The visible hand in economics

Key’s speech and credit growth

Posted on: November 24, 2008

Over at Kiwiblog they cover John Key’s speech at the APEC summit. The following passage is quoted, and then David Farrar suggests that economics blogs should discuss it – it seems simple enough so lets give it a go together🙂

The question is: faced with this situation again would we do something different to address it? To my mind, this question should lead economies to consider whether monetary policy, fiscal policy, and prudential policy should be more counter-cyclical, and lean against credit growth in an upswing

Now, this by itself tells me very little. Simply put, John Key appears to be saying that “credit market policy” should be counter-cyclical. Now, just 18 months ago people were complaining about interest rates being too high – that is counter-cyclical monetary policy guys, and it helps to tighten domestic credit markets. Our institutions have been relatively prudent (as lenders and households actually do face the risk associated with there decisions, unlike the US😛 ).

Of course, there is more to this statement than just that – there are good inferences and a bad inferences to make from the flavour of the speech. Let me sketch them out – then we can discuss them, or whether these inferences are fair🙂

Good

The good part is that John Key was effectively saying that the government should try to develop the institutional structure of the credit market, such that, risk and return and clearly shown and, such that, the risk is faced by the person getting the return. I am guessing this is part of what he assumes is the role of prudential policy (although that is not necessarily the case).

Also good, although not important, is his mentioning of fiscal policy. Fundamentally, raising government spending without informing the Reserve Bank of what you are doing will hurt the impact of monetary policy. Better information provision between government institutions (at least the financial ones) would help lead to better policy.

Bad

The bad for me comes out in two ways:

  1. An attitude of blaming the people in financial markets for the recent market failure,
  2. Stating that monetary policy needed to do more to prevent an asset price bubble.

On the first note, I don’t think it is fair to blame people for acting in their own interest. The governments of the world need to stop the blame game and look for ways to improve the institutional structure of markets (reducing information asymmetries would be prime on my list). Blaming the individuals involved merely leads to aggresive, anti-trader, behaviour – which is not in anyones interest.

Secondly, I realise that now it is popular to say that central banks should have “popped the housing bubble”. There are a couple of things I would say here though.

  1. It is hardly clear how you can use monetary policy to pop a housing bubble, when expectations of house price increases reach elevated levels,
  2. If we did regulate housing specifically, the bubble probably would have moved into some other asset class – with the same results and a more inefficient housing market,
  3. In the NZ context, the RBNZ did end up lifting rates significantly, they did tell people housing was over-valued – as a result, hopefully no-one is planning to change the behaviour of our central bank.

Yes, bubble cause pain when they pop – but it isn’t even conclusive that the pain they cause is worse than the additional assets they lead to the creation of.

Conclusion

I can’t say much until I know exactly what sort of regulation John Key is implying. He is right when he says:

Reforming the global financial system will require a balancing act between, on the one hand, moving away from the largely unregulated environment of today and, on the other, ensuring we do not completely undermine financial markets

However, we all need to go one step further and ask “what is the market failure we are regulating?”

7 Responses to "Key’s speech and credit growth"

Good post.

To some degree people are to blame but because they wanted to exploit the absence of regulation in various ways.

However, from a policy perspective it would be pointless going after them for that reason.

Massive informational asymmetries played a big role – and it may well be that regulation is required to ensure that the sellers are providing enough information on the underlying assets.

Nevertheless, financial markets are good at finding arbitrage opportunities and it’s only a matter of when they find the next asymmetry to exploit.

Do you think another bubble is coming?

I’m hoping that we can quickly get through the idea that the financial markets alone are to blame for the current situation.

What gives me greater concern is that usually serious and sensible people (and I include John Key in that group) are suggesting that we return to a system of coordinated counter-cyclical macro policy that was tried and found wanting on both strong theoretical and empirical grounds.

Has anyone seen a serious critique of Friedman’s view that monetary policy is subject to long and variable lags? That is, you simply can’t run counter-cyclical monetary policy because you will not know when it will have effect.

While fiscal policy is probably subject to shorter lags, politics has shown us that while turning the tap on in bad ties is easy, turning it off again is much harder.

This is where the Australian Treasury’s idea of “go hard, go early, go households” worries me. While most of the spending is in one-off lump sum form, some of it is in ongoing programmes (pensions, family assistance).

“To some degree people are to blame but because they wanted to exploit the absence of regulation in various ways.

However, from a policy perspective it would be pointless going after them for that reason. ”

We can always “blame people”. I mean, the reason I can’t get a 50 inch TV for super cheap right now is because other people are “bidding up the price” – so I could blame them for it.

I am never keen to blame people for acting in their own self-interest – especially when the consequence of their actions on other people is not clear (as in the financial market case).

“Do you think another bubble is coming?”

There is always another bubble coming.

“Has anyone seen a serious critique of Friedman’s view that monetary policy is subject to long and variable lags? That is, you simply can’t run counter-cyclical monetary policy because you will not know when it will have effect”

Indeed. That is one of the primary reasons why the RBNZ generally keeps rates within a 1% of neutral and moves only very incrementally.

Also the estimated lag is about 18 months methinks.

“While fiscal policy is probably subject to shorter lags, politics has shown us that while turning the tap on in bad ties is easy, turning it off again is much harder.”

I do not think fiscal policy is subject to shorter lags when the decision making process is included – fiscal policy is incredibly untimely.

I agree with your point that it is hard for governments to change policy as an institution – ultimately, I don’t think fiscal policy should be used as a counter-cyclical instrument outside of “automatic stabilisers”.

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