The missing component of monetary policy and inequalities

Monetary Policy and inequalities

In my last blogpost, I conducted a brief literature review which concluded that monetary policy is deemed to have negligible distributional outcomes in the long run provided that central banks adhere to their mandate of ensuring price stability(BIS 2021, pp. 50, 51). As a matter of fact, in case of high inflation or recession, the monetary response is known to have an undesirable impact on inequality, at least in the short-run (Ibid., pp. 39-44). At the same time, there is evidence that unconventional monetary policy such as asset purchase programmes benefit wealthy households as they boost stock prices (i.e., the portfolio of the wealthy) (Bernanke 2015). The same is true for low interest rates (BIS 2021, pp. 52,53). However, this effect is thought to be neutralised by other channels together with the avoidance of deflation, recession and unemployment through the economic stimulus of expansionary monetary policy (Lenza et al. 2018, Dossche et al. 2021, Mäki-Fränti et al. 2022, BIS 2021). But then, can the evidence that unconventional monetary policy boosts stock prices be separated from the steep increase in wealth inequalities?

Financial assets, such as companies’ stock, are a dominant source of wealth in today’s economy (Piketty 2014, Pistor 2020). In fact, recent research illustrates that inequality is partly linked to the different composition of household portfolio between middle-class and the wealthy. Middle class households usually invest their wealth in housing, whereas richer people hold more stock (Kuhn et al. 2020). At the same time, the substantial part of the population that does not own stocks or real estate is probably more vulnerable to financial downturns. Coupled with the evidence suggesting that unconventional monetary policy boosts stock prices, it follows that also income and wealth are reallocated with a favourable effect for wealthy households (BIS, p 50). Wealthy households, therefore, gain relatively more from unconventional monetary policy. This is not the same as saying that there is unequivocal evidence concluding that richer households are the ones to benefit the most (for a survey of the recent literature, see Colciago 2019 and Ilzetzki 2021). In fact, unconventional monetary policy, as already mentioned, affects other macroeconomic factors that are thought to have an offsetting effect on inequality: inflation, economic activity, and employment. (BIS, pp 39-54). But then, are there any missing components of the whole picture?

The moral hazard component

There is an additional distributional channel of loose monetary policy that has received little attention so far. Asset purchase programmes and low interest rates, by providing fiscal support in economic downturns, contribute to making debt safer. Such stabilising power is key since it protects markets from collapse during recessions. Still, by making debt safer, asset purchases increase moral hazard, promote over-indebtedness in good times and maximize the bargaining power of stockholders during financial turmoil.

For example, imagine the case of collateral debt obligations (CDOs) obtained through securitisation. Securitisation consists in pooling together mortgages or other illiquid loans and splitting their value through sophisticated financial techniques into marketable securities (the CDOs) that are backed by the originating mortgages. On the one hand, securitisation promotes credit intermediation and facilitates risk allocation. On the other hand, securitisation hinders the job of supervisory authorities, as it uses off-balance sheet instruments that hide the real leverage of market players.

By making extensive use of securitisation techniques, banks do two things: first, they increase growth but they also heighten financial fragility. More generally, that financial ‘deepening’ or financialisation increases simultaneously growth and proneness to crisis has been confirmed by empirical studies (e.g., Levchenko et al. 2009, Beck et al. 2016; Loayza et al., 2017). Therefore, the pro-growth regulatory stance that we have witnessed in the last decades may have arguably contributed to the occurrence of banking crises and volatility and urged the loose monetary policy by central banks to save the system from the brink of collapse. As a result, to grasp the full picture of the distributive effects of monetary policy, one needs to observe the whole economic cycle, and the role played by monetary policy within the whole distribution chain.

As previously mentioned, the main objective of monetary policy is to safeguard price stability. As such, conventional and unconventional monetary policies are thought to have counterbalancing effects on the wealth divide, but this only comes in a second moment in time, namely T+1. Monetary policy responds to balances or imbalances that materialise during the economic cycle, but easy monetary conditions also build-up financial imbalances in T+1 (BIS 2021, Farhi, Tirole 2012). That is, the pro-growth culture in T+0 may have some responsibility in the building of wealth inequalities.

This pro-growth regulatory stance is in line with what in competition law is referred as the More Economic Approach. As in the case of competition, the More Economic Approach to EU financial integration focuses only on the provable economic effects of a given policy and prevents the banking supervisor from intervening into areas that cannot be proven to decrease economic welfare. That is, the More Economic Approach has a bias for under-enforcement of state regulation (in jargon, type II errors or false negatives). A good example are the legal barriers that have been put in place by the banking union legal framework to preclude the SSM from interfering into accounting.^[1] At the time of the formulation of Basel III capital requirements, it was discussed whether accounting standards should play a role in offsetting the procyclicality of banks’ income statements. The issue was whether prudential provisioning should be used to offset the expansionary phases of the economic cycle. Due to strong opposition from the accounting world, it was decided that countercyclical provisions would be circumscribed to countercyclical capital buffers, without involving accounting (Saurina and Trucharte 2017).

