The Riksbank and financial stability: No instruments, therefore not an objective

(English translation of an article of mine on the website of the Swedish business newspaper Dagens Industri, July 21, 2014.)

Should the Riksbank have financial stability as an objective besides price stability? According to an op-ed by Carl B. Hamilton in Dagens Industri on July 17, the answer is yes.[1]  According to Hamilton, this is even a practice already established by the Riksdag (the Swedish parliament). The Riksbank Act needs to be amended, but only as a formality.

But Hamilton forgets that the Riksbank has no effective policy instruments to affect financial stability, except in connection with the management of financial crises. He also forgets that the government with the support of seven parties in the Riksdag – including Folkpartiet (the Liberal Party) – has decided that the Riksbank will not receive any such instruments. Without the instruments, the Riksbank neither can nor should have financial stability as an objective. 

If the Riksbank would have financial stability as an objective, it would have to have policy instruments that can affect financial stability. From this point of view, it is crucial to distinguish between crisis prevention and crisis management.

Regarding crisis prevention, according to the proposal for an enhanced framework for financial stability (in Swedish) that the government announced in August 2013, Finansinspektionen (the Swedish FSA) has received control of all crisis-preventing instruments. The Riksbank wanted that role, but it did not happen. The Riksbank is therefore without crisis-preventing instruments.

But does not the Riksbank’s policy rate affect financial stability, for example, by affecting household indebtedness and thereby any risks associated with household debt? In principle, one would think so, but according to the Riksbank’s own calculations, the policy rate has a very small and uncertain effect on household debt in the medium term, and no effect in the long term. However, it has a clear effect on inflation and unemployment. The Riksbank’s calculations thus provide no support for using the policy rate to affect financial stability via household debt (and Hamilton does not report any own calculations).

However, by deviating from the inflation target and creating unexpectedly low or unexpectedly high inflation, the Riksbank can make households’ and other borrowers’ debt burden higher or lower. The Riksbank’s “leaning against the wind” for four years – from the policy rate increases starting in summer 2010 to the rate cut back to 0.25 per cent in summer 2014 – has led to an unemployment rate far above a long-run sustainable rate and inflation well below the target and household expectations. The unexpected low inflation has in fact increased household’s real debt burden and, if anything, increased any risks with household debt and related threats to financial stability.

The experience of this policy strengthens the conclusion that the policy rate is an inappropriate instrument to affect financial stability. The Riksbank’s best contribution to financial stability is instead to meet the inflation target and support the general economic policy’s main objective, full employment.

Regarding crisis management, however, the Riksbank – as central banks in general – has an important role, as the Riksbank can provide unlimited liquidity support in kronor (lending of last resort) to crisis-hit banks. Thus, for crisis management, the Riksbank has an important instrument. Finansinspektionen, the National Debt Office, and the Ministry of Finance also have important instruments and roles in crisis management. Therefore, the Riksbank and these authorities share responsibility for the crisis management. Under the new framework for financial stability, the crisis management will be coordinated by the new Financial Stability Council.

Hamilton states that the Riksdag has already given the Riksbank responsibility to prevent threats to financial stability: “the Riksbank’s activities with two objectives are … accepted and adopted in a democratic way”. He sees no problem with the Riksbank “very easily encountering almost purely political positions”. [My translations from Swedish.]

Hamilton has here a different perspective than the government and the seven Riksdag parties supporting the government’s proposal. The government says that a reason to give the responsibility for crisis prevention to Finansinspektionen is to ensure democratic control. It can be read as it would be inappropriate from a democratic standpoint to provide an imprecise and difficult-to-evaluate objective such as financial stability to an authority with such far-reaching independence as the Riksbank.

Neither does the Finance Committee, where Hamilton is a member, seem to share his view that the matter is settled. Or how else can we understand that the Committee has given the foreign experts that will assess the Riksbank’s monetary policy during 2010-2014 (Marvin Goodfriend and Mervyn King) terms of reference (in Swedish) that include “to discuss if, how, and to what extent a central bank should take into account financial stability and risks of over-indebtedness in the conduct of monetary policy”? [My translation.]

The conclusion is that the Riksbank neither has nor should have a mandate to prevent threats to financial stability. Hamilton may think that it should be different, but then he must argue the merits and not try to hide behind claims of a practice that does not exist.

[1] Carl B. Hamilton is the economic-policy spokesperson for Folkpartiet (the Swedish Liberal Party) and a member of the Riksdag’s Finance Committee, which supervises the Riksbank.