The hierarchy of financial policies

Governments have four policy areas relating to the financial sector: fiscal, monetary, microprudential, and macroprudential. Each area is run by a government authority, of which more than one can be housed in the same institution, such as the central bank.

There is a clear hierarchy of reputation and power between those four domains and the authorities that run them, determined by political legitimacy, immediacy, history, and mission clarity, and we should expect any disputes that arise between them to be resolved in a manner that reflects this (Claessens and Valencia 2013).

The hierarchy is not static. In times of stress, both the ranking of the four policy areas and the distance between them is likely to change, with implications for legislation and policy planning. Furthermore, the rankings between the institutions and their policy domains are not the same.

Fiscal policy

The most powerful domain is fiscal policy, so the ministry of finance sits on top. It may not interact with the other authorities regularly, but when it does so, it is usually without taking their concerns into account.

There are four reasons for the ministry's pivotal position:

Monetary policy

Below fiscal policy we have monetary policy, implemented by the central bank.

Since successfully slaying the high inflation of the 1970s and 1980s, central banks have enjoyed a good reputation and considerable independence, and are usually the most directly powerful and independent of all government agencies with delegated authority. This unusual power is justified because of the importance of monetary policy and our desire to prevent politicians from tinkering with interest rates.

In spite of its independence, the central bank is still beholden to the ministry of finance, and perhaps increasingly so. Delegated power is only retained so long as the government is happy with it.

One example of this is Iceland in 2009 when, after the government had to recapitalise the central bank, it felt the need to get rid of the governor. As it lacked the legal means to do so, it solved the problem through the costly and disruptive process of rewriting the entire central bank legislation.

There is one interesting exception – the ECB, which is not subservient to any ministry of finance and is protected by treaty. There seems to be no quick way that politicians can change its mandate or powers, though given time and sufficient consensus, the European Parliament and Council could presumably find a way. However, perhaps as a consequence, it also has extensive rules limiting its powers, so it is both more independent and more restricted than central banks generally.

Microprudential policies

Microprudential policies (also known as ‘micropru’) focus on the stability and conduct of each financial institution in isolation, have less prestige, and are controlled more directly by the ministry of finance than monetary policy. Micropru may be housed in the central bank, a separate authority,or some hybrid between the two.

Micropru does not have the same independence as monetary policy and is dependent on the ministry of finance for getting financial regulations through Parliament and for the necessary political cover.

Its reputation is unlikely to be sterling. It is improbable that the authority will get much credit when things go well, but because it touches every facet of the financial system, a regular stream of failures is inevitable.

However, micropru is recognised as important, and its rules are sufficiently arcane that the authority can mostly do its job in peace (though if there are too many scandals it may be dissolved and reorganised, as in Germany after the failure of Herstatt Bank in 1974).

The objectives of micropru can be in conflict with macroprudential policies, perhaps on the levels of capital requirements or decisions on whether individual financial institutions should be allowed to fail. The micropru authority is more likely to win such battles, as argued by Danielsson et al. (2015).

It seems less likely that the objectives of micropru challenge monetary policy, but if they do, the monetary policy authority or ministry of finance will decide.

Macroprudential policies

Macroprudential policies (‘macropru’) are concerned with financial stability and systemic risk, and have both ex-ante and ex-post functions: prevention and resolution. The macropru authority is usually housed within the central bank.

Macropru has the disadvantage of being concerned with the distant future. Since the typical OECD country only suffers a systemic crisis once every 42 years on average, one is not usually imminent.

As memories of the last crisis fade, we are likely to see increasing questioning of costly measures designed to deal with a potential crisis that may be far in the future. The other three policy domains can always point to some clear and present need or danger, while, at least in peacetime, macropru mostly has hypothetical worries based on which it proposes to take restrictive and hence unpopular preventative action. Until a crisis materialises, all it can do is cry wolf, and inevitably over time its credibility suffers.

This means that when the objectives of ex-ante macropru are different than those of monetary policy, perhaps on interest rates or liquidity creation, the direct and immediate benefits from monetary policy are likely to trump the more distant advantage of reducing systemic risk, and particularly so when a macropru authority wishes to take a politically unattractive preventative stance.

A macropru authority, just like the monetary policy authority, needs to make politically unpopular decisions, and the freedom from political interference is important for the successful execution of the policy mission. Central banks, as the executioners of monetary policy, have been made independent for this reason, which begs the question of whether macropru should be granted the same independence.

Many countries have attempted the independence of macropru via institutional setups, typically financial stability committees with representation from the ministry of finance, the central bank, and the micropru authority.

Such an arrangement may work well in peacetime. However, if a serious crisis happens the ministry of finance will demonstrate its power, as we saw in 2008, and the politicians will assume direct control of macropru. The authority is likely to have lower status than the policy because the most critical decisions will not be made by the authority.

That is both inevitable and fair. In a democratic society, major decisions affecting society need democratic legitimacy, and that means a process with a political representative on top. The competence might be with the macropru authority, but unelected bureaucrats working for the central bank should not solely decide on costly measures such as bailing out major financial institutions. Those are decisions for the democratically elected political leadership.

Consequently, the independence of the macropru authority in peacetime is weaker than that of the monetary policy authority. Monetary policy has one primary objective and two tools, price and quantity of money. The government and the general public can directly monitor its performance, and it is easy to justify the independence when the central bank meets its target.

Macropru has multiple conflicting objectives and even more tools with unproven strengths and side effects. Failure is there for all to see, but success is rarely noteworthy.

While both monetary and macropru policies directly affect the voters, if anything, macropru – for example, via real estate – has an even stronger impact on individual voters, giving rise to lobbying against preventative policies such as loan to value limits. However, the origins of a real estate bubble are more likely in general government policies and/or monetary policy, limiting the ability of the macropru authority to mitigate the systemic risk arising from real estate.

Paradoxically, the macropru authority has little control over what may be its most serious concern.

It is therefore harder to justify giving the macropru authority the same independence as the monetary policy authority, and as a practical matter, it is unlikely to happen. If monetary policy and macropru are housed in the same agency – an independent central bank – macropru has the potential to undermine the independence of the central bank, and therefore its credibility and ability to execute monetary policy, a point made by Chwieroth and Danielsson (2013).

Conclusion

In conclusion, four different domains deal with financial policy with a clear ranking in importance between them: fiscal policy on top, followed by monetary policy, macropru, and micropru at the bottom.

The ranking is different for the agencies in charge of these domains. Fiscal is still dominant, followed by monetary, but the micro authority has more power than the macro authority.

As well as importance, this ranking reflects political legitimacy, immediacy of objectives and tools, history, reputation, mission clarity, vulnerability to lobbying, and the myriad other issues that affect which institution can make and implement decisions.

Splitting financial policy into four distinct domains is sensible, but can lead to sub-optimal outcomes when the four domains overlap and compete. By contrast, housing them within the same institutions may reduce conflict and facilitate decision making but risks some areas being ignored.

In either case, when things go wrong, the legitimacy of the financial authorities can be undermined. Recognising the hierarchy and conflicts in policy and institution design might lead to better outcomes.