Andrew G Haldane: Ambidexterity
Remarks by Mr Andrew G Haldane, Executive Director, Financial Stability, Bank of England,
at the American Economic Association Annual Meeting, Philadelphia, Pennsylvania,
3 January 2014.
* * *
For most of the post-war period, central banks have executed macro-economic policy with, at
most, one hand - the monetary policy hand. It is generally felt that their dexterity improved
steadily over that period. This culminated in a long period of low and stable rates of inflation
and a steadily growing economy between the mid-1990s and 2007 - the "Great Moderation"
[Goodfriend, 2007]. Central banks had becalmed both inflation and the business cycle - and
had done so single-handedly. Or so it appeared.
But even while the economies of major advanced countries were an ocean of pre-crisis calm,
a storm was brewing out in the credit market seas. When this storm hit in 2008, it caused a
contraction in global output only rivalled by the Great Depression. Great Moderation turned
abruptly to Great Recession. In response, questions began to be asked about whether
monetary policy, while necessary, was sufficient to stabilise simultaneously the
macroeconomy and the financial system [Bank of England, 2009].
Unlike the Great Depression, central banks' response to the Great Recession was swift and
sizable. Central bank interest rates in most advanced economies quickly fell to close to their
floor, while central bank balance sheets rose to new heights. Relative to money spending,
central bank money supply is at its highest levels in the 15-year history of the European
Central Bank, the 100-year history of the US Federal Reserve, the 131-year history of the
Bank of Japan and the 319-year history of the Bank of England.
Accompanying these monetary policy changes has been a marked shift in regulatory
philosophy. Since the crisis, financial regulation has become explicitly macro-prudential
[Morris and Shin, 2008; Bank of England, 2011; Hanson et al, 2011]. This is an expression
much-used, but generally little-understood. In a nutshell, it means that policymakers have
begun using prudential means to meet macro-economic ends.
Those macro-economic ends include tempering swings in credit and leverage - the classic
credit cycle. The credit cycle is a long-established feature of the financial landscape [Aikman
et al, 2014]. Chart 1 shows its pattern in the UK over the past 130 years or so. The credit
cycle is every bit as regular as the business cycle. But it differs from the business cycle in
two critical respects: its amplitude is at least twice as large and its duration at least twice as
long. Both are important for the design of macro-prudential policy regimes.
The larger amplitude of the credit cycle is one reason why credit booms have, more often
than not historically, resulted in banking crises (Table 1). Because financial crises cause
large and long-lived disruption to the economy, this suggests a strong empirical link between
credit cycles and macroeconomic destabilisation. Or, put differently, curbing the credit cycle
appears to be an important ingredient of broadly-based macro-economic stability.
In principle, monetary policy could be used to curb the credit cycle. In practice, the differing
duration and synchronicity of the credit and business cycles means this is unlikely to work
well. Pre-crisis experience illustrates well just that point. At the same time as the wider
economy was operating in cruise control, credit markets were in overdrive. Hitting these two
birds - one flying high, the other low - with one (monetary policy) stone would have defied
even the most astute marksman [King, 2013].
What is needed, in these instances, is a second instrument. In the language of Tinbergen
[Tinbergen, 1952], two cycles and two objectives call for two instruments. This is where
macro-prudential policy comes in. One of the aims of macro-prudential policy is to act
counter-cyclically on the credit cycle, constraining credit booms and cushioning busts
[Aikman et al, 2014]. In this role, macro-prudential policy is complementing monetary policy
in its role of stabilising the macro-economy. Macro-economic policy then becomes, in effect,
two-handed or ambidextrous.
Since the crisis, this two-handed approach to policy has been taken up actively by a number
of countries internationally [IMF, 2013]. For example, counter-cyclical prudential policy is now
baked into new international regulatory rules. The so-called Basel III reforms introduced for
the first time a "Counter-cyclical Capital Buffer" (CCB) to be adjusted to counteract the credit
cycle [BCBS, 2010]. While a small step for mankind, this is a giant one for bank regulators.
It is also, inevitably, something of a step into the unknown. What will be the impact of
changes to the CCB on credit and growth? Will the two arms of policy (monetary and
macroprudential) be better than one? And, if so, what institutional arrangements best deliver those
benefits? Policy experience from the recent past and the present can shed light on these
questions.
