William R White: Making macroprudential concerns operational (Central Bank Articles and Speeches)

In recent years, we have witnessed many bouts of financial instability arising from a wide diversity of proximate causes: operational problems, institutional failures, short-term problems in the functioning of financial markets, mean revisions in overextended financial markets, and contagion across markets and between countries. In this paper, I focus on problems arising from financial overextension or systemic imbalances since they often lie at the heart of other observed problems. As hypothesised in a recent paper, the increasing incidence of financial instability arises from the coincidence of three secular trends. The first is liberalisation of global markets for goods and services. Together with advances in technology, and technology transfer to such giants as China and India, this has contributed to disinflationary pressures globally over an extended period. The second is the liberalisation of financial markets, which, again together with advances in technology, has increased the likelihood of justified optimism (favourably affecting credit and resource allocation) turning into unjustified optimism which breeds boom-bust cycles. The principal manifestations of this have historically been rates of growth of credit, asset prices and fixed investment well above historical norms; in effect, imbalances. The third secular trend has been the narrowing focus of “independent” central banks on the objective of constraining the rate of growth of prices of currently produced goods and services, regardless of other short-term developments. Echoing insights from an earlier literature, the “elasticity” of the financial system has increased while at the same time policy resistance has decreased. Rupture is commonly the end product of such overextensions.