purposes, in many countries there is none. Ambrose Evans-Pritchard puts it well, I think:

Trade unions in the West are strangely silent, pushed to the margins by the atomised structure of modern work. Europe’s political Left is so compromised by ideological defence of monetary union – a Right-wing project, or “bankers’ ramp” as the Old Left used to say – that it cannot muster any articulate policy.

Hollande’s extraordinary statement that supply creates its own demand, at a time when the Eurozone economy is up against the zero lower bound, and unemployment is terrifyingly high in several EMU member states, is just an extreme, self-satirizing, example of the phenomenon. If what Europe needs is for France to make Germany an offer it can’t refuse — allow the ECB to seriously loosen monetary policy, or we may not be able to stick with EMU — then we’re not getting it any time soon.

Now, if you’re on the right I suppose you might welcome the fact that the left is committing hara kiri on the altar of European orthodoxy, but you shouldn’t. For the reality is that orthodoxy is letting the people badly down, as Martin Wolf pointed out today, and the people aren’t stupid. If the left is not going to offer them an alternative, then Eurosceptic parties will. And unfortunately most of those are on the extreme right.

(H/T Mark Thoma.)