I want to compare and contrast the pursuit of monetary stability with the pursuit of financial stability. I am talking mainly about Canada, though much of what I say applies to other countries as well.
1. Ask n monetary economists, and you will get at least n different definitions of what they mean by "monetary stability". But in practice, in Canada, we have a precise meaning of how we have decided to define "monetary stability". It means 2% CPI inflation. We have cut the theoretical Gordian knot by a political decision.
Nobody is saying that the 2% CPI inflation target is the theoretically precise meaning of "monetary stability". Many economists would say that it bears some resemblance to their preferred theoretical definition. And many more would say that it is better to have some agreed-on definition, even if only approximately valid theoretically, than to re-open the debate about what monetary stability means every few weeks. People need to know the rules of the game for monetary policy, and it's more important that the rules of the game are known than that they are theoretically ideal rules.
Ask n financial economists and you will also get at least n different definitions of what they mean by "financial stability". And we don't have a political agreement of what it means in practice, either.
2. We know who is responsible for ensuring monetary stability in Canada. It's the Bank of Canada.
Nobody knows who is responsible for ensuring financial stability in Canada. But we know it is not one single body. The Bank of Canada, Finance Canada, the Office of the Superintendent of Financial Institutions, Canada Deposit Insurance Corporation, provincial regulators of financial markets, Canada Mortgage and Housing Corporation....(I'm sure I've left out some important players)...all play a role. This wouldn't matter if the division of responsibilities were: clear; mutually exclusive; jointly exhaustive; and matched the distribution of power to fulfill those responsibilities. But they aren't.
3. We know, at least in principle, what tactics the Bank of Canada follows to meet its well-defined strategic goal of monetary stability. If it expects inflation will fall below the 2% target in the medium term, the Bank of Canada will lower the overnight rate; and if it expects inflation to rise above the 2% target, it will raise the overnight rate. And we know how the Bank of Canada views the transmission mechanism between the overnight rate instrument and the inflation target.
We know much less about the tactics that are followed by the various players to meet their ill-defined strategic goals of financial stability. Under what circumstances would a financial institution be bailed out or allowed to fail? Under what circumstances would a financial market, like the market for Asset Backed Commercial Paper, be bailed out or allowed to fail?
4. We know that the body responsible for monetary stability is to some extent independent and insulated from partisan politics, so that the rules of the game should be seen as implemented in a disinterested manner.
The various bodies that have various responsibilities for financial stability are in many cases not independent and insulated from partisan politics (and sometimes that means Federal and sometimes provincial partisan politics).
Putting all 4 points together, we see the extreme contrast between the pursuit of monetary stability and financial stability. The first is a model of clarity, transparency, responsibility, and governance. The second isn't.
John Crow (former Governor of the Bank of Canada) has written a brief(pdf) for the CD Howe Institute, focusing on the dangers of the division of responsibilities for financial stability. He argues that the Bank of Canada should be placed in overall charge of systemic financial stability. I think that's a good first step. It should go a long way to resolving my point 2 above. Perhaps it would also help resolve points 1, 3, and 4 as well.
Do we need the government to ensure financial stability? Do you trust the government to ensure financial stability? There is an argument to be made that our current instability is the result of too many efforts to minimize risk and fear, too much insurance, too many guarantees. If private capital woke up everyday aware of the possibility they could lose everything at any time, perhaps they would be more careful.
Posted by: pointbite | June 29, 2009 at 12:35 PM
Makes me think of the criminal justice system, and how the various players refuse to take responsibility. Environmental enforcement is similar: many chefs, no chiefs, no responsibility and a plethora of laws and regulations that go unenforced.
In that list Nick, you forgot the role of the federal government and fiscal policy in maintaining "financial stability". Are you expecting the Bank of Canada to challenge the federal government on let's say value-added consumption sales tax cuts at the height of a giddy economic boom where many of the governing party's key financial supporters are making lots of dough?
Putting all these responsibilities under the roof of the Bank of Canada increases probability of partisan political interference.
Posted by: westslope | June 29, 2009 at 12:53 PM
I'm not very confident that any one organization would be given exclusive control over policy that impacts financial stability. Even if the Bank were given a mandate to ensure financial stability, governments would invariably find any number of back doors to exert influence on the system because political realities demand it. On the other hand, I think Harper/Flaherty may have been just as happy to have been able to stand back and let the Bank take the heat for situations like we've seen over the past 9 - 18 months.
Posted by: Andrew F | June 29, 2009 at 12:56 PM
So by 'model of governance', you mean not accountable to the people in a democratic fashion, correct?
Let's face it, financial stability is more complicated than setting an inflation target. Wishing that it isn't won't get you anywhere.
Posted by: Declan | June 30, 2009 at 01:05 AM
pointbite: Most people take it for granted that we do need more not less government. I am not so sure. I know of one clear model that argues for a role for government/central bank in improving financial stability: the Diamond/Dybvig model of bank runs, where bank runs can happen in equilibrium, and a lender of last resort can make things better.
But here I take a different approach: given that there will be government oversight and regulation of the financial sector, which branch(es) of government should do it, and how? Even if we decide that it is best to let a financial institution or market fail in some circumstances, some body must take the decision to do nothing, and have some clear rules or criteria for doing so.
westslope, Andrew, and Declan: The line between that which should be political and not is tricky. I do rather like the current inflation-targeting regime, where the government signs off on the 2% target, giving it the democratic legitimacy, but does not interfere in the decisions the Bank makes to hit that target.
