– Peter Morici is a Professor at the Smith School of Business, University of Maryland, and former chief economist at the United States International Trade Commission. The views expressed are his own. —

From Berlin to Bangkok, governments are screaming about the falling dollar, because they can no longer rely on reckless American consumers to power their economies.

From the late 1980s to 2007, the global economy enjoyed The Great Moderation-low inflation and sustained growth interrupted by brief recessions. Driving global growth was an eight fold increase in the U.S. trade deficit, facilitated by a doubling of the value of the dollar against other currencies from 1989 to 2002.

Deregulation and new technologies powered U.S. growth, and Americans flush with success bought whatever the world had to sell. However, when imports substantially exceed exports, Americans must consume more than they earn producing good and services, or demand for what they make is inadequate, inventories pile up, and layoffs and recession follow.

From 2003 to 2007, the U.S. trade deficit averaged $665 billion, and Americans massively borrowed from abroad to keep the U.S. economy going. They posted as collateral overvalued homes financed on shaky mortgages. When mortgages failed, banks failed, home prices dropped, and retail sales tanked. The U.S. economy was thrust into the worst recession in 70 years and pulled the rest of the world into crisis.

Imports of oil and consumer goods from China account for the lion share of the U.S. trade deficit. Americans drive big cars powered by thirsty engines. They sit on vast untapped deposits of natural gas but burn too much heating oil in the winter. Simply, conservatives in Congress are unwilling to submit to genuine energy conservation, and liberals teach developing domestic fossil fuels resources is evil.

For nearly two decades, China has maintained an undervalued currency. The Chinese government tightly regulates private trading in the yuan, and each year, purchases more than 400 billion U.S. dollars with newly printed currency to keep the yuan artificially cheap against the dollar. That is 10 percent of China’s GDP and 20 percent of exports to make Chinese goods artificially inexpensive on U.S. store shelves and juice Chinese exports.

China amasses huge trade surpluses that power its impressive growth, and the rest of the world suffers slower growth to compensate. An economic miracle sold to the world as policy genius but really built on currency mercantilism and beggar-thy-neighbor protectionism.

Japan has propped up its economy by purchasing dollars and permitting private investors to borrow yen at near zero interest rates and trade those for dollars-denominated Treasury securities. Now, Tokyo signals it will not let the yen drop much below 90 per dollar when a market equilibrium value would be closer to 80.

Other Asian export powerhouses have practiced variants of the Chinese and Japanese currency model too. It is no wonder the dollar was so strong for so long.

In recent years, private investors have grown wary of massive American borrowing. They have turned to the best substitutes available for the dollar-the euro, yen and gold-and driven up their values and pushed the dollar down against every major currency but the Beijing regulated yuan.

Now, with Americans no longer able to borrow madly to prop up global growth, protests are shouted around the world about a “cheap U.S. dollar.”

The hard facts are the dollar became overvalued earlier in this decade, in no small measure thanks to the currency policies of China and other Asian governments. Now, as private traders flee the dollar, its average value has fallen near the middle of its trading range for the 1990s.

The dollar has fallen too much against the euro and some other currencies, because China, Japan and other Asian exporters have been unwilling, in varying measures, to abandon currency mercantilism and let their currencies rise in value as free markets would require.

If China and others ceased subverting currency markets, the yuan would rise at least 40 percent, other Asian currencies would appreciate too, the U.S. trade deficit would shrink dramatically, and the new demand for American goods would rocket the U.S. economy.

With higher incomes, Americans would need to borrow less, and the global economy could go forward, embracing free trade in goods and currency.

– Mark T. Williams, a former Federal Reserve Bank examiner, teaches finance at Boston University’s School of Management and is writing a book on the rise and fall of Lehman Brothers. The views expressed are his own. —

In the real world, outside the Washington Beltway, when someone does a bad job they do not get more work.  The Council of Institutional Investors and the CFA Institute Center for Financial Market Integrity task force report agrees with this fundamental point:  Don’t give the Fed the new job.  As an ex-Fed examiner, I applaud this conclusion.