The US dotcom bubble
As a first case study, consider the behaviour of the US economy after the bursting of the
dotcom bubble in 2001. Chart 2 plots US official interest rates in the period just before and
after this event. Interest rates fell sharply, from 6.5% at the beginning of 2001 to 1% by the
middle of 2003, to cushion the effects of the financial headwinds created by the dotcom
bubble popping.
Consider now what interest rate path would have been predicted had policy been responding
mechanically to deviations of inflation from target and output from potential - in other words,
following a standard "Taylor rule" [Taylor, 1993]. As Chart 2 shows, this would have implied a
less dramatic fall in interest rates in the US. After the dotcom crash, a gap opened up
between actual and Taylor-rule implied US interest rates. This was both sizable (on average,
one or two percentage points) and persistent (lasting from early 2001 right up until summer
2008). Over that period, the Taylor rule suggested US monetary policy was looser than could
be explained by inflation and output alone.
Whether by coincidence or causality, what happened next in US credit markets was
dramatic. Chart 3 plots the ratio of US credit-to-GDP, relative to its long run trend, over the
same period - the "credit gap". This indicator has a special significance from a regulatory
perspective because it will act as a guideline path for the setting of the CCB once Basel III
comes into effect. The US credit gap rose steadily from around 2001 up until 2008. Relative
to its long-run trend, credit-to-GDP reached a peak of over 10 percentage points. By
historical standards, this is a huge credit boom.
We can now ask ourselves the counter-factual question, how different might the world have
looked had macro-prudential policy been available to assist monetary policy? Answering this
question rigorously would require that we re-run the paths of policy, the economy and the
financial system over this period - a full counter-factual simulation. That is beyond the scope
of this paper.
As a shorthand, we can still do something simple but nevertheless informative about the way
the world might have looked. This is done by simply redrawing the path of US banks' capital
ratios on the assumption that the CCB had been in place. In particular, we can use the Basel
III calibration of the link between the CCB and the credit gap to simulate a hypothetical path
for US banks' capital ratios. Such an exercise is essentially identical to the common practice
of constructing Taylor rules for monetary policy, as in Chart 2.
Chart 4 draws the macro-prudential policy-implied path of US bank capital ratios. In
deference to the architect of modern theories of credit-induced instability, let us call this the
"Minsky rule" [Minsky, 1986]. The path of the Minsky rule is, in many respects, the
mirrorimage of the Taylor rule. It suggests that hypothetical US banks' capital ratios would have
been systemically and significantly tighter than their actual path between 2000 and 2009. In
other words, a tight macro-prudential stance would have counteracted the effects of a loose
monetary policy stance.
Although it is impossible to know for certain, it seems plausible that having this extra degree
of policy freedom would have helped stabilise the US economy and financial system. A
tighter bank capital regime would have tended to slow pre-crisis credit growth, thus
constraining the boom. And more capital in the US banking system would have helped
protect the wider economy from the credit crunch that followed the bust. In short, the
boombust cycles in US credit and GDP would have plausibly been somewhat less severe had US
policy been ambidextrous.
The euro-zone crisis
As a second historical example, consider the behaviour of some euro-zone crisis countries.
In the run-up to monetary union, monetary policy was loosened significantly in a number of
the peripheral European countries whose interest rates converged on core euro-area
countries. As Chart 5 illustrates, between 1995 and 1999 interest rates fell by between 3 and
6 percentage points in Ireland, Spain and Portugal. And in Greece between 1995 and 2001,
interest rates fell by a remarkable 16 percentage points.
Whether by coincidence or causality, what happened next in credit markets in these
countries was dramatic. The credit gaps in each of Spain, Portugal, Ireland and Greece
widened significantly and continued widening through the early part of this century (Chart 6).
By 2008, these credit gaps stood at over 25 percentage points in Greece and Portugal,
almost 40 percentage points in Spain and over 50 percentage points in Ireland. It is unlikely
that any of these countries have previously seen credit booms on this scale.
It is useful again to rerun history and ask how macro-prudential policy might have looked
over this period. Charts 7 and 8 give the "Minsky rule" paths for bank capital ratios in Spain
and Ireland relative to their actual paths. As in the US, they show macro-prudential
policyimplied capital ratios lying significantly above their actual paths, by progressively larger
amounts. At their peak, Minsky rule paths for bank capital are more than twice their actual
levels in Spain and three times their actual level in Ireland. Macro-prudential stringency
would have counteracted the loosening of monetary policy.
