Recent debate over the optimal form of regulatory architecture for increasingly integrated and interconnected financial systems has largely focused on redefining the balance between regulators and the universe of financial institutions they regulate. This piece identifies a less “fashionable” – though no less significant – contributor to the global financial crisis, that is, the dysfunctional relationship which often existed between financial regulators and monetary policy authorities. The fact that this dysfunction has not been discussed in depth suggests that its negative consequences are no less likely to re-emerge in the future.
Using Ireland’s economic downturn as a guide, this blog will explore the ways in which monetary policy affects how financial institutions ought to be regulated and whether closer coordination of these two functions might lessen repeated instances of overexpansion of credit. This is not to say that monetary policy instruments should be used as regulatory tools, but rather that more “joined-up thinking” might enable wielders of such instruments to better manage the consequences of their actions on the financial system.
Monetary Policy and the Credit Environment in Ireland (1996 – 2006)
The story of Ireland’s economic rise and fall is well-told, with most accounts of the latter referencing a confluence of (1) reckless bank lending (2) weak prudential supervision and (3) misguided fiscal policy which contributed to it. Indeed, many commentators have concluded that the banking and subsequent economic crises were caused, either largely or in part, by home-grown phenomena.
Notwithstanding this, the impact of cheap and freely-available credit on Ireland’s economic trajectory cannot be underestimated.
Between 1996 and 2006, GDP growth rates in Ireland exceeded the Eurozone average by almost 5% annually. As a member of the single currency, however, Ireland ceded control over its monetary policy to the European Central Bank which had a responsibility to set appropriate nominal rates for the entire Eurozone. Subsequently and even consequently, Ireland had difficulty reining in inflation, leading to a period of very low, and sometimes negative, real interest rates: the ECB policy rate was less than the Irish inflation rate for most of the decade prior to the crisis. Estimates suggest that, had Eurozone interest rates been set in accordance with a Taylor rule for Ireland, the interest rate would have been almost 6% higher on average during the period, and up to 12% higher in 2000.
With Ireland’s entry to the Eurozone, Irish banks began to fund much of their lending through short-term foreign borrowing. This allowed Irish financial institutions to extend much higher volumes of credit to borrowers at lower cost and contributed to the credit boom, the sharp increase in household debt, the property bubble and the general overheating of the economy.The removal of exchange rate risk facilitated foreign funding, including for the growing current account deficits. As Honohan (2009) and others have noted, this finance easing meant that Ireland’s boom could continue for longer than without EMU membership and the asset bubble could become greater.
Of course, there were many other viable policy instruments – such as fiscal policy or bank regulation – which were not deployed to offset the expansionary effects of Eurozone membership on the macroeconomic environment. However, it is submitted that the deleterious effects of political inertia at a domestic level were exacerbated by this disconnect between an ineffective national regulatory strategy and a supranational monetary policy which was inappropriate for Ireland. Moreover, reforms to European banking regulation still leave much of the enforcement to national authorities in tandem with the European Systemic Risk Board, while monetary policy remains within the exclusive remit of the ECB. Nor should the international community see Ireland as an isolated case: many writers have identified a similar disconnect in the context of the subprime debt crisis in California and elsewhere across the United States, making this issue one of more widespread applicability.
Benefits and Costs of Greater Prudential and Monetary Coordination
It can be argued that there are important positive externalities from combining monetary policy and prudential regulatory roles. As the implementer of monetary policy, a central bank has continuous interaction with market participants that gives it a window into emerging vulnerabilities, an important attribute for an effective regulator. Conversely, having responsibility for the oversight of financial institutions may help the central bank better understand the transmission of monetary policy actions into the real economy.
On the other hand, it has been suggested that the combination of financial supervision and monetary policy, each of which is by itself of great importance, would concentrate too much power in a single organization. Even if the concentration of power were justified, exercise of regulatory responsibilities would become the subject of intense political scrutiny both in good times, where the authority might try to restrain financial expansion, and in bad, when it could provide discretionary support to particular threatened institutions. While political scrutiny, in itself, is no bad thing, the risk that it could lead to the politicization of the central bank’s monetary policy role, with potential adverse consequences for price stability, must be taken into account.
Reigniting responsible conversation
The purpose of this brief exposition is not to pass judgment on the robustness of the Central Bank of Ireland, the European Central Bank or its administrators, but rather to reignite a responsible conversation on the on-going relationship between prudential regulators and monetary policy authorities. At the very least, Ireland’s experience should inform the current debate over financial regulatory and supervisory reform.