Macroprudential policy through the lens of Sherlock Holmes

Jens Weidmann of Bundesbank says macropru policy is much like investigation of Sherlock Holmes:

When Arthur Conan Doyle published his first stories about the consulting detective in Victorian times, criminal investigations usually started out from testimonies and motives. Physical evidence was sought after theories had been built. And detectives were still lacking or renouncing fundamental forensic tools. It was only in 1901 that the British police adopted fingerprinting, for example.

Sherlock Holmes’ method of deduction, to reach conclusions based on observed facts, helped him to unravel mysteries virtually from the comfort of his armchair. But the master detective also had to go to crime scenes to search for tiny traces with his magnifying glass and collect the data he needed.

The analysis of risks to financial stability can resemble piecing together strands of evidence in a criminal case. Indeed, Richard Barwell, the Head of Macro Research at BNP Paribas Asset Management, once referred to the principle of evidence-based macroprudential policy as the “Sherlock Holmes approach

Monetary policy impacts all. Macropru policy based on investigation and evidence, like Holmes can impact specifically:

Monetary policy in the euro area is a one-size-fits-all approach, since key interest rates, in particular, are set for the currency union as a whole, in keeping with our objective of price stability.

Given the subdued price pressures in the euro area in the aftermath of the financial and sovereign debt crises, monetary policy accommodation has certainly been warranted. But the long period of ultra-low interest rates comes with risks and side effects, some of which I have mentioned earlier.

And what might be, by pure chance, the right amount of monetary stimulus to kick-start lending in one Member State might over-rev the financial engine in another.

That’s when macroprudential policies come into play. They can act on a national level, taking the state of the specific financial system into account, and can counteract the build-up of financial imbalances even in an individual sector. Moreover, macroprudential policy tools can differentiate between borrower and lender vulnerabilities, a topic Guido Lorenzoni will tackle in greater detail in session 4 of our conference.

By contrast, the impact of monetary policy on the economy is much broader. Let’s dip back into the world of crime for a comparison here: of course, the police could muster strong forces to round up many suspects in order to catch a single criminal. But Sherlock Holmes may have been equally successful without arresting innocent citizens – just with the help of science, logic, and his magnifying glass.

However, since financial imbalances can jeopardise price stability, monetary policy should be aware of its ability to affect risk taking. As we have learned painfully from the financial crisis, severe problems in the financial system could eventually spill over to the real economy and to inflation.

Ideally, macroprudential policies can quell a fire before it turns into a blaze. We therefore need further research to find out how to make macroprudential tools as effective as possible.

Interesting once again from Weidmann…

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