For those peripheral European economies that experienced a credit boom, it is plausible to
think a tighter macro-prudential stance would have helped reduce the severity of the global
crisis of 2008 and the euro-area crisis of 2010. Tighter capital standards would have slowed
pre-crisis credit growth, tempering the boom. And the extra capital built up in the European
banking system would have helped contain some of the collateral damage from the resulting
credit bust. In short, as in the US, the boom-bust cycles in credit and GDP in the euro-area
would plausibly have been much less severe had policy been ambidextrous.
The current conjuncture
The third example is from the present. In response to the crisis, short-term interest rates in
major advanced economies fell rapidly to their floor and have remained there (Chart 9).
Aided and abetted by programmes of quantitative easing, real long-term rates have followed
suit, falling to historically unprecedentedly low levels (Chart 10). These responses from
monetary policy were a natural reaction to the opening-up of sizable output gaps in many
advanced economies. Extraordinary times called for extraordinary measures.
Whether by coincide or causality, what has happened since in financial markets has been
striking. The risk-taking cycle in some advanced economies has decisively turned. For
example, issuance in the US high-yield market reached a record high in 2013, with half
coming in a "covenant-lite" form (Chart 11). This is evidence of a renewed "hunt for yield"
among investors [Stein, 2013].
We do not need to run a counter-factual experiment to determine the macro-prudential
responses to these emerging pressures. A number of countries have already taken
preventative macro-prudential action to forestall excessive risk-taking (Table 2). These
measures are intended to forestall too rapid an accumulation of credit. In short,
macroprudential stringency is seeking to counteract any adverse risk-taking consequences of loose
monetary policy.
In the UK, the Bank of England's Monetary Policy Committee (MPC) has been pursuing a
policy of extra-ordinary monetary accommodation. Recently, there have been signs of
renewed risk-taking in some asset markets, including the housing market. The MPC's
macroprudential sister committee, the Financial Policy Committee (FPC), has been tasked with
countering these risks. Through this dual committee structure, the joint needs of the
economy and financial system are hopefully being satisfied.
Some have suggested that having monetary and macro-prudential policy act in opposite
directions - one loose, the other tight - somehow puts the two in conflict [De Paoli and
Paustian, 2013]. That is odd. The right mix of monetary and macro-prudential measures
depends on the state of the economy and the financial system. In the current environment in
many advanced economies - sluggish growth but advancing risk-taking - it seems like
precisely the right mix. And, of course, it is a mix that is only possible if policy is
ambidextrous.
To underscore this point, Chart 12 plots a scatter of counter-factual Taylor and Minsky rules
in the UK over the period 1964 to 2011. Points in the upper right and lower left quadrants
signal monetary and macro-prudential policy operating in the same direction; points in the
upper left and lower right, these policies operating in opposite directions. The points are fairly
evenly scattered across all four quadrants. This tells us that the right
macroprudential/monetary policy mix depends critically on the relative needs of the economy and
the financial system. But two arms beat one, hands-down.
Institutional arrangements and macro-prudential policy
Finally, if macro-prudential policy is a useful addition to the policy toolkit, who should have
control over it? Here, a comparison with monetary policy experience is illustrative.
Macro-prudential policy faces many of the same dilemmas as monetary policy. The most
serious of these is the time-consistency dilemma [Kydland and Prescott, 1979; Chari and
Kehoe, 2013]. In the monetary policy sphere, this manifests as a desire to loosen policy
today to support the economy when tightening to control inflation tomorrow would be more
appropriate. In the macro-prudential sphere, it manifests as a desire to loosen regulation to
support today's growth when tightening to counter tomorrow's crisis would be more
appropriate. In both cases, policy faces an inter-temporal trade-off in its objectives - a
myopia trap.
The time-consistency dilemma is likely, if anything, to be even more acute when fighting
crises than when fighting inflation [Haldane, 2013]. The reason is that credit cycles last at
least twice as long as business cycles. The myopia trap for macro-prudential policy is even
more painful than for monetary policy. That is why "This Time is Different" has so often in the
past been the pre-crisis refrain [Reinhart and Rogoff, 2008].
