History shows the limits of macroprudential policy in curbing dangerous risk-taking
AMERICA’S Federal Reserve faces a dilemma: to put the economy back on its feet it is keeping interest rates at zero and buying bonds; but in doing so, it worries, it is egging on dangerous risk-taking. Cue “macroprudential” policy. In theory, central banks would use regulatory and supervisory authority to stamp out excesses in specific markets while leaving monetary policy to take care of inflation and employment.
History suggests this is easier said than done. “Macroprudential” may be new jargon, but America has tried variants of it for decades, from credit controls to down-payment limits. And the record is not a ringing endorsement for macroprudential policy, according to a new working paper by Douglas Elliott of the Brookings Institution, Greg Feldberg of America’s Treasury Department and Andreas Lehnert of the Fed. They found controls were often circumvented by regulatory arbitrage. And when controls worked, political pressure sometimes led to their repeal.
As the authors note, evaluating the record of macroprudential policy is complicated by sketchy data, numerous regulators and markets, and the blurred line between permanent and cyclical regulatory changes. Broadly, the macroprudential controls aimed either to regulate the supply of credit or the demand for it.
Supervisory pressure, reserve requirements and interest-rate ceilings have all been used to control the supply of credit, but success at suppressing bank lending often merely led other lenders to fill the void. In 1929 the Fed, alarmed at the speculative surge on Wall Street, instructed banks to curtail lending to stockbrokers. Bank loans duly declined, but total loans still rose as corporations, attracted by the high interest rates on offer, stepped in.
From 1935 the Fed had the power to use reserve requirements—the portion of deposits banks must keep on hand as cash—to manage the business cycle. The authors find that from 1948 to 1980 higher reserve requirements modestly reduced the growth of bank credit. But the impact on overall credit growth was muted as non-banks made loans that banks no longer could. In the 1960s and 1970s large banks found sources of funding that escaped the requirements, forcing the Fed to rejig the rules.
Interest-rate ceilings had similar problems. As market interest rates began to rise in the 1950s, banks lost deposits to other institutions not covered by the ceilings. This helped restrain lending and inflation, but over the years it mostly affected small banks; large banks diversified their funding sources. The advent in the 1970s of money-market funds, combined with dramatically higher interest rates, led to massive outflows of deposits and, eventually, legislation abolishing the ceilings.
Regulators had more success controlling demand for credit. In 1941 Franklin Roosevelt invoked the Trading With the Enemy Act of 1917 to authorise the Fed to restrict consumer-instalment loans. The idea was to suppress consumption and free resources for the war effort. The Fed, which administered controls through its Soviet-sounding “Division of Selective Credit Regulation”, used them to suppress inflation while interest rates were subordinated to the Treasury’s funding needs. The authors found that tightening the controls generally caused credit growth to slow.
In 1950 the Fed’s authority was extended to home loans. In October that year it set out a specific target: reduce home construction by one-third over the coming year. To do so it set limits on loan-to-value ratios and maturities that became more restrictive with the size of the loan. At the same time the Federal Housing Administration and Veterans Administration, which guaranteed residential mortgages, raised down-payment requirements and reduced loan limits. Home construction consequently fell, albeit by a quarter, not a third.
Succeeding too well
Though they worked, credit controls were deeply unpopular. At one congressional hearing bankers called them “a long step in the direction of government planning”. In 1952 Congress stripped the Fed of its authority to use the controls.
In 1969 Congress restored that authority with the Credit Control Act, hoping that the Fed could target inflation-prone sectors while sparing the broader economy the pain of higher interest rates. Republicans attacked the bill for establishing “a complete credit police state.” One Fed official promised never to use the authority “short of a national war.” The act was not invoked until 1980, as part of President Jimmy Carter’s battle against inflation. The Fed imposed higher reserve requirements on banks advancing credit cards and personal loans, and (for the first time) on money-market funds.
The controls succeeded spectacularly: credit plummeted, even in exempted categories such as car and home loans. America tumbled into a short, sharp recession, prompting the controls to be lifted. The experience soured the Fed and Congress on credit controls; the law was repealed shortly afterwards.
Indeed, by the mid-1980s, most direct restraints on credit had been repealed and the Fed came to rely on interest rates alone to regulate demand and borrowing. Supervisors continued to issue warnings: they did so about subprime lending in 1999, home-equity lending and commercial property in 2005, and exotic mortgages in 2006. None had much impact on overall credit growth. This was partly because so many lenders were not regulated as banks. But it was also, the authors note, the first major credit expansion in Fed history when supervisory guidance was not backed up by direct actions such as tighter monetary policy, interest-rate ceilings or credit controls.
Although such controls are popular elsewhere, there is little talk of bringing them back. To work, they would require multiple regulators co-ordinating across multiple markets, in the face of fierce political opposition. Instead, regulators simply hope to make the financial system more resilient should a bubble one day burst.