Creating an independent Systematic Risk Oversight Board (SROB) to monitor firms that pose significant risk to the market would inject new honesty to regulatory supervision.  This sound proposal comes at a time when Treasury Secretary Geithner would like to give his former employer, the Fed, additional regulatory duties even if they have failed to earn this right.  The report also is critical of previous light-touch regulation.  The SROB would provide a firmer approach, not repeating the mistake made by the Fed of coming with a knife to a gunfight.

A new oversight board would provide a fresh approach to preventing banks and other financial firms like insurance companies from engaging in risky and financially harmful practices.  Importantly, the task force report recommends restricting risk-taking activities, forcing banks to refocus on their core competencies – taking in deposits and making loans.  Although banks can get into trouble making loans, such activities are more transparent and easier to monitor than the trading of derivatives that, in a flick of a finger, can blow up a firm.  The report also advocates strengthening capital adequacy standards, important for a cushion against losses and insolvency.

Traditionally, banks have made money only three ways — loan interest, fees for services, and trading.  It would be extreme to say that all banks should be restricted from trading.  But there are many that lack the expertise, capital, trained staff, or sophisticated monitoring systems needed to adequately measure, monitor and control risk.

In a capitalistic system it is important to allow market forces to work so that risk taking is adequately rewarded and excessive risk taking is penalized.  However it is equally important to make sure that risky practices of banks do not come at the expense of broader market disruption, economic decline, lost jobs, and financial hardship.

The banking industry is at a fundamental inflection point.  To say, “It’s business as usual, let the Fed do the heavy lifting,” does not address the underlying problem.  How much risk taking should be allowed and how much concentrated financial power should be permitted in the hands of a few banks and non-bank financial firms is a paramount policy issue.

Since 2008, the five largest independent Wall Street investment banks — Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns — have gained banking powers, been merged with other banks, or were purged by the market.  (Goldman’s latest quarterly earnings of more than $3 billion in profit, most from risky trading, stunned the Street.)  Over the last decade there also has been a rapid movement towards “universal” banking.  Examples include Citigroup, Bank of America, Barclay, HSBC, and Deutsche Bank that provide a full array of risk-taking products from commercial loans to derivatives trading.  And, increasingly, large insurance companies are acting and feeling like banks.

Concentrated power in our regulators can come at too high of a cost because this new breed of risk takers need to be regulated and examined differently.  Establishing an independent oversight board outside of the Fed also sends an important message to the market that regulators will no longer be rewarded for a job poorly done.

Not until we established more of a performance-based regulatory system and increase accountability at the agencies entrusted to protect us (e.g., the Fed, FDIC, OCC, and SEC) will our regulatory system begin to operate effectively.   If the Fed thinks it can do a better job, it will have the opportunity to earn back the trust of the market and, if successful, the task force oversight board could eventually be phased out.

More eyes viewing banking activities can only assist in better risk identification, monitoring and mitigation, before excessive risk taking is allowed to occur again.  The market, the economy, and the American people have suffered from lax regulatory oversight.  A new, independent Systematic Risk Oversight Board is a step in the right direction.

– Robert R. Bench, a former Deputy Comptroller of the Currency in the Reagan administration, is a senior fellow at the Boston University School of Law’s Morin Center for Banking and Financial Law. The views expressed are his own. –

“Le laissey faire, c’est fini” – French President Nicolas Sarkozy

There indeed is a French flavor to the administration’s proposals for reforming the structure of regulation and supervision of financial institutions operating across the United States. In many ways the proposals resemble the “Commission Bancaire,” the French regime for financial oversight.

Perhaps the proposals reflect commitments the U.S. has been making at the meetings of the G20 countries, consisting of countries which finance much of U.S. government operations and American consumer credit.

If we want those countries to continue to be our banking lifeline, we need to engage in reforms to satisfy their expectations for financial discipline and integrity. We cannot restore confidence and trust in our financial institutions and markets until investors feel again that U.S. financial transactions are on the “up and up.”

The same goes for domestic investors and savers. Financial institutions made promises to U.S. pension funds, municipalities, and trusts. Those promises were broken, as losses of 20, 30, and 40 percent have been incurred. U.S. financial institutions sold “dreams” to American financial consumers: first house, vacation house, student loans, secure retirements, etc. For some, those dreams are totally broken. For many, the dreams have turned into nightmares.

