The Challenges of Achieving Financial Stability

The end of the dot.com bubble in 2000 led to a debate over whether central banks should take financial stability into account when formulating policy, in addition to the usual indicators of economic stability such as inflation and unemployment. The response from many central bankers was that they did not feel confident that they could identify price bubbles before they collapsed, but that they could always deal with the byproducts of a bout of speculation. The global financial crisis undercut that response and has led to the development of macroprudential tools to address systemic vulnerabilities. But regulators and other policymakers who seek to achieve financial stability face several challenges.

First, they have to distinguish between the signals given by financial and economic indicators, and weigh the impact of any measures they consider on anemic economic recoveries. The yields in Europe on sovereign debt for borrowers such as Spain, Portugal and Ireland are at their lowest levels since before the crisis. Foreign investors are scooping up properties in Spain, where housing prices have fallen by over 30% since their 2007 highs. But economic growth in the Eurozone for the first quarter was 0.2% and in the European Union 0.3%. Stock prices in the U.S. reached record levels while Federal Reserve Chair Janet Yellen voiced concerns about a weak labor market and inflation below the Federal Reserve’s 2% target. When asked about the stock market, Yellen admitted that investors may be taking on extra risk because of low interest rates, but said that equity market valuations were within their “historical norms.” Meanwhile, Chinese officials seek to contain the impact of a deflating housing bubble on their financial system while minimizing any economic consequences.

Second, regulators need to consider the international dimensions of financial vulnerability. Capital flows can increase financial fragility, and the rapid transmission of financial volatility across borders has been recognized since the 1990s. Graciela L. Kaminsky, Carmen M. Reinhart and Carlos A. Végh analyzed the factors that led to what they called “fast and furious” contagion. Such contagion occurred, they found, when there had been previous surges of capital inflows and when the crisis was unanticipated. The presence of common creditors, such as international banks, was a third factor. U.S. banks had been involved in Latin America before the debt crisis of the 1980s, while European and Japanese banks had lent to Asia in the 1990s before the East Asian crisis.

The global financial crisis revealed that financial integration across borders exacerbated the downturn.  The rise of international financial networks that transmit risk across frontiers was the subject of a recent IMF conference. Joseph Stiglitz of Columbia University gave the opening talk on interconnectedness and financial stability, and claimed that banks can be not only too big to fail, and can also be “too interconnected, too central, and too correlated to fail.” But dealing with interconnected financial networks is difficult for policymakers whose authority ends at their national borders.

Finally, officials have to overcome the opposition of those who are profiting from the current environment. IMF Managing Director Christine Lagarde has attributed insufficient progress on banking reform to “fierce industry pushback” from that sector. Similarly, Bank of England head Mark Carney has told bankers that they must develop a sense of their responsibilities to society. Adam J. Levitin, in a Harvard Law Review essay that summarizes the contents of several recent books on the financial crisis, writes that “regulatory capture” by financial institutions has undercut financial regulation that was supposed to restrain them, and requires a political response. James Kwak has emphasized the role of ideology in slowing financial reform.

Markets for financial and other assets exhibit little sign of stress. The Chicago Board Options Exchange Volatility index (VIX), which measures expectations of U.S. stock price swings, fell to a 14-month low that matched pre-crisis levels. Such placidity, however, can mask the buildup of systemic stresses in financial systems. Regulators and other policy officials who seek to forestall another crisis by acting peremptorily will need to possess political courage as well as economic insight.