Procyclicality in the Financial System: Do We Need a New Macrofinancial Stabilisation Framework?

Abstract

The successful pursuit of the objective of low inflation by central banks in recent decades has also delivered low variability of both inflation and output. At the same time, numerous financial and other "imbalances" (defined here as significant and sustained deviations from historical norms) have emerged. Should these imbalances revert to the mean, there could be significant effects on output growth. Although such an adverse outcome remains only a possibility, the question asked in this paper is whether we might still benefit from a new macrofinancial stabilisation framework in which monetary and regulatory policies gave more attention to avoiding the emergence of imbalances in the first place.

The Instability and Inequities of the Global Reserve System

“…These boom-bust cycles follow the endogenous unstable dynamics analyzed by Minsky (1982), who argued that financial booms generate excessive risk taking by market agents, which eventually leads to crises. A similar explanation has been suggested more recently by White (2005), who underscores how the "search for yield" characteristic of low interest rate environments generates incentives for credit creation, carry trade, and leverage that easily build up asset bubbles.…”

Capital Account Liberalization and Management

“…This is consistent with Minsky's (1982) view that financial markets follow a pattern of endogenous unstable dynamics, as they generate excessive risk-taking by market agents during booms -indeed, this risk-taking increases the longer the boom lasts -that eventually lead to crises. A similar explanation has been suggested by White (2005), who underscored how the 'search for yield' characteristic of low interest rate environments generates incentives for credit creation, carry trade, and leverage that easily build up asset bubbles. In developing countries with thin or small markets, there exists a short-term bias in financial markets (as discussed below), bubbles are easier to create, and their effects can be devastating.…”

An Overview of Macroprudential Policy Tools

“…While many, policyoriented papers, notably at the BIS, had drawn attention to the need for a macroprudential approach (e.g., Borio, 2003, Borio and White 2003, White, 2006, these mostly did not adopt the formal perspectives of externalities. Several recent papers, however, have identified the externalities that can give rise to procyclicality and systemic risk, with Brunnermeier et al (2009) one of the first to do so.…”