U.S. customers of U.S. financial institutions rage at those institutions’ lack of performance and executives’ performance bonuses. U.S. financial leaders sit on the beach while American taxpayers are stuck on a treacherous fiscal sandbar.

In essence, this financial crisis has reminded us all that the financial system is a public utility and the U.S. financial institutions are chartered by the government because of their social utility to the commonwealth.

In recent years, unfortunately, financial institutions became less involved in financial service and consumed by financiering for the sake of volume — because volume drove individual compensation up and down the executive ladder. Splendid financiering is the work of rascals and humbugs, wrote Hugh McCullough, the first Comptroller of Currency in 1863. President Obama’s new proposals are dealing with 21st century rascals and humbugs.

The proposals are for getting back under the umbrella of government charters the financial transactions that escaped the regulatory umbrella in recent years. They are intended to show global investors and U.S. taxpayers that Washington intends to return U.S. finance to a safe-and-sound enterprise first and foremost, but should something go wrong in the future the losers will be private capital and not taxpayer capital.

The proposals call for a return to a “trust but verify” regime in which significantly more federal examinations will be carried out across all elements of U.S. finance. This will include a stronger advocacy for consumers of financial products.

More specifically, the president’s reforms call for a dramatic extension of federal regulation and supervision of financial markets and financial institutions, while also calling for a status quo and/or expansion of financial supervision in state governments. All significant financial holding companies will fall under regulation and supervision of the Federal Reserve. So will all significant clearing and settlement systems for financial products.

Financial institutions will have to have more capital reserves and liquidity, cushioning the taxpayer from risks. Those cushions will be managed in a counter cyclical way, i.e., the institutions put away more earnings in good times so it is available when things go wrong. And they’ll have to put it away in protection before they can pay it out in compensation. This process will involve the accountants coming up with revised policies for marking-to-market and for loss reserves, further dampening any chance for irrational exuberance in the future.

Significantly, the president’s proposals provide for special bankruptcy proceedings to deal with sick, large financial institutions. The FDIC has those proceedings for sick banks and this year is deploying those proceedings just about weekly. But big problems arise when the bank is owned by a holding company and that holding company is large, complex, and likely multinational. For an enormous amount of reasons, normal bankruptcy rules cannot be used because that involves freezing activity at the holding company, which in turn would freeze the entire financial system because of interconnectedness. So, new, customized wind-up processes need to be devised for large, systemically important financial institutions, not just banks.

The president requests new processes because without them the government remains stuck in the rut of using taxpayer monies to keep the sick company afloat. And trust and confidence in finance will not be restored until sick financial companies are resolved.

If this reads as if we have entered “old Europe” somewhat, perhaps we have. The financial system and institutions in it have failed the “test of the marketplace.” The “invisible hand” of the marketplace has needed the guiding wallet of the American taxpayer. Financial managers have privatized their profits but socialized their losses. Reforms are necessary to restore the balance between the government and its government-chartered institutions.

Personally, I would have liked the president’s proposals to have spoken more about restoring integrity in private-sector governance. That also must come in order to regain confidence. Maybe we need a simple proposal to change “CEO” to that European “Governor” to remind executives on whose behalf they really work for every day.

– Stephany Griffith-Jones is executive director of the Initiative for Policy Dialogue at Columbia University. The views expressed are her own. –

There are many important challenges facing G20 leaders when they meet in London in early April.

The first is to coordinate sufficiently large fiscal and other measures to ensure that world aggregate demand recovers, and a major recession is avoided.

It is also crucial that concrete measures are taken that will allow developing countries, especially those that may become foreign-exchange constrained, to sustain growth. This will not only be key for avoiding a large slowdown in growth and increase in poverty in those countries, but also to guarantee important demand for developed country exports. It is estimated that around 200 million people could be pushed into poverty, mainly in developing countries, if rapid action is not taken to soften the impact of the crisis on those countries.

