Past dialogues on central banking's future, which pitted inflation targeting against financial stability, produced three solutions: central banks should adopt a counter-cyclical policy approach; a world monetary authority should be created to promote multilateral cooperation among central banks; and price stability must remain central banks' primary goal. Although these solutions have some merit, they are inadequate to address effectively the complex and far-reaching failings that led to the 2007-2009 global financial crisis.
The crisis represented a comprehensive systemic failure, involving breakdowns at almost all levels, from macroeconomic theory to micro-level incentives to institutions. The economics profession (and institutions within the existing financial architecture, including regulators) had become excessively specialised, rigid, and self-interested. As a result, it could no longer account for the evolution of economic systems, with their constant adaptation of rules, tools and behaviours.
In order to develop effective policies, central bankers must adopt an entirely new approach - one that is comprehensive, systems-oriented, flexible, and socially conscious. They must recognise that, despite the cyclical nature of economic activity, not all cycles are the same; counter-cyclical measures must account for the factors that gave rise to the cycle. Moreover, any solution to the crisis must incorporate a wide array of instruments and reforms.
Monetary policy, together with other financial stability-enhancing tools like regulatory policy, aims to protect the real value of money and its effectiveness as a medium of exchange and store of value. Whereas monetary stability presupposes price stability, financial stability ensures that the value of money is not eroded through credit, operational or other risks.
Fortunately, the premise of recent dialogues on central banking and financial stability suggests a more complete understanding of the problem. Potential solutions must account for the unintended consequences of efforts to ensure financial stability. For example, stability can be achieved by allowing the largest banks to dominate, while requiring that they hold large amounts of high-quality capital to cushion against shocks. But in the long run, the real sector would probably suffer from monopolistic rents, inadequate competition, and a lack of innovation.
A more comprehensive solution would focus on securing systemic stability in the real and financial sectors through the use of long-term tools and targets, based on the priniciple that finance should serve the real sector. In other words, monetary policy and financial market reform should act in tandem to deliver the real sector objectives of economic efficiency, social inclusivity, and environmental sustainability.
The unspoken allegation against current monetary policy is that, in rescuing the financial sector from its follies (paid for by the real sector), it has enabled policy makers to defer financial sector reforms that would close regulatory and supervisory gaps and eliminate incentives to game the system. But monetary policy and financial sector reform are subject to severe constraints, rooted in the mismatch between the scope of financial activities and that of monetary and regulatory policy.
Money and finance have gone global, through technology, innovation, and financial liberalisation. But regulatory and monetary instruments remain national and, thus, incomplete. With capital flowing freely across borders, national authorities have lost the ability to protect their currency's value and safeguard financial stability.
This model is based on the assumption of a frictionless global financial market, in which actors are free to speed up transactions and increase their leverage through off-balance-sheet and offshore transactions, in order to escape regulation. If they fail, the system rescues the key players through expansionary monetary policy, spreading the costs globally.
While a centralised global monetary or financial authority would offer a more complete solution, the requirement that countries yield some sovereignty over fiscal, monetary, and regulatory matters raises issues of legitimacy, making it an unlikely option. Indeed, the world's current monetary and financial architecture would have to collapse before such a global scheme could become feasible.
In the absence of such an authority, a modular approach to systemic reform is needed - resembling, for example, America's repealed Glass-Steagall rules, which barred commercial banks from engaging in investment banking. Macro-prudential regulations, which are essentially capital controls, could be used to minimise the negative spillover effects of unrestricted, leveraged capital flows. Financial transaction taxes and higher margin requirements would slow down transactions, while higher capital and lower leverage ratios would reduce the debt load in the system.
In a systemic reality, everything is relative, because all players act in response to one another. Diverse, flexible arrangements - with the interaction among various standards, rules and behaviours fostering competition, innovation, and experimentation - are thus more stable than rigid, compartmentalised systems.
Given this, global leaders must emphasise adaptable, forward-looking solutions that account for the shifting forces affecting monetary and financial stability. After all, when it comes to monetary policy and financial sector reform, there are no permanent tools or targets, only permanent interests.
The writer is at the Fung Global Institute, Hong Kong
Copyright: Project Syndicate, 2013