Controlling banks' capital no panacea

Allister Heath
VIRTUALLY every week during the&nbsp; bubble years, I would talk to economists who were well aware that the economy was on an unsustainable path. In 2005, 2006 and 2007 some of these were so anxious that they could barely sleep at nights. They usually hailed from the Austrian School of Economics &ndash; many of whom are based at George Mason University in the US and are followers of Friedrich von Hayek and Ludwig von Mises &ndash; or were neo-monetarists, heterodox followers of the late Milton Friedman, in many cases connected through the Institute of Economic Affairs&rsquo; shadow monetary policy committee.<br /><br />These economists thought that the supply of money was growing too fast and that central banks needed to hike interest rates to curtail liquidity. They also emphasised the growth in leverage, and how this was spilling over into asset prices, current account deficits, ridiculous amounts of M&amp;A and LBOs, covenant-light debt and plunging risk premia. Central bank-determined base rates were the key driver &ndash; and not just in the UK floating-rate mortgage market. Lower base rates meant rates on commercial paper issued by structured investment vehicles (SIVs) and conduits fell, fuelling the shadow banking system and boosting the supply of mortgages from the likes of Northern Rock.&nbsp; All of this insane behaviour can be traced to excessively low central bank interest rates, especially given that in those days there was a small and stable gap between Libor and base rates. <br /><br />Most central bankers rejected these warnings. The Bank of England&rsquo;s job was clear: target consumer price inflation, not asset prices. It didn&rsquo;t believe there was a strong link between money sloshing around the economy and consumer prices, the only thing it cared about. There was history to the debate: during the 1980s, the Bank had come under pressure to formally target the rate of growth of the money supply. It eventually rejected the view that money was the key variable and decided to focus on the retail price index. In the late 1980s it started to follow the low-inflation Deutsche Mark, a policy which ended in tears when an exuberant money supply fuelled the house price boom and eventually triggered high consumer prices too. <br /><br />Which brings us to the debate on macro-prudential regulation. In good times, banks would hold more capital; in bad times, less. There are two reasons for this: the first is dynamic provisioning, which makes sense: build up reserves to make sure you don&rsquo;t go bust when loans start to default. The second is much less convincing: if banks are forced to jam on the brakes when the going gets good, bubbles could be eliminated. Central bankers are fans of this approach as they want us to believe that had they used interest rates to control the explosion of credit, the damage to GDP would have been too great. Much better, they claim, to start varying how much capital banks must put aside &ndash; and use interest rates only for fighting consumer price inflation. But this is too simplistic, given how central bank policy stoked the bubble.&nbsp; Another problem with macro-prudential rules is that regulators within and between countries will disagree on the state of the economy, which could be a nightmare. Using prices to control the supply of money is better than using quantity controls. It is a lesson we learnt in the 1970s, when credit was rationed. Let us hope we are not about to forget it.<br />