The Credit Suisse saga shows us that it is the SNB and not the Finma that must ensure financial stability.
Can we avoid the next financial crisis? I had chosen this title for a TEDx in Geneva in 20191. The day before the event, the organizers changed it to “How to avoid the next financial crisis? When I asked if this new title was not a bit pretentious, they told me that it was not, it was just… challenging. Since then, I have been trying to meet this challenge, which is all the more exciting because it seems to be mission impossible.
Should financial stability be explicitly included in the mandates of central banks? It is often mentioned in their mission statement, 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 cheerfully crosses when it states, in Article 5 of the National Bank Law: “It [the National Bank] ensures price stabilitý. In doing so, it shall take account of economic developments.”
In doing so…: what a sublime semantic turn of phrase, heavy with meaning! These two words reveal the monetarist leanings of our central bank in the purest logic of Nobel Prize-winning economist Milton Friedman. For him, the job of a central banker must 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 then not hesitate to hire more people. Killing inflation to secure 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 my part, I believe that central banks should not have only one objective but … three:
- Ensure sustained economic growth or at least avoid recessions
- Maintain the inflation rate around its 2% target
- Guarantee a strong financial stability
The objective of financial stability cannot be left to a bank supervisory authority like Finma. The example of Credit Suisse has shown us how painfully a bank can be forced into bankruptcy even though it meets the financial soundness criteria laid down by the regulator. Financial stability is a macroeconomic objective, just like growth and inflation.
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. By reducing key interest rates to their lowest level – see below – and by buying financial assets to inject money into the economy, central banks have largely contributed to ensuring strong economic growth and a thriving financial sector, without paying the price of above-target inflation.
But this stability was only apparent and these ultra-accommodating policies ended up causing lagging inflation. This inflation is like the glass ketchup bottle that you desperately shake on your plate. Unexpectedly, the epilogue is often brutal.
Today the triple objective has turned into an impossible trilemma: the three 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.
I did the exercise and constructed an “overall” 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).
.jpg)
What message does this measure of headline inflation give us today? Since 2020, it has happily exceeded the critical threshold of 4%, fueled by both consumer prices and real estate prices. Tightening of US monetary policy was therefore de rigueur. The current sharp decline in headline inflation 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.
Read the article on the website