Do we need a credit policy?

January 22, 2009

John Kemp Great Debate— John Kemp is a Reuters columnist.  The views expressed are his own —

The last eighteen months have witnessed a revolution in financial regulation — if by that we mean a fundamental reconstruction, total change or turn round from the previous orthodoxy occurring in a relatively compressed time.

In particular, the sheer scale of recent policy interventions in the banking system is throwing up very uncomfortable questions about the government’s role in the economy, centered on its function as the ultimate re-insurer of risk and its function via the central bank as “lender of last resort” (LOLR) to the banking system.

The classic statement of LOLR operations set out in Walter Bagehot’s “Lombard Street” is to “lend freely, at penal rates, against good collateral”.

But in the aftermath of recent rescues, not much remains of the original doctrine. The Fed and other central banks are now lending freely, but to a wider range of institutions never envisaged before, against poor collateral, on increasingly generous terms, and providing support for solvency as well as liquidity.

Central banks and finance ministries are shouldering losses that properly belong to private shareholders and creditors. In the process they are protecting almost all depositors, and helping bail out shareholders. Walter Bagehot would be amazed at how far his doctrine has evolved.

The broadening of the lender of last resort guarantee was probably inevitable. But it makes explicit what was always implicit: in an integrated financial system the liabilities of the whole system are contingent liabilities of the central bank and ultimately the taxpayer.

In previous crises, the off-balance sheet liabilities of vehicles such as conduits have been consolidated back onto the balance sheet of the sponsoring commercial and investment banks. But in the current, system-wide crisis the liabilities of not just large banks but almost all financial institutions are being partially consolidated back onto the balance sheet of the central bank and the public treasury.

If system-wide liabilities are all, in some sense, contingent liabilities of the central bank and taxpayer, should the central bank and taxpayer regulate the quantity and type of these liabilities to limit the resulting fiscal and monetary risk?  Is there a maximum size of banking sector and financial system that economies such as the Iceland, Switzerland or even the United Kingdom can safely maintain in relation to their national output?


The attached paper ( sketches out some of these issues in more detail and tries to frame the relevant questions for both policymakers and financial institutions trying to pick through the rubble of the global banking system.

For the time being, there are more questions than answers. But what is clear is that the current crisis marks a fundamental break with past practice. Modest adjustments or evolutions of existing theory and policy will not be sufficient. The theory has broken.

The twin framework of fiscal and monetary policy (in place since the 1930s); the central banking doctrine of lender of last resort (in place since the late nineteenth and early twentieth centuries); and the inflation-targeting framework for monetary policy (in place since the 1990s) have all been weighed in the balance and found wanting.

Only a fundamental rethink from first principles can equip the system to face the challenges posed by the current crisis and prevent a recurrence.

In particular, central banks and financial regulators may need to develop a far more explicit policy to control the quantity and distribution of credit, separate from, but complementing existing monetary and fiscal policies.

Rather than interest rates, which manipulate the cost of funds, this “credit policy” may need to operate through direct quantitative controls, including reserve requirements, volume quotas, or deposit to lending ratios, perhaps imposed in a contra-cyclical or contra-trend manner designed to limit credit growth during expansions.

This would mark a sharp break with the free-market principles which have informed bank regulation and government policy over the last three decades, but no more sharp than the wholesale rescue of bank depositors, shareholders and borrowers with public funds over the last eighteen months.

It is time to consider whether the volume and composition of credit should be an explicit target for government policy, alongside output, inflation, employment and income distribution.

For previous columns by John Kemp, click here.


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John, an issue larger than “by whose authority?” in terms of state nationalization is to ponder the underlying motivation(s). That is, why are central governments pursuing these socialist policy initiatives?

I would suggest that the primary motivation is nothing more than the perpetuation of governing the welfare state. Indeed, we have reached a tipping point where the clients of the welfare state now form a majority, and thus explicitly allow central governments to act in this fashion. (As can be seen by the election of Obama in the US.)

If this is the case, the real issue is not necessarily stabilizing an unsound financial system (one that will most likely be resolved with a combination of consols [perpetual bonds], external investment and inflation [monetization]), but how to restart the underlying economic engine in sufficient volume to support the tremendous financial requirements of the welfare state?

Assume for the moment that the financial crisis is averted; what economic model will provide the necessary output? The credit fueled model worked for a few generations, but has proven unsustainable. The point is that even if we were able to reach stability, there is simply nothing in place to restore growth to a level sufficient to support the welfare state.

The welfare state is therefore doomed, which raises much more serious questions than a mere financial crisis.

Posted by Snerfling | Report as abusive


To address the credit crisis in the US, we must recognize one of its root causes: chronic trade deficits.

Furthermore, we must address one of the most dangerous consequences of the credit expansion: weapons of mass financial destruction such as credit default swaps

According to Free Market Fundamentalists (FMF), chronic trade deficits simply shouldn’t exist, yet obviously they do.

According to FMF, the politically correct way to deal with a chronic trade deficit is to do nothing. They think currency exchange rates will automatically adjust to restore equilibrium. Yet obviously this hasn’t happened.

