How to avoid the next financial crisis?

The turmoil in the banking sector earlier this year demonstrates the critical role that central banks play in ensuring financial stability. Financial stability cannot be left in the hands of the Banking Supervisory Authority alone, as the Credit Suisse saga showed. To ensure financial stability, central banks should include financial asset prices in their inflation target.

 

Michel Girardin
Visiting Professor of Macro-finance, University of Geneva          
CEO of MacroGuide LLC                                          

 

Should financial stability be explicitly included in the mandates of central banks? It is often mentioned in their mission, but... one quickly understands that financial stability is not the main objective of central banks, which prefer to focus on inflation.

The SNB website informs us that "one of the SNB's tasks is to contribute to the stability of the financial system". But between "contribute" and "ensure", there is a step that our monetary institute would not dare to cross cheerfully when it states: "It [the National Bank] ensures price stability. In doing so, it shall take into account the development of the economic situation."

In doing so...: what a sublime semantic turn of phrase, heavy with meaning! These three words reveal the monetarist inclination of our central bank in the purest logic of Nobel Prize-winning economist Milton Friedman. For him, the job of a central banker has to be boring: it is simply a matter of adjusting the growth of the money supply to the evolution of the nominal gross domestic product in order to ensure that the inflation rate reaches its objective of 2% and ... settles there. With this policy, the central bank thus ensures price stability and, in so doing, establishes framework conditions for sustained economic growth. Price stability should boost the confidence of companies, which will not hesitate to hire more people. Killing inflation to ensure jobs: this was the doctrine of Milton Friedman and the monetarists he inspired in the 1950s.

Today, we know that the fight against inflation can be done at the expense of growth. Sacrificing the latter in order to overcome the former: both the American and European central banks have made this their credo since the surge in prices accelerated with the war in Ukraine.

For our part, we believe that central banks should not have only one objective but three:

  • Ensure sustained economic growth or at least avoid recessions
  • Keeping the inflation rate around its 2% target
  • Guarantee a strong financial stability

In the decade following the 2008 crisis, these three objectives were not contradictory. Central banks pursued an ultra-expansive monetary policy, and were themselves surprised that this laxity did not have inflationary consequences.

Today the triple objective has turned into an impossible trilemma: the 3 objectives mentioned above have become contradictory and mutually exclusive. Central banks have to choose between fighting inflation and supporting growth. They must also and above all realize that if they seek to increase the stability of the financial sector - through increased capital requirements in the banking sector - this will be done at the expense of growth, with a marked risk of recession.

So how can we avoid - as much as possible - the next financial crisis? First of all, it is important to recognize that inflation is not only visible in the household basket.  It is also hidden in the price of financial assets.

If we want to avoid the next financial crisis, we must act preventively, before speculative bubbles burst and cause serious recessions. To do this, we need to include the price of financial assets in the household basket.

We have done the exercise and constructed a "global" inflation index with 2/3 of the prices of goods and services in the US household basket and 1/3 of the price of financial assets. For the latter, the price of real estate is an excellent measure of the speculative bubbles that plague the financial markets. By setting a limit of 4% per year for this new inflation index (the curve in red on the graph), the American Central Bank would now have early warning signals of financial crises such as the financial crash of 1987, the bubble in technology stocks in 2000, the subprime crisis in 2007, or the near-general financial collapse of 2022.  The Central Bank could therefore intervene before the financial excesses become too great, as shown by the annual variations of the S&P500 stock market index (orange bars on the right-hand scale).

Une image contenant Tracé, ligne, diagramme, texteDescription générée automatiquement

Chart 1: Fed should target global inflation

 

What message does this measure of global inflation give us today? Since 2020, it has happily exceeded the critical 4% threshold, fueled by both consumer and real estate prices. Tightening of US monetary policy was therefore de rigueur. The current sharp decline in headline inflation below this critical threshold suggests that the Fed should loosen its monetary stance.

Certainly, if the next financial crisis is to be avoided, central banks must act preventively, not reactively. An inflation target extended to financial asset prices would allow central banks to achieve their triple objective before it becomes a trilemma.

 

 

Biography

Michel Girardin is a visiting Professor in Macro-finance at the University of Geneva.

With more than 1 million students, his video course on investment management ranks in the top 5 most popular trainings worldwide on Coursera’s Massive Open Online Courses (MOOCs) platform.

He has more than 25 years’ experience as Chief Economist and Chief Investment Officer in the Swiss Private banking sector.

In 2013, he founded MacroGuide Ltd, a financial advisory firm, helping Pension funds and Professional investors shaping their Investment policy.

Michel holds a PhD and a B.A in Economics from the University of Lausanne as well as a Master of Science in Economics from the London School of Economics. Quadrilingual Fr/En/It/Ge, he is a dual Swiss and French citizen.