QUICKLY REFORM THE IMF’s COMPENSATORY FINANCING

The calls for significantly expanding the resources of the International Monetary Fund (IMF) by several G20 leaders are welcome. One effective way of doing this would be through a counter-cyclical expansion of official liquidity, by a one-off, large issue of IMF Special Drawing Rights (SDRs). This would compensate for the large contraction of private liquidity, which has resulted in a sharp fall in private capital flows to developing countries. Once the situation normalizes, the SDRs could be reabsorbed by the IMF. The major objection to SDR issues in the past has been the threat of inflation. It has no validity at present. The dominant threat is of deflation and recession.

A complementary or alternative measure is for the IMF to modify its facilities so it can lend rapidly, at sufficient scale, and without overburdening borrowers with the heavy conditionalities of the past, especially when the sources of crises are exogenous.

Thus, there should be a major and quick reform of IMF compensatory financing .This has become urgent, given recent very sharp falls in commodity prices, with highly negative effects, especially on low income countries. Existing facilities for those countries are clearly insufficient, especially as regards the scale of their lending. It is therefore urgent to scale up these facilities.

The recent creation of a new IMF Short-Term Lending Facility (SLF) for countries with good policies facing short-term liquidity constraints is welcome. As yet, no country has used it. It may need modifying to extend its very short maturity and to make it accessible to a larger group of countries.

It is also important that aid to low-income countries is increased. Furthermore, multilateral and regional development banks need to rapidly and greatly expand their lending.

CORRECT THE REGULATORY DEFICIT OF GLOBAL FINANCE

The magnitude of the current crisis is clearly associated with inadequate regulation of banks and financial markets.

The new regulatory governance should be based on a well-functioning network of national authorities and include truly international regulation of global financial institutions . A global financial regulator needs to be created, building on institutions like the Bank for International Settlements.

This new institutional structure should have real power to influence decisions of national regulators, especially in the largest countries, including industrial countries. Secondly, it should take macro-prudential concerns clearly into account. Finally, it should consider the potential costs of financial instability on the real economy.

The current deep crisis and numerous previous ones that hit developing countries seem to demonstrate that crises are inevitable in deregulated financial systems. There is, therefore, ever-growing consensus that more complete and more effective financial regulation is required.

There are two broad principles on which future financial regulation needs to be built. The first is counter-cyclicality, in order to correct the main market failure of banking and financial markets — their boom-bust nature. The key idea is that provisions and/or capital required should increase as risks are incurred, that is, when loans are disbursed. In this way, provisions and capital requirements should increase during periods of rapid credit growth and decrease when lending expands at slower rates. This would strengthen banks in boom times and discourage them then from excessive lending. It would also make it easier for them to continue lending in difficult times. It is encouraging that the Basle banking Committee has recognized this principle in broad terms.

The second key principle for modern, effective regulation should be comprehensiveness. Economic theory tells us that for regulation to be effective, the domain of the regulator has to be the same as the domain of the market to be regulated. There is need for comprehensive and equivalent transparency, as well as regulation of all financial activities, instruments, and actors. Both minimum liquidity and solvency requirements need to be regulated.

Ensuring enough demand globally and in developing countries is crucial to avoid a large recession in the near future. Appropriate regulation of the financial sector is key to avoid future costly crises. Both tasks are difficult, but essential.

– Alexander Smith is a Reuters columnist. The opinions expressed are his own –

New regulations may be cooked up to curb the excesses of its bankers but London will always attract those who believe its streets are paved with gold.

Some predict that the financial crisis spells the end for London as a major global financial centre, arguing it has thrived on lax regulation and a quasi-tax haven status and that the regulatory backlash which inevitably follows such a catastrophic economic debacle will suffocate the innovation and the financial incentives which have driven the growth of services in the British capital.

But these doomsters are overlooking key factors which have made London a world hub for centuries. London’s geographical position — most notably Greenwich Mean Time — has served it well as a bridge between the time zones, its almost unrivalled cultural diversity, its global outlook, the advantage of English as the common language of finance and not least the trading and financial heritage it has built up since Roman times.

Throw in the advantages of maintaining its own currency during a period of downturn (particularly when a weaker pound gives it an economic advantage) and London is well served alongside New York and Singapore, Hong Kong or Tokyo when competing with other centres which have harboured global ambitions such as Frankfurt, Paris or more recently Dubai.

