The severity of the recession might appear to tilt the argument in favour of “leaning”, but the question still arises as to how effective such a policy would have been in restraining the boom in credit and property prices and at what cost to activity. Together with colleagues from the Bank (Bean et al, 2010), I recently attempted to investigate this question using simple vector autoregressive models of the US and UK economies. I will refer you to the paper for the details, but Table 1 shows the results of counterfactual simulations of a pretty aggressive “leaning against the wind” policy, in which the policy rate is held around 200 basis points higher over the 2003–2006 period. The simulations suggest that the peak in real house prices would have been about 7½% lower in the United States and some 20% lower in the United Kingdom. The impact on the stock of credit is, though, more modest: just 3–4% lower by the end of 2006. Moreover, the cumulative impact on activity is considerable, with output around 3% lower by the time the crisis begins. Clearly, then, the terms of trade for controlling the risks to financial stability through monetary policy alone do not look very favourable: even substantially higher interest rates over a sustained period would not have prevented the crisis. A similar conclusion is reached by Bernanke (2010) and Carmen Reinhart and Vince Reinhart (2011).
Moreover, restricting domestic credit expansion will not serve if the cross-border activities of banks result in their most vulnerable exposures originating overseas. That, of course, was the case in the present crisis, where the main losses to UK and European banks arose from holdings of securities linked to the behaviour of the US housing market. On top of that, a unilateral increase in interest rates may well end up having a perverse effect on credit growth, because it sucks in capital flows from abroad to take advantage of the interest differential, so boosting the real exchange rate and adding to the supply of funding to the banking sector. The obvious conclusion is that one needs to look to other instruments – so-called macroprudential regulation – which act directly against the expansion in credit during the upswing and limit the contraction in any bust; in other words they stabilise the supply of intermediation schedule, XS. Given our earlier discussion, an obvious way to do this is by raising capital requirements on banks, thus improving their resilience, during the upswing of the credit cycle and reducing them during the subsequent downswing, allowing banks to maintain the supply of financial services. The new Basel III agreement on capital and liquidity regulation makes specific provision for such a countercyclical capital buffer of up to 2.5% of risk-weighted assets on top of the increased base Core Tier 1 capital ratio of 7%, i.e. a potential increase in capital requirements of more than a third.