The credit crisis

It’s a tired cliché - but no less true for that - that generals fight the current war according to the lessons learned in the last. The current generation of policy pundits have grown up on a simple diet of deregulation. This is itself unremarkable given the general good sense behind tidying up the detritus of the best part of a century’s ad hoc favouritism - a policy that was once sold under the nonsensical title of “protection all round”.

But the credit crisis has reminded us of something that was just as integral a part of Adam Smith’s message to humanity as the bit we remember about the invisible hand. Private competition only works well to transform self-interest into social good in a properly functioning market.

And that makes the functioning of markets themselves a public good par excellence. The rules according to which market participants interact are a public good as is the liquidity and price discovery which the growth of the market provides.

That’s why Smith offered these comments on prudential regulation of credit:

Such regulations may, no doubt, be considered as in some respects a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments, of the most free as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty exactly of the same kind with the regulations of the banking trade which are here proposed.

Liquidity is a notoriously fickle public good within a financial market. Each of the players is happy participating in a liquid market, and in doing so they further deepen its liquidity. But because most participants are risk averse, that liquidity can dry up with frightening speed each departing at the first whiff of serious grapeshot. That’s why, in the wake of the Great Depression, we built public institutions to vouchsafe the public good of liquidity in core financial markets.

Central banks now protect liquidity by operating as lenders of last resort. And notwithstanding various intervening fashions, it’s widely understood that both monetary and fiscal policy can beneficially lean against the wind of the business cycle, moderating both the booms and busts to which a purely private market would be doomed.

We’ve learned some lessons along the way; for instance, to do its job well a central bank needs a degree of insulation from the fickleness of politicians who have an incentive to avoid hard decisions. So we’ve strengthened the independence of the central bank and, as a result, the independence of monetary policy.

Likewise central banks have innovated in their attempt to shore up the liquidity of the financial system in the current crisis. Thus as the RBA Governor told us recently, “In periods of particularly unusual market duress, central banks should be prepared to move beyond the normal scope of operations to provide liquidity against a broad range of assets”.

I’ve argued that we should extend these lessons more widely. Along with some more illustrious colleagues like Alan Blinder and Brad Delong (at least I beat them into print!) I’ve suggested we should begin building institutions that can provide greater fiscal policy independence. We could begin with an independent board (or even the RBA) publicly advising the government on its fiscal stance in the way the Productivity Commission advises it on micro-economic reform.

Likewise, while I support the RBA’s moving “beyond the normal scope of operations” to shore up liquidity in financial markets, given the extent of financial innovation in recent times and the speed with which risks are transmitted in our increasingly integrated world, we should be thinking about this subject more deeply.

The RBA’s limited preparedness to lend against residential mortgage-backed securities (RMBS) helps protect the liquidity of the banking system, but at the cost of competitive neutrality. It helps the banks but does nothing for what was the 20 per cent or $50 billion per annum of the housing finance market where liquidity has simply collapsed - securitised Australian mortgages which are among the safest in the world.

Current RBA practice addresses the short term problem of liquidity for banks - but exacerbates the long term damage the collapse of primary securitisation markets is causing to the competitiveness of the home loan sector and beyond. Banks have stepped into the vacuum expanding their market share. But with limited capital they’re starving other customers for credit.

Christopher Joye and Joshua Gans’ “Aussie Mac” proposal involves extending this government function in the way that Fannie Mae has done in the US since 1938 and the Canada Mortgage and Housing Corporation, which has done so since it first helped returned soldiers into homes in 1948. “Aussie Mac” would involve government doing what the RBA is now doing for banks - effectively guaranteeing high quality mortgages - but on a larger scale and with competitive neutrality.

Naturally, as in the days of Smith, any “intervention” is looked upon askance by some and slated by some as “government assistance”. It is not. Government guaranteed involvement in vouchsafing liquidity in the market should be seen as a trade in which the state agrees to bear a risk that those in the private sector have, by their withdrawal from the market, indicated they cannot or will not bear. At the same time Government should charge an appropriate premium for its insurance, reflecting its unique position in the marketplace as the least cost bearer of such risk.

In its role as lender of last resort the central bank is in a fine position to price its own services at a healthy profit and it should do so. And just as the RBA is currently charging banks a healthy margin for lending against their residential mortgages, so too the government should charge a healthy premium for insuring residential mortgage securities during times of extreme dislocation. And as is generally the case with trade, it doesn’t take place unless both parties gain from it. Only in this case, in addition to the Government expecting to come out ahead financially, we get a powerful economy wide benefit of the perseveration of liquidity in the financial markets.

In short, if done right, as with the opening of a new trade route, everyone could expect to be a winner including a government eager to deliver a higher surplus.

One final thought: right now the credit crunch is acting in concert with higher interest rates to produce a desired slowing of our economy, but rising bank margins are building costs into our economy which we’ll rue once this tightening cycle is over and our economy needs to pick up steam.

So let’s get on with innovating the tools we’ll need to fight this, and future wars, rather than honing instincts we developed during the last one.