There's an (imperfect) analogy between government making the laws but an independent judiciary deciding particular cases. Rule of Law vs Rule of Man, etc.
I too am a bit uneasy about too much power in one body (the Bank of Canada). But it's even harder to separate monetary policy from financial stability. Financial instability has been the largest obstacle to the Bank hitting its inflation target, plus the ability to print money is a central tool in attaining financial stability.
Posted by: Nick Rowe | June 30, 2009 at 12:04 PM
Nick, I know that this is a bit off topic, so feel free to ignor. Earlier you said that you liked the idea of a "belts and suspenders" approach to stimulus in a liquidity trap. In this post you say the BOC is solely responsible for inflation (and by inference I assume you mean stabilization policy.) Stephen says Canada has had no fiscal stimulus.
1. Was your belts and suspenders argument intended to apply to a closed economy model (like the US and world economies?) Or did you also favor large fiscal stimuls in Canada? If so, are you disappointed?
2. Do Canadian macroeconomists implicitly take world AD as a given, and assume that in a pinch the BOC can always depreciate the C$ if necessary? Thus making a backup policy like fiscal stimulus less essential?
3. My own view is that if the Canadian inflation forecast is where the BOC wants it to be, Canada is lucky that they haven't had US-style fiscal stimulus. We will have a huge debt burden requiring higher taxes.
Thanks.
Posted by: Scott Sumner | July 01, 2009 at 01:43 PM
One model that supports government interference in a specific scenario, how many opposing it? Which scenarios are more likely? I know realistically there is little chance the government will do a philosophical 180 and leave us alone, but when respected economists (like you) make such "givens" people often confuse their positions as support of a system they may actually feel is broken. You can't put an asterisks at the bottom of your policy... It's unfortunate many experts make a recommendation, then when you take them aside you discover a whole second set of opinions they were too shy/embarrassed/afraid/whatever to say in public. Maybe we need more economics Professors to blog anonymously so you can argue with each other without fear of damaging your reputation. Would something like that interest you?
Posted by: pointbite | July 01, 2009 at 03:03 PM
Scott: in normal times (i.e. before the current financial crisis) it was well-understood in Canada that the Bank of Canada was solely responsible for Aggregate Demand, that the fiscal authorities should not try to do countercyclical stabilisation, and that the Bank would offset with monetary policy any effects of fiscal policy on AD. That consensus was only put into temporary abeyance with the current recession, in part because of the fear that the Bank of Canada might "run out of ammunition".
1. My "belt and braces/suspenders" argument for monetary plus fiscal stimulus was intended to apply to an open as much as a closed economy. The open economy effects of fiscal policy on AD are complicated by our lack of knowledge about how the exchange rate will respond to fiscal policy when the nominal interest rate is stuck at zero. (I had an argument with Paul Krugman on that topic a few months back). My own (tentative) view is that fiscal policy is more effective than it normally is in a small open economy under ZIRP. (If I am right, all the extra AD from fiscal spending stays at home; none of it spills over to increase demand for net exports, because the exchange rate will depreciate to make sure it doesn't. But I may be wrong. It all depends on what one assumes about the expected future exchange rate.
I was never hung ho about fiscal stimulus in Canada, but on balance had a slight lean towards it. Compared to the US: we don't perhaps need it as much; but then the debt and deficit is less worrisome.
I'm not quite sure what to make of Stephen's graphs. They did surprise me. I'm a little disappointed. But then maybe the expectation of fiscal policy can be effective too.
2. We take AD in the rest of the world as given exogenously. The Bank of Canada never deliberately targets the exchange rate (and almost never directly intervenes in the forex market, though it reserves the right to do so in exceptional circumstances if forex markets freeze up). The exchange rate is seen as one of many indicators to which the Bank might respond, and one of many relative prices which responds to the Bank's actions. (There was a recent, successful attempt by the Governor to "talk down" the exchange rate).
3. I think the inflation forecast is not far off where the Bank wants it to be. But it will take longer than it wanted to return to target. And it might have been different with a different fiscal policy. We still have a deficit, because tax revenues have fallen, and will continue to fall. I think the main thing about fiscal policy is that the extra spending is taking a long time to happen.
Posted by: Nick Rowe | July 01, 2009 at 04:16 PM
pointbite: there are many issues on which people voting or speaking anonymously would feel much freer to vote or speak against the politically correct viewpoint. But I feel relatively comfortable speaking my mind on nearly all economic issues. The biggest thing holding me back from speaking my mind on financial market regulation is that I'm not sure what my mind is.
But one of the common arguments in favour of increased regulation does seem to be badly flawed: "Look at all the stupid things people did! A regulation could have stopped them doing that!" Sure, but would the regulators have been equally stupid? My reading is that regulators get caught up in exactly the same ways of thinking that, in hindsight, appear to have been mistaken.
The nice thing about the bank runs/lender of last resort theory is that it has a role for government which does not assume that government is any smarter than average.
Posted by: Nick Rowe | July 01, 2009 at 04:28 PM
Nick, That's interesting. I was especially interested in your view that exchange rates were not viewed as much of a stabilization tool. I would have thought that economists in smaller countries (than the US) would be less worried about liquidity traps than American economists, because currency devaluation would be an easy "ace in the hole" to create inflation if necessary. But I can imagine reasons for central banks wanting to stay away for that option if at all possible.
Thanks for responding. I don't know enough about Canadian regulation to contribute to the main topic.
Posted by: Scott Sumner | July 01, 2009 at 10:58 PM