A look to the future, instead of the past
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The full effects of the Credit Crunch are yet to be realised, but politicians and economists around the world are already thinking about how to stop it happening again.
The Shadow Chancellor, George Osborne, has outlined his preliminary plans in a speech to Harvard Business School on an official visit to the US. Although given thousands of miles from home and only vaguely reported in the British press there are signs that this could have been one of the most important policy speeches Osborne has yet made.
In the speech Mr Osborne signalled a willingness to consider radical reform of monetary policy with far-reaching consequences for the Bank of England. He said “The credit cycle demonstrates starkly that controlling retail inflation is not enough. Recent threats to stability have come not just from the demand cycle but from the credit cycle.”
This means that governments and regulators across the world, but especially in the UK and the US, were wrong to regard the sharp increase in borrowing by households, companies and financial institutions as a benign phenomenon.
Mr Osborne believes that the monetary authorities, in our case the Bank of England and the Federal Reserve in the US, need to take greater account of inflation in the price of houses and other assets when endeavouring to promote economic stability.
But he concurs with the chairman of the Chairman of the Federal Reserve, Ben Bernanke, that economic instability might actually be exacerbated if central banks were to use only interest rates to control both asset prices and consumer price inflation as conventionally measured.
Thus there may have been times in the past few years when a sharp rise in interest rates to restrict the growth of credit might have had a dangerously deflationary effect on the wider economy.
Osborne is therefore attracted to a proposal put forward last year by a former member of the Bank of England’s monetary policy committee, Charles Goodhart, whose effect would be to impose restrictions on how much banks can lend during years of strong economic growth and would ease those restrictions when the economic cycle turns down.
As a theory it is attractive. It would work by giving the Bank of England the power to oblige banks to hold more capital in their balance sheets relative to their loans or assets when the economy is growing strongly and less capital when, like now, it would help if the banks could be encouraged to lend a bit more.
However, it is important to remember that what got us into the mess we’re in wasn’t direct lending by our banks: it was the way they packaged up loans to homeowners and highly leveraged businesses into securities for sale to investors. So unless the largely unregulated providers of credit are somehow brought into the regulatory net, it’s not clear that imposing new capital constraints on banks will have much of an impact. It is heartening, however, that there is recognition of the mistakes made in the run up to the credit crunch and a desire to avoid such irresponsible behaviour in the future.