In the monetary policy sphere, an institutional solution has been applied to this myopia
problem. Specifically, in most countries these days monetary policy decision-making has
been delegated to a long-sighted, arms-length agency - typically, an independent central
bank. This is now accepted best practice globally [Goodfriend, 2007]. Because it faces a
time-consistency dilemma every bit as acute, the self-same logic applies to macro-prudential
policy. In other words, one safeguard against financial crisis myopia comes from placing the
levers of macro-prudential policy in the hands of an arms-length, independent central bank
[Haldane, 2013].
There is a second reason for doing so. Experience from the past and the present suggests
that using the monetary and macro-prudential arms in tandem may have helped stabilise
simultaneously the financial sector and wider economy. That calls for
monetary/macroprudential co-ordination. Such co-ordination is more likely to be happen if these two arms are
attached to a single body and head. Monetary and macro-prudential policy then represent
two halves of the same central bank brain.
In practice, these arguments have not, so far at least, entirely won the day internationally. A
significant number of new macro-prudential frameworks have emerged internationally in the
past few years. In some cases, including in the UK, central banks have been handed
macroprudential responsibilities. This has enabled explicit co-ordination between the monetary and
macro-prudential arms when tackling the joint needs of the economy and financial system -
for example, in the UK through joint meetings of the Bank's MPC and FPC.
But in a number of other countries, responsibility for macro-prudential policy has been
located outside of central banks [IMF, 2013]. We have a mixed model. In this institutional
respect, macro-prudential policy today resembles monetary policy perhaps a generation ago.
It is, of course, still early days for macroprudential regimes. Monetary policy took a
generation, if not two, of trial and error to find its feet. For policymakers finding their feet
today, doing so will be far easier using two arms than one.
Chart 1 Credit and business cycles Chart 2 US interest rates
Source: Bank calculations Source: Thompson Reuters DataStream; Bank calculations
Chart 3 US Credit Gap Chart 4 Actual and implied capital in the
US
Sources: BIS, OECD and Bank calculations Sources: BIS, OECD, FDIC and Bank calculations
Chart 5 Policy rates in Europe Chart 6 Credit gaps in Europe
Chart 7 Bank capital ratios in Spain Chart 8 Bank capital ratios in Ireland
Sources: BIS, OECD and Bank calculations Sources: BIS, OECD and Bank calculations
Chart 9 Policy rates in advanced Chart 10 Real long-term interest rates
economies
Source: Thomson Reuters DataStream
Sources: Bloomberg and Bank calculations.
Chart 11 Covenant-lite and other
Chart 12 Taylor-Minsky rule for the UK
highyield
loan issuance in the US
Source: JPMorgan Chase & Co.
(a) Volume as of 15 November 2013.
Table 1 The credit cycle and subsequent crises
Crisis years** within 5 % peaks with crisis years within
Total peaks 1880-2008*
years following a peak the following 5 years
AUS 9 6 67%
CAN 11 6 55%
DEU 9 2 22%
DNK 10 4 40%
ESP 8 5 63%
FRA 5 3 60%
GBR 9 7 78%
ITA 11 8 73%
NLD 8 1 13%
NOR 13 5 39%
SWE 10 4 40%
USA 9 6 67%
112 57 51%
* Interwar data missing for most countries. Data coverage incomplete for other countries e.g. only post-1945 data
available for France.
** Defined as years in which either a banking crisis or a currency crisis or both ("twin crisis") occur.
Source: Bordo et. al. (2001) and Bank calculations. Reproduced from Aikman et al (2010).
Table 2 International experience with macro-prudential tools
Country Action Other
Sweden Risk weight floor on residential mortgages of 15%, Followed LTV limit. Announced
from an average of 5%. intention to increase to 25%.
Switzerland Sectoral capital buffer of 1% on residential mortgages Limited impact so far. Also
followed an increase in risk
weights on high LTVs.
Hong Kong Repayment criteria toughened, a risk weight floor of Action on car park spaces
15% for residential mortgages, LTV on car park spaces followed leakages of the house
and commercial property price exuberance into other
sectors
New Zealand Restriction of new high LTV lending to 10% of new
loans
Singapore Debt service ratio, reduced repayment periods, Part of a series of measures.
tightened LTV, increased land supply
Norway Countercyclical capital buffer of 1% from July 2015
UK Removed incentives for household lending in Funding
for Lending scheme.
FPC given ability to recommend changes to
affordability criteria on mortgage lending.
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