Their backup argument is: “So what? If trade surplus nations want to loan our own currency back to us at artificially low interest rates, let them. We can always print money to pay back the debt if need be. Doing so would be both inflationary and it would bring down the value of the dollar, which will eventually restore equilibrium, So, let the debt pile up! If we need to inflate our way out of debt, no problem. The inflation hurts foreign lenders and helps domestic borrowers.”

Of course, what the FMF don’t mention is that borrowing from trade surplus countries also fuels asset bubbles, which in turn trigger financial crises such as the one we’re currently in.

FMF also believe that when someone lends money to capitalists they will invest it wisely and rationally. Yet is this the case. Take housing for example. For many years now, US citizens have been saving less and less, but “investing” more and more in houses.

So if no one is saving, then where is the money coming from to finance our “investment” in housing. Obviously, its coming from foreign lenders who are running trade surpluses.

So, ultimately how do we use our investments in houses to pay off foreign lenders. For many years we seemed to think we could pay off foreign lenders by continuing to inflate the housing asset bubble.

But paying off lenders by getting them to lend you even more money is essentially a Ponzi scheme. Perhaps Obama should make Bernie Madoff the new treasury secretary!

Of course, housing price inflation can’t exceed the overall rate of inflation for very long. So now the bubble has burst, but the banks seem to be the ones in trouble, not foreign lenders.

If homeowners default on the loans, then why don’t we let bank stock holders and bond holders simply take it on the chin. The government insures savings accounts up to a certain dollar limit.

So, if bank stock holders and bond holders haven’t been wiped out yet, why are taxpayers on the hook. Once the stock holders and bond holders have been wiped out, the taxpayers will own the houses that are in foreclosure. Then the taxpayers can rent or sell these houses back to other taxpayers who want to rent or buy them, and the proceeds will be used to pay interest to the depositors insured by the FDIC.

The reason why taxpayers are now obliged to bail out bank bond holders and stock holders can be explained with three words: Credit Default Swaps.

Sometime CDS are described as a form of an insurance policy, which may be why insurance companies like AIG were selling them.

But unlike fire insurance, there was no regulation of the CDS “market.” We have our Free Market Fundamentalist friends to thank for this.

Now why do you suppose we have always regulated other forms of insurance, such as fire insurance. Let’s see … if I could take out a big fire insurance policy on my neighbor’s house, then if his house happens to burn down then I could make a lot of money. But why stop at one house. If I could take out a fire insurance policy on all the houses in town, and then the entire town burned down, then gee I could be super rich!!!

Since we are at least wise enough not to let people take out fire insurance unless the have an insurable risk (i.e. they own the house that might burn down), we are able to minimize the problem of arson.

But not so with our financial industry. It seems that in the infinite wisdom of the FMF we have let people take out financial fire insurance policies on our entire banking system. So if the banking industry burns to the ground, then these policy holders will get super rich, right. Well, not so fast. As it turns out the insurance companies who have been issuing financial fire insurance don’t have enough money to pay off.

So, now the taxpayers are on the hook for trillions and trillions of dollars if the financial industry burns down. These are the weapons of mass financial destruction that Warren Buffet warned us about.

So, we need to do two thinks:

1. We need to defuse the weapons of mass destruction in CDS market. The first step in doing this will be to regulate the market so that all existing and all new CDS policies will have to be registered. Then the government will have to take a drastic step. All policies that do not have an insurable risk will be declared null and void. The tax payers and the government will not be blackmailed.

2. We need to fix the trade imbalance. Warren Buffet has shown the way here as well. Since exchange rates obviously don’t adjust automatically, the US has two options: (1) we inflate our way out of debt or (2) we establish trade barriers. Technically, when your currency devalues it acts like a generalized tariff on all imports and a generalized subsidy on all exports. Market buffs like generalized tariffs and subsidies, and in this case I tend to agree with them (I would make an exception in the case of oil, which we should tax to help save the planet).

Unfortunately, exchange rates don’t work unilaterally. Other nations can refuse to let their rates adjust by loaning us money at artificially low interest rates.

So, is there another approach to generalized tariffs and subsidies that the US can take unilaterally. The answer is YES. Buffet and others have been proposing Import Certificates for years.

What’s an import certificate. Well, you can read up on the idea at wikipedia (see link below), but in brief the government would award import certificates to domestic exporters (i.e. for every dollar of foreign exchange generated by an exporter, he would get a certain number of import certificates). Importers would need to buy certificates to import goods and services. So, the importer would in effect pay a tariff and the proceeds would go to the exporter. This would not entail tariffs on specific goods and services. Since there would be a market in import certifications, there would be a generalized tariff on all imports, and a generalized subsidy on all exports.

So, are import certificates a form of protectionism. Well, yes. But if we inflate our currency to bring down exchange rates, then that too could be considered a form of protectionism.

If we don’t want our chronic trade deficit to eventually become a financial crisis, and we don’t want to inflate our way out of debt, would also create a financial crisis, then we have to do something. I say we use import certificates. ificates

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