The City of London, also known as the Square Mile, which immodestly by British standards bills itself as “the world’s leading financial centre” also clings to a host of antiquated traditions whose quaintness, including the appointment each year of a Lord Mayor, remains a tourist draw if nothing else.

Another factor in London’s immediate favour is the infrastructure spending which is taking place to coincide with the Olympics in 2012. The massive Crossrail project will link the capital’s east and west, while despite constant carping from its users, the underground “Tube” network is undergoing a major upgrade to bring it into the 21st Century. The lure of the capital’s arts and culture, its shops, restaurants and pubs all combine to keep people coming to visit and to live and work.

Mayfair’s hedge funds, the mammoth City bonuses and the days of light-touch regulation may be a distant memory, but London still has the trading infrastructure, the expertise and the confidence to reassert its position at the heart of the financial system. Given its dependence on financial services, London is far from immune from the global downturn, but with huge volatility in the markets it has traditionally dominated, including foreign exchange and commodities, as well as booming equity and debt issuance, its prospects are nothing like as bleak as its detractors would have us believe.

London’s streets may be paved with less gold than before, but that won’t stop people finding new and inventive ways to make money on them.

– At the time of publication Alexander Smith did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

– John Kemp is a Reuters columnist. The views expressed are his own –

The international system of bank regulation, epitomised by the Basle II process and the light-touch principles-based regulation of Britain’s Financial Services Authority (FSA) has comprehensively failed.

In too many instances, light-touch principles-based regulation with an emphasis on banks’ internal risk controls turned out to be no effective regulation at all.

Former Fed Chairman Alan Greenspan was the most prominent proponent of this approach, which relied on the profit-maximising self interest of financial institutions to limit risk-taking to prudent levels.

In this view, bank leaders themselves could be relied upon to manage their institutions prudently — after all bankruptcy is not in the interest of shareholders. Previous bank failures (such as Barings) were the result of failure to measure risks properly, or failures of internal communication and control.

So the job of regulators was to set out principles and ensure banking institutions had adequate internal systems and controls, then allow senior management to ensure the overall level of risk was prudent.

This reliance on internal risk-management systems has proved to be a huge error. As Greenspan himself noted recently, bank leaders had not acted in the careful manner he had expected when he pushed for them to be freed from the old, more restrictive regime.

As a result, credit control will be much more intrusive in future. As noted in a companion column, there is renewed interest in some form of overall credit policy to limit the quantity of credit (and debt) within the economy and ensure it is consistent with macroeconomic stability.

But intensive contra-cyclical credit controls will only work if they are imposed on a broad range of institutions and on a worldwide basis — otherwise the banking system will arbitrage between regulators, and business will be booked in the jurisdiction with the “lightest touch”.

This is precisely what happened in the last decade, when the FSA, and the Commodity Futures Trading Commission (CFTC) in the United States, arguably led a race to the bottom among regulators to offer the most generous regime in the hope of creating a competitive advantage for their home jurisdiction and winning more business.

So any new credit control instruments will need to be implemented on a multilateral basis and agreed through the Basle Committee on Banking Supervision, in tandem with the Madrid-based International Organisation of Securities Commissions (IOSCO).

The Basle Committee’s updated Capital Accord (Basle II) has already been rendered moot even before it has been fully implemented. Basle II’s decision to allow banks to rely on their own complex internal risk control systems when judging how much regulatory capital they need to hold now looks quaint. Of the three pillars in Basle II — (1) capital requirements, (2) supervisory review, and (3) market discipline — the third now looks wholly outdated, and elements of the first and second need substantial re-working.

Some form of Basle III will be needed to buttress the contra-cyclical credit instruments which national regulators and central banks will deploy to manage the credit cycle and limit debt to GDP ratios to more safe levels.

Basle III needs to settle on an agreed range of credit instruments and credit-creating institutions that will be subject to regulation, how regulation will be applied on a counter-cyclical basis, the respective roles of supervisors and bank management, and how to ensure against regulatory arbitrage.

