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27 September 2021

No model and no loss function is not a recipe for good macroprudential policy

Richard Barwell written for MacroprudentialMatters.com

Without greater clarity over objectives, it is hard to see how policymakers can be held accountable, giving rise to the possibility of “framework hysteresis”. Visit macroprudentialmatters.com to read the full article

No model and no loss function is not a recipe for good macroprudential policy

There is a problem with macroprudential policy. The two core building blocks of an economic policy regime – a model of the system and a loss function to guide policy decisions – are missing. Without a reliable model of the system, policymakers cannot forecast with any accuracy how that system will behave in the future or how it will respond to policy interventions. Without a loss function, policymakers are unable to evaluate outcomes and hence whether they are making the situation better or worse.

Incomplete foundations

The ideal model for policy purposes captures all the salient features of the system that policymakers are trying to influence. In the macroprudential sphere that model would ideally provide a compelling and internally consistent description of:

  • the key features of the system that ultimately contribute to the financial cycle, such as the build-up of leverage, debt, liquidity, maturity mismatch and bubbles within the financial sector; and
  • the macro interactions between the financial sector and the real economy that are reflected in the financial positions of the household and corporate sectors and in particular the state of the property market; and
  • the institutional detail on both sides of the regulatory perimeter within the financial system, such as the state and structure of the balance sheets of systemically important institutions, and how the complex web of interconnections between institutions and across markets evolves in response to market conditions and policy interventions; and
  • the correlated shifts in the behaviour and beliefs of chief executives and risk-takers at major financial institutions and within the broad investment community that drive market outcomes; and
  • how the policy levers at the policymaker’s disposal influence those system features, macro interactions, institutional detail and behaviours and beliefs.

The loss function codifies the objectives and preferences that the social planner would like the policymaker to adopt by translating outcomes on a relevant set of variables into a measure of social welfare, typically defined as a loss relative to some ideal level. The policy problem is then transformed into choosing the policy setting that minimises the social loss, given the policymaker’s understanding of and uncertainty about the current state and structure of the system. Without a working understanding of that loss function it is hard to know how to calibrate the policy stance (you can observe outcomes but not rank them) and even whether you are contravening the Hippocratic Oath of economic policy: first do no harm.

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Written for the Macroprudential Matters website, proudly managed by the Qatar Centre for Global Banking and Finance at King’s Business School. Read the rest of the article here.