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The Best Monetary Policy Is Strict Financial Regulation

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FEDERAL RESERVE
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On Wednesday, in her first speech on monetary policy, Janet Yellen, the new chairwoman of the Federal Reserve, pointed out a discouraging paradox: In recent years, private-sector forecasters have been surprisingly accurate at forecasting changes in the unemployment rate, but they have been equally inaccurate when forecasting changes in the federal funds rate, the baseline interest rate controlled by the Fed.

Since interest rates supposedly have a strong effect on unemployment, how can forecasters be so right about unemployment if they're so wrong about interest rates?

Three economists at the Bank of International Settlements -- Morten L. Bech, Leonardo Gambacorta, and Enisse Kharroubi -- have been studying this question, and coincidentally their results were published this week in the journal International Finance.

Bech and his colleagues amassed a dataset of interest rates and economic output for 24 industrialized countries from 1960 to today. Over that time period, these countries experienced 78 recessions, of which 34 were the result of financial crises like the one we experienced a few years ago. In each recession, the BIS economists measured how much the central bank lowered interest rates to stimulate recovery -- and then how long it took for the economy to recover its lost output.

Unsurprisingly, they found that "normal" recessions -- the ones without a financial crisis -- were much less severe. On average, they resulted in an output loss of 1.9 percent, which it took the country 3.8 years to recover. Financial crises, on the other hand, resulted in an output loss of 8.2 percent, which it took 5.1 years to recover.

What was perhaps more surprising was the fact that "accommodative" monetary policy -- i.e. lowering interest rates -- had no effect on the economy after a financial crisis. This wasn't the case with normal recessions. Typically, the more the central bank lowered the interest rate, the faster the economy recovered its lost output. But not so with financial crises.

In times like these, interest rates simply don't matter as much as they normally do.

That doesn't sound like good news for Janet Yellen. What's a central banker to do?

Fortunately, the BIS economists did find one thing that accelerated recovery from financial crises: private-sector deleveraging. After a normal recession, it doesn't seem to matter whether households and firms pay down their debt, but after a financial crisis, it significantly speeds up economic growth.

As luck would have it, the Federal Reserve has a tool at its disposal that can reduce the economy's reliance on debt. It's called the "capital requirement," and it refers to the difference between what a bank owns and what it owes.

When a recession strikes, asset prices fall, and since banks own a lot of assets, their value goes down. If they go down too much, they can fall below what the bank owes to its lenders and depositors, meaning it's basically bankrupt. It doesn't own enough to pay what it owes.

So the Fed sets a minimum capital requirement. The more capital a bank is required to have, the more it has to own relative to what it owes. It's a buffer. The bigger the buffer, the more room asset prices have to fall before the bank becomes bankrupt.

Unfortunately, banks don't like high capital requirements. They want to rely on debt. Why use your own cash when you can use somebody else's cash? Lower capital requirements are cheaper -- but they're also more dangerous because it's easier to go bankrupt when you owe so much relative to what you own.

Banks argue that high capital requirements restrain lending because they can't borrow as much debt to fund their loans, but another paper published in the latest issue of International Finance debunks this myth. In it, the German economists Claudia M. Buch and Esteban Prieto study the behavior of German bank lending for the past 44 years, and they find that banks with higher capital actually issue more business loans.

This doesn't come as a surprise to those of us who understand how banks actually operate. They don't lend based on how much debt they can borrow. They lend based on how many loans they can sell. The more, the better. The only question is, will they fund the loans with cash or debt?

Janet Yellen may have her work cut out for her in this post-financial-crisis economy, but there is a way to stimulate the economy and prevent future crises. It all starts with financial regulation.

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This op-ed was published in Friday's South Florida Sun-Sentinel.