BANK REGULATION AND MONETARY POLICY
The failure of Basle II process bank regulation at multilateral level has been matched by failure among national regulators. The events of the last 18 months have demonstrated that a credit-fuelled banking crisis cannot be contained within the financial sector and has potential to destabilise the rest of the economy severely. Credit policy is a matter of macroeconomic strategy, not just financial regulation.

If credit expansion has the potential to destabilise the real economy, and the liabilities of much or all of the financial system are contingent liabilities of the central bank and the finance ministry as lenders of last resort, then the quantitative control of credit is arguably too important to be left to a financial regulator, such as the FSA or the U.S. Office of the Comptroller of the Currency (OCC) and U.S. Office of Thrift Supervision (OTS).

Quantitative credit control needs to be brought within the remit of the central bank, so that credit expansion can be adjusted in tandem with interest rates (and indirectly in response to changes in government fiscal policy) to ensure internal, external and financial balance simultaneously.

While banking regulators may still have a “tactical” role in supervising prudential management and risk controls within individual institutions, the “strategic” role of limiting credit extension across the financial system as a whole to a safe level is too important, and properly belongs to the macroeconomic managers at the central bank.

Recent regulatory trends have seen institutional responsibility for financial regulation dispersed across multiple institutions, and separated from monetary policy at the central bank. This trend may now have to be reversed.

A more consolidated and intensive approach appears inevitable. Proposals to combine the various US regulators or at least to give the Fed over-arching responsibility as a super-regulator for the financial system have received widespread support, though the details of institutional reform have yet to be agreed.

In the United Kingdom, the wisdom of separating financial regulation from the Bank of England and passing responsibility to the FSA is increasingly questioned. The need for a lender of last resort support to a wide range of institutions, and the macroeconomic consequences of a widespread debt crisis, have pushed the Bank of England back into the heart of financial regulation.

If a new instrument for controlling the quantity of credit is eventually implemented, it will probably have to be managed out of the central bank. The FSA may retain responsibility for the prudential supervision of individual banking institutions, but the overall framework of control will need to be set by the central bank.

EMERGING REFORM AGENDA
If proposals for regulatory reform are to stand any chance of being implemented, they will need to move beyond a sterile debate over market-led discipline and innovation versus stodgy heavy-handed state regulation.

They will have to recognise that collective action problems and moral hazards in the credit creation process make some form of quantitative control essential. The system needs to achieve a financial balance alongside internal balance and external balance, and for that it needs to develop a third instrument, credit policy, alongside the traditional monetary and fiscal policies.

Credit policy will need to act directly on the volume of credit created, and amount of risk, independently of its price, which is the province of interest rates and monetary policy.

It will need to be contra-cyclical and apply to a broad range of institutions to be effective.
It must be dynamic, capable of being modified as the financial system evolves and pioneers new ways to circumvent the existing controls.

It must also be applied on a multilateral basis to prevent the type of regulatory arbitrage which occurred in the late 1990s and 2000s.

The Basle Committee is the most promising forum for reaching agreement. But Basle III will need to be developed much more quickly than Basle II, which took more than a decade, has still not been implemented fully, and risks becoming a stillborn historical curiosity, a monument to an age which has passed.

That suggests Basle III should focus on a much simpler set of credit control instruments, and eschew complexity in favour of a blunter but more effective approach. Crude but effective safeguards may be preferable to interminable arguments and theoretical elegance.

– John Kemp is a Reuters columnist.  The views expressed are his own –

UK Prime Minister Gordon Brown’s call today for a new G20 charter of principles on financial regulation  reflects an emerging consensus among policymakers that, once the immediate crisis has passed, the regulatory framework must be fundamentally redesigned.

In particular, policymakers are concerned with how to correct the basic moral hazard problem in which bankers have an incentive to extend too much credit, while private firms and households have an incentive to take on too much debt.

A consensus is emerging that the volume of credit expansion needs to be restrained and managed as a separate policy objective. This marks a sharp break with past practice — in which central banks attempted to control the cost of credit by manipulating short-term interest rates, but have increasingly left its quantity to decisions by individual banks and borrowers.

There is also something of an emerging agreement that if credit control is a separate economic objective alongside “internal balance” (output-inflation) and “external balance” (trade and capital flows) then a new instrument needs to be developed to achieve this target.

