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The Actuary The magazine of the Institute & Faculty of Actuaries
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The Trouble with Markets: saving capitalism from itself - by Roger Bootle

The second reform concerns the regime for controlling bubbles. It could have two parts: micro and macro. The micro part concerns the limiting of lending behavior. I have doubts about such an approach. It would be regrettable if regulations put in place to ensure macro stability entailed substantial micro inefficiency.

In this regard, I am dubious about the restrictions on the multiple of incomes on new mortgage lending being proposed by the UK’s Financial Services Authority. There can be circumstances when it is good business, and good for both borrowers and the economy at large, that lending at high multiples does take place. In a reformed and macro-regulated financial system, within the context of a regime of macroeconomic management that gave the prevention of bubbles serious weight, detailed regulation of such things as mortgage multiples can be avoided.

Moreover, quite apart from these considerations of efficiency, I doubt that on its own micro regulation would be enough. We need a system that is robust – belt and braces. Accordingly, whatever happens with micro regulation, I suspect that we must look to macro policy for a good part of the defense against bubbles.

One way of doing this is to add some sort of ’macroprudential’ instrument to the policymakers’ toolkit. The most favored candidate is variable capital ratios. If these did their job effectively, arguably the framework governing pure macroeconomic policymaking could be left pretty much untouched. In particular, those countries that set interest rates in pursuit of an explicit inflation target, such as the eurozone and the UK, could continue, much as before.

Although, as I argued above, variable capital ratios have some merits, I am highly dubious that they will solve the problem on their own. Perhaps the next bubble will not depend on much increased lending by banks; at least not domestically regulated ones. Or perhaps increased capital ratios will be less effective in discouraging excessive lending than the regulators originally envisaged.

In fact we have a test case to go on: Spain. Since 2000, Spanish banks have had to make provisions for latent losses; that is, those that are likely to emerge but are unrecognized by conventional accounting. It seems as though this model has enabled Spanish banks to withstand the current crisis pretty well. But strikingly, it did not prevent Spain from undergoing a massive property boom. Whatever restraint was felt as a result of these provisioning arrangements was swamped by the effects of low interest rates imposed by the ECB.

Accordingly, I do not believe that such “macroprudential” instruments will be enough on their own and that the monetary policymakers can simply carry on setting interest rates as before, confident in the belief that prudential control of the system is being carried on by someone else. On the contrary, I believe that the objectives of monetary policy will have to be reformed in order to give greater prominence to asset prices. This is not the same thing as targeting asset prices. That is something central banks should not do, even if they could. But it does mean accepting that bubbles can happen, that when they do, the effects on the economy can be devastating, and that interest rate policy can and should play a part in preventing them.

Moreover, far from being a diversion from the modern central bank’s concentration on inflation, this would be a refinement of it. The point is that money can be in the process of debauch even while the current rate of consumer prices index (CPI) inflation is nugatory. This is what happened in the mid-1990s. Rates of consumer price inflation were very low, but asset prices, particularly for residential property, were rampant. Yet the policy regime centered on CPI inflation, and on that score there was no sign of any problem on the horizon. Accordingly, central banks cut interest rates to low levels and left them there.

But rampant asset price inflation is not consistent with monetary stability in the medium term. Accordingly, if asset prices are rising strongly for a persistent period, it is otiose for a central bank to argue that all is well, as long as the rate of CPI inflation is benign.

As I argued in Money for Nothing, central banks need to give greater prominence to asset prices as part of a new focus on financial stability. This need not necessarily replace inflation targets – or the Fed’s joint mandate – but rather would modify the way in which they operate. In the new regime, central banks would give greater prominence to asset prices simply by emphasizing their link with price stability in the medium term. In many cases this would not even require a change in the wording of their objectives, let alone new legislation. Rather, it would require a reinterpretation or, at most, some minor rewording.

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A review of The Trouble with Markets can be found at http://www.the-actuary.org.uk/872423 and a Q&A with the author can be found at http://www.the-actuary.org.uk/870189.