Financial Stability and Macroprudential Policy
John’s work on the impact of financial liberalisation on consumption and housing inspired his contributions to the literature on financial stability and macroprudential policy. He has emphasised the need for better models of macro-financial linkages (see Duca et al.
2010, forthcoming; Muellbauer 2010; Duca and Muellbauer 2014; Hendry and Muellbauer 2018; Muellbauer 2018a; Aron et al. 2019a). In a paper for the BIS,[213] critical of the conventional wisdom, Muellbauer (2010) noted that in dynamic stochastic general equilibrium (DSGE) models without financial frictions, asset prices act merely as a proxy for income growth expectations, with no causal role. His UK aggregate consumption evidence strongly contradicts this finding, for all possible discount rates, and both for a perfect foresight and an empirical rational expectations approach to measuring income expectations. By contrast, his “credit-augmented consumption function” explains the data well. The BIS paper reported new evidence on the striking rejection on aggregate data of the consumption Euler equation central to all DSGE models; it showed that UK micro-evidence on households in different age groups is consistent with the generalised consumption model. The limitations of newer DSGE models with financial frictions and housing, and the business cycle implications of amplification mechanisms and non-linearities operating via households and residential construction, were explained. The paper then suggested econometric methodology appropriate for designing better evidence-based central bank policy models. Hendry and Muellbauer (2018) reiterated these themes, also addressing the failure of rational expectations in the presence of structural breaks. In a detailed analysis of models at the Bank of England, they explained how the Bank's DSGE-based empirical models had failed before, during and after the global financial crisis.Since the financial crisis, there has been an explosion of research into housing markets. In a comprehensive review of the literature and policy implications of international house price cycles, Duca et al. (forthcoming) discuss within financial sector contagion and amplification, the transmission mechanism to the real economy, and feedback loops from the real economy back to the financial sector. These features link with recent developments in macroprudential policy and risk monitoring. They find the real estate and financial crisis affected the US economy not only by hurting residential construction and consumption (via MEW), but also by impairing the functionality of finance from both financial intermediaries (indirect finance) and securities markets (direct—and ultimately indirect finance). A holistic approach should understand the supply side of housing markets and how institutional differences in supply as well as in credit market structures influence outcomes. It is imperative for policy makers and the economics profession to address critical gaps in data, on general and mortgage credit standards, as well as measures of the housing stock and the land component of house prices. Omission of such factors often leads researchers to draw misleading conclusions from simplistic housing models, for example, on whether house prices are overvalued (see Muellbauer 2012), important for assessing risks to financial stability.
Emphasis on the importance of institutional differences and the need to avoid “one-size-fits-all” thinking is an ever-present theme in John's research. The macro implications of Anglo-German housing and credit market differences (see Muellbauer 1992) was an important reason why Maclennan et al. (1998) argued strongly that the UK did not meet the criteria for a common currency area with major Continental European economies and, hence, did not belong in the Eurozone. In Muellbauer (2018b), he draws on the same cross-country comparisons for ideas to solve the UK housing affordability problem, which has had unfortunate implications for cross-sectional and intergenerational inequality.
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