With three targets (internal balance, external balance and financial balance) Tinbergen’s Rule says there need to be three independent policy instruments — fiscal policy, monetary policy, and a distinct credit policy.

In his recent speech to the CBI Annual Dinner in the East Midlands last week, Bank of England Governor Mervyn King alluded to the need to develop a new policy instrument to achieve credit-policy objectives. He stated a strong preference it should not be interest rates. King argued rates should continue to be used to target output and inflation.

The clear implication is the “new policy instrument” referred to by King will have to be some form of direct quantitative control, so as not to interfere with interest-rate strategy, and allow the authorities to manipulate the volume of credit for any given level of interest rates.

SECOND GENERATION CONTROLS
In 1945-1975, banking crises were few, but credit was expensive and unavailable to many households and businesses. The banking system was tightly controlled and the quantity of credit was rationed through a variety of direct mechanisms (reserve requirements, intensive bank examinations, margin requirements and a host of other direct lending controls).

Most of these were dismantled during the 1980s and 1990s. They could be resurrected but this would face stiff opposition from within the industry. It would also face hostility from within the economics establishment (broadly in favour of market solutions) and among politicians (worried about the impact of reduced access to credit for many households, and voters, in the lower half of the income distribution).

Fed Vice-Chairman Don Kohn and Prof Lawrence Summers (now head of the Obama administration’s National Economic Council) both poured scorn on what they saw as a rose-tinted view of the heavy regulatory past at the Fed’s annual Jackson Hole symposium in 2005. Both men are presumably chastened by the subsequent meltdown. But their personal opposition to intensive quantitative controls is probably still intact, and shared by many policymakers at the top of the new administration, in Congress, and among the wider regulatory community.

So the search is on for a compromise. The idea is to create a new instrument or instruments that would work with the grain of the market, rather than cut against it, and enable regulators to exercise some control over the quantity of credit being extended while preserving flexibility for banks to innovate.

If the old pre-1980 quantitative controls are seen as “first generation” methods, the hunt is on for more sophisticated market-friendly “second generation” methods that promote stability while protecting growth.

The first design issue for these new quantitative controls is whether to impose them directly or indirectly.

First-generation quantitative controls were formulated within the central bank and consisted of a series of prescriptive lending ratios.

The trend in recent years has been towards a more indirect approach, in which the central bank and other regulators set out general principles and a flexible framework; banks are then free to manage their business and risk-taking within this. One key question is how far second-generation controls will build on the modern principles-based indirect approach, or revert to a more prescriptive command-and-control one.

COUNTER-CYCLICAL INSTRUMENTS
The second design issue is how to make quantitative controls “active” rather than “passive”. First-generation controls were largely specified in passive terms: fixed capital and lending ratios that were invariant over the cycle. But there is an emerging consensus second-generation controls should be more active and capable of varying over the cycle, limiting credit growth during the expansion phase, but also mitigating the collapse of credit during a contraction.

Contra-cyclical bank regulation policies are especially popular at the moment, because the industry is in the contraction phase, and contra-cyclicality implies a loosening of policy. The real challenge is to create a contra-cyclical approach that is sufficiently robust it can compel the banks to increase their capital cushions during an upturn.

One option is to impose reserve requirements or risk-weightings which rise above the long-term mean during expansions and are allowed to fall below it during the contraction phase. But that raises thorny questions of who measures the cycle and how. Dating and measuring business and credit cycles, and identifying turning points are notoriously difficult in real time.

To take a recent example: the start of the most recent expansion is controversial, with many commentators now arguing the Fed missed the beginning of the upturn and failed to raise interest rates in a timely manner. If the Fed, or another regulator, had been responsible for adjusting reserve requirements or risk-weightings, as well as interest rates, would the adjustments have been any more successful?

If relying on regulators’ discretion to identify turning points in the credit cycle is problematic, is there a way to make contra-cyclical controls endogenous to the lending system?

The aim would be to make reserve requirements, risk-weightings or other instruments depend on the volume of credit extended in the immediate past period(s). Credit controls would be progressively tightened the longer and faster credit expands, and progressively loosened the longer and further