Cost-Benefit Analysis of Leaning Against the Wind: Are Costs Larger Also with Less Effective Macroprudential Policy?

Abstract

"Leaning against the wind" (of asset prices and credit booms) (LAW), that is, a somewhat tighter monetary policy and a higher policy interest rate, has costs in terms of a weaker economy with higher unemployment and lower inflation. It has been justified by possible benefits in terms of a lower probability or magnitude of a future financial crisis. A worse macro outcome in the near future is then considered to be an acceptable cost to be traded off against a better expected macro outcome further into the future. But a crisis can come any time, and the cost of a crisis is higher if initially the economy is weaker due to previous LAW. LAW thus has an additional cost in the form of a higher cost of a crisis when a crisis occurs. With this additional cost, for existing empirical estimates, the costs of LAW exceed by a substantial margin the possible benefits from a lower probability of a crisis. Furthermore, empirically a lower probability of a crisis is associated with lower real debt growth. But if monetary policy is neutral in the long run, it cannot affect real debt in the long run. Then, if a higher policy rate would result in lower debt growth and a lower probability of a crisis for a few years, this is followed by higher debt growth and a higher probability of a crisis in the future. This implies that the cumulated benefits over time of LAW are close to zero. But even if monetary policy is assumed to be non-neutral and permanently affect real debt, empirically the benefits are still less than the costs. Finally, somewhat surprisingly, less effective macroprudential policy, and generally a credit boom, with resulting higher probability, magnitude, or duration of a crisis, increase costs of LAW more than benefits, thus making costs exceed benefits by an even larger margin.

Keywords: financial stability, macroprudential policy, monetary policy

JEL Classification: E52, E58, G01