Thomas Donlan‘s latest editorial commentary for Barron’s suggests he’s not particularly impressed by those charged with overseeing government monetary policy.
Janet Yellen indicates that she believes that supporting the U.S. economy with low rates is much more important than allowing markets to set realistic, risk-adjusted prices for money and credit. But a weak economy is not strengthened with a deluge of funny money.
Yellen also says that “macroprudential” regulation belongs on the pedestal that was long occupied by control of interest rates and the money supply. Making a startling admission for a person in charge of monetary policy, she said it “faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood.”
She leavened that, however, with a parallel admission that central bankers have little experience with their macroprudential tools, which are regulatory constraints on borrowing and leverage.
In her recent speech to the International Monetary Fund, Yellen gave examples of macroprudence: capital requirements, with especially stiff ones for the biggest banks; liquidity requirements; a resolution regime to settle claims and debts of banks that do collapse; and margin and clearing requirements for derivatives.
She said the world needs “a regulatory umbrella wide enough to cover previous gaps in the regulation and supervision of systemically important firms, and markets can help prevent risks from migrating to areas where they are difficult to detect or address.”
Apparently, Yellen believes that regulators can build an infinitely large umbrella with power that surpasses the power of profit and with speed that surpasses the speed of thought.
“We have much to learn to use these measures effectively,” she conceded, but her idea of meaningful success was represented by the Fed’s stress tests and the “countercyclical capital buffer” of Basel III.
A stress test is like a war game—oxymoronic. It’s a theoretical exercise using hypothetical scenarios and calling the result reality. Even assuming that the test designers are sincere, their imaginations are limited. And in the stress test, the test-takers have such an extreme incentive not to fail that cheating is or will become a more attractive alternative.
