Relative to money spending, central bank money supply is at its highest levels in the 15-year history of the European Central Bank, the 100-year history of the US Federal Reserve, the 131-year history of the Bank of Japan and the 319-year history of the Bank of England. Accompanying these monetary policy changes has been a marked shift in regulatory philosophy. Since the crisis, financial regulation has become explicitly macro-prudential [Morris and Shin, 2008; Bank of England, 2011; Hanson et al, 2011]. This is an expression much-used, but generally little-understood. In a nutshell, it means that policymakers have begun using prudential means to meet macro-economic ends. Those macro-economic ends include tempering swings in credit and leverage – the classic credit cycle. The credit cycle is a long-established feature of the financial landscape [Aikman et al, 2014]. Chart 1 shows its pattern in the UK over the past 130 years or so. The credit cycle is every bit as regular as the business cycle. But it differs from the business cycle in two critical respects: its amplitude is at least twice as large and its duration at least twice as long. Both are important for the design of macro-prudential policy regimes. The larger amplitude of the credit cycle is one reason why credit booms have, more often than not historically, resulted in banking crises (Table 1). Because financial crises cause large and long-lived disruption to the economy, this suggests a strong empirical link between credit cycles and macroeconomic destabilisation.
For those peripheral European economies that experienced a credit boom, it is plausible to think a tighter macro-prudential stance would have helped reduce the severity of the global crisis of 2008 and the euro-area crisis of 2010. Tighter capital standards would have slowed pre-crisis credit growth, tempering the boom. And the extra capital built up in the European banking system would have helped contain some of the collateral damage from the resulting credit bust. In short, as in the US, the boom-bust cycles in credit and GDP in the euro-area would plausibly have been much less severe had policy been ambidextrous. The current conjuncture The third example is from the present. In response to the crisis, short-term interest rates in major advanced economies fell rapidly to their floor and have remained there (Chart 9). Aided and abetted by programmes of quantitative easing, real long-term rates have followed suit, falling to historically unprecedentedly low levels (Chart 10). These responses from monetary policy were a natural reaction to the opening-up of sizable output gaps in many advanced economies. Extraordinary times called for extraordinary measures. Whether by coincide or causality, what has happened since in financial markets has been striking. The risk-taking cycle in some advanced economies has decisively turned. For example, issuance in the US high-yield market reached a record high in 2013, with half coming in a “covenant-lite” form (Chart 11). This is evidence of a renewed “hunt for yield” among investors [Stein, 2013].