Macroprudential Policy: Big Words for “We Still Don’t Know”

by JT McGee

Central banks use macroprudential policy to outsmart Wall Street.Inserted in my daily reading of exciting macroeconomic publications is this new buzzword; you know, “macroprudential policy?” I mean, nothing says buzzword like seven or eight syllables—I think it’s eight…

Anyway, this new buzzword is everywhere, and I love it. I love it mostly because it’s just a great way to say, “we still don’t know, but we know more than you!”

Economics is a science that isn’t a science. We have a really hard time testing what works and what doesn’t. How can you test what works and what doesn’t when you can’t have a perfect control?

Well…you can’t test it perfectly. That’s why this quote is so famous:

An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today. – Laurence J. Peter

It’s true, isn’t it? When economists say that they have new macroprudential policy measures, they’re telling us that they have new solutions gleaned from yesterday’s problems.

Drawing Circles with Straight Lines

Economics is, in a lot of ways, like attempting to draw a circle with straight lines. Can it be done? No. It obviously can’t. I could give you 8 straight lines and you’d give me a hexagon; I could give you 16 and you’d give me a 16-gon.

Each way along the line we get closer to what is a circle but we’ll never really get there. This process of adding more straight lines is, explained with some goofy mathy word thing, the way we try to compute pi down to the very last digit.

It’s also similar to the whole “.9 repeating = 1” thing. If 1/3 is .3 repeating, and 3x.3 repeating = .9 repeating, then why does 3/3 (three-thirds) equal 1? It’s all kind of silly, really—where did that .000000000000000000001 go that we couldn’t find?

More realistic, let’s use the analogy with a needle, since sharp objects should help me get to the point (haha, pun!) of this article. Needles are super sharp, but even at the very end of them, they are still flat. We obviously cannot make a needle that is pointy all the way to the tip—it’s just impossible.

These examples are all theoretical, but when we craft them into the operating system of our existence—the economic institutions that shape human behavior and action—they become vastly tangible.

Financial Crises

Every single financial crisis is due the reality that we can’t make a circle of straight lines just like we can’t find an end to pi, even though we’ve found a practical end to it.

LTCM had perfect arbitrage, it thought, in arbitraging short-term borrowing costs with long-term debt. Theoretically, in an efficient market, the difference between bonds set to mature in 30 years should be the same as a bond set to mature in 29.75 years. So LTCM would borrow in the short-term, effectively hedge out the difference in yields, and rely on the markets to revert to efficiency, at which point it would exit its position for a huge profit. (They were earning 40% per year with leverage—killin’ it!)

Of course, LTCM = Asian Financial Crisis.

Leverage comes at a cost to everyone. Interjecting another analogy, we could make one car faster than another by lowering it closer to the ground. If we lowered it by one inch compared to our competitor, we’d kick the crap out of the other car. Eventually, the back and forth of our efficient racecar market would produce two cars that are 1” above the ground. 99% of the time, the road is clear, but in the race for the fastest car we’d eventually hit a speed bump. The car would crash, catch on fire, and burn all for that extra .001mph.

New Macroprudential Policy

The Federal Reserve's zero interest rate policy created macroprudential policy.We’re smarter now!

To make a long story short, inflation is running rampant in the emerging markets, mostly due to the advanced economies fuelling their bubble. I covered this in a post about 2011-2012 capital flows.

The traditional tool of monetary policy, the interest rate, is no longer effective. Since the world sees a 0-.25% rate for US dollar carry as a weak dollar policy (it is) the world is borrowing in the US and lending in emerging markets. For the emerging markets to tackle high inflation, they’ll have to use macroprudential policies, since raising interest rates domestically would only bring in more international capital.

This is why China is so adamant about using reserve requirements, as rate hikes (they’ve recently gone to rate hikes out of pure necessity) only make borrowing in US Dollars and lending in Chinese Renminbi sexier to carry traders. Reserve requirements have historically been the untouchable lever of monetary policy. Now they’re rebranded as macroprudential tools to out-think the markets.

There you have it! Macroprudential policy…you’ve now a new friendly buzzword to throw around in casual conversation.

Photos by: Adam Baker, Gage Skidmore

{ 2 comments… read them below or add one }

Ross @ Go Be Rich May 30, 2011 at 14:48

Okay, so I think I’m going to officially follow your blog in an attempt to learn what some of these stock-market terms mean…this would be the area of finance I’m weak in. I’m liking all the analogies though, it makes it a little easier to understand, and a bit more interesting to read.

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JT McGee May 30, 2011 at 15:12

Alright, another reader. 😀

This is a relatively new term, which we’re likely to see all over the financial media in the coming months to years. It means practically nothing, just that central banks are now setting monetary policy with new tools designed to protect the entirety of the financial framework, not just the relatively mundane boom and bust cycle. It falsely assumes that investment interest is static, when it is super dynamic.

Of course, future destruction and blowups in the financial markets will exist as long as we leverage up full-tilt for fat profits. I see no end to that, regardless of regulatory, fiscal, or monetary policy measures. Macroprudential or just ordinary, we’re still flawed.

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