Although this is probably in line with the predominant understanding of market freedoms, flexibility for implementing accounting standards may impinge on the rights of other stakeholders and lead to greater proneness to crisis. For instance, accounting directly affects the determination of a bank’s risk weighted assets, which in turn are used for calculating prudential provisioning. This prudential provisioning eventually cushions market shocks in times of distress, shocks that may prompt the ECB’s monetary policy into crisis management mode.

As argued by experts (Bernanke, BIS 2021), there is probably little monetary policy alone can do to turn the tides of the broader forces that are driving the staggering wealth divide. In fact, avoiding the use of unconventional monetary policy to prevent inflation or recessions can have a more detrimental impact on the wealth divide (ibid). However, as the regulatory framework stands (preventing the supervisor from encroaching into accounting), central banks, and in particular the ECB, could wear their prudential supervision hats to adopt a more preventive stance towards financial innovation, or at least to those innovations that maximise interconnectedness and therefore systemic risk (Roukny et al. 2018). Under the scope of supervision, financial innovations whose long-term welfare impact is dubious could be deducted from Common Equity Tier 1 (CET1) under prudential valuation in a preventive fashion. This is probably against a shared wisdom that has informed financial regulation in the last decades but changing our culture may be the only way to revert the unsustainable trend of heightened wealth inequalities.

List of references

Bank for International Settlements (2021), Annual Economic Report.

Beck, T., Chen,T., Lin, C., Song, F. (2016) ‘Financial innovation: The bright and the dark sides’, Journal of Banking & Finance, 72, pp. 28–51. doi:10.1016/j.jbankfin.2016.06.012.

Bernanke, B.S. (1AD) ‘Monetary policy and inequality’, Brookings, 30 November. Available at: https://www.brookings.edu/blog/ben-bernanke/2015/06/01/monetary-policy-and-inequality/.

Colciago, A., Samarina, A. and de Haan, J. (2019) ‘Central Bank Policies and Income and Wealth Inequality: A Survey’, Journal of Economic Surveys, 33(4), pp. 1199–1231. doi:10.1111/joes.12314.

Dossche, M, J Slačálek and G Wolswijk (2021), ‘Monetary policy and inequality’, ECB Economic Bulletin 2/2021.

Farhi, E. and Tirole, J. (2012) ‘Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts’, The American Economic Review, 102(1), pp. 60–93.

Ilzetzki, E. (2021) ‘Monetary policy and inequality’, VoxEU.org, 18 August. Available at: https://voxeu.org/article/monetary-policy-and-inequality (Accessed: 16 April 2022).

Kuhn, M., Schularick, M. and Steins, U.I. (2020) ‘Income and Wealth Inequality in America, 1949–2016’, Journal of Political Economy, 128(9), pp. 3469–3519. doi:10.1086/708815.

Lenza, M. and Slacalek, J. (2018) ‘How Does Monetary Policy Affect Income and Wealth Inequality? Evidence from Quantitative Easing in the Euro Area’, SSRN Electronic Journal [Preprint]. doi:10.2139/ssrn.3275976.

Levchenko, A., Ranciere, R. and Thoenig, M. (2009) ‘Growth and risk at the industry level: The real effects of financial liberalization’, Journal of Development Economics, 89(2), pp. 210–222.

Loayza, N., Ouazad, A. and Ranciere, R. (2017) Financial Development, Growth, and Crisis: Is There a Trade-Off? Working Paper. Washington, DC: World Bank. doi:10.1596/1813-9450-8237.

Mäki-Fränti, P. et al. (2022) Monetary Policy and Inequality: The Finnish Case. SSRN Scholarly Paper ID 4014139. Rochester, NY: Social Science Research Network. doi:10.2139/ssrn.4014139.

Piketty, T. (2014) Capital in the twenty-first century. Cambridge Massachusetts.

Pistor, K. (2020) ‘The value of law’, Theory and Society, 49(2), pp. 165–186. doi:10.1007/s11186-020-09388-z.

Saurina, J., Trucharte, C., (2017) The countercyclical provisions of the Banco de España 2000-2016.

[1] See recitals 9 and 39 of Regulation (EU) No 1024/2013 (the ‘SSM Regulation’)