Although my friend Srinivas Thiruvadanthai did not mean to pose the question as such, I thought I would credit him with a ‘Trilemma’ that, I hope, will remain for posterity! His blog post triggered the following thoughts:
Another thoughtful and thought-provoking post as usual, Srini. The last paragraph of the post has been the rallying cry of BIS economists from White to Borio (including Cecchetti or not?).
I found the paragraph on the ‘ex-post criticism’ of the Fed not being easy enough in mid-2008 to be particularly insightful. Hindsight is a gift for critics that is denied to policymakers in real time!
The blog post can be considered a formulation of ‘Thiruvadanthai Trilemma’ between free-market finance, financial stability and economic stability. You can have two of the three but not all of them.
Notice that I have taken interest rates out of this trilemma. That is deliberate. In other words, the problem that there is no one single interest rate that stabilises the financial economy and the real economy at the same time disappears if (a) we remove the paradigm that ‘markets know best’ particularly for the financial sector and for financial markets (in a sense, I believe, the comments by Ms. Carolyn Sissoko reflect that) and if (b) the relevant horizon to evaluate the correctness of the monetary plolicy setting was long enough.
Let me take up my point (a) above. The question is whether regulating finance alone is both necessary and sufficient to enjoy both financial and economic stability at the same time. Yes, some would say.
That is what Ms. Caroline Sissoko has said in her coments on his post. But, is that really the case? We will never know because two things were at work in the post-Great Depression period and, in particular, in the post-WW II period. Economic growth was a low-hanging fruit. Therefore, it is possible that, regardless of how the financial sector or financial markets behaved, sustained high growth would have washed away all sins – with or without tight regulation. We will never know.
Therefore, it logically follows that in the era of slower growth that we face now, the case for financial sector and financial market regulation becomes stronger and not weaker.
Critics would object that this would further jeopardise the already lower growth. Well, the IMF has the answer. In a paper that is now a book, ‘Too much Finance’, the authors argue that financial development in advanced nations has already crossed the theshold at which it is beneficial for economic growth.
So, financial sector/financial market regulation will take care of the ‘Thiruvadanthai Trilemma’.
Fortifying that will be a monetary policy setting that chooses its relevant horizon more carefully than what central bankers have done in the last three+ decades. It should be longer than the business cycle so that it encompasses the financial cycle. I am merely paraphrasing the arguments made regularly by BIS economists. That is my point (b) above.
In a long enough time horizon, the dilemma, of fixing a high enough rate that handles financial market exuberance without hurting real economic activity or a low enough rate that allows financial intermediation to repair or to resume while the economy is overheating, solves itself.
In recent times, I beleive that the former dilemma has imposed much bigger long-run costs on the economy and on the society than the latter dilemma, in the above paragraph.
If unelected and technocratic policymakers optimise their decision over a reasonably long time frame, then the need for (or, the impossibility of) multiple policy rates is avoided or obviated.
If they cannot do that in practice that easily, then another approach is to have the domestic economy counterpart of ‘unremunerated reserve requirements’ that is applied to regulate capital flows. There can be a counter-cyclical credit surcharge (or discount) that the central bank, in its capacity as a banking regulator, prescribe for credit allocation, on the top of the policy rate. There can be times when this surcharge (negative or positive) can be zero. In that case, the policy rate works both for the financial economy and for the real economy. This can be on top of (and not in lieu of) countercyclical capital buffers that regulators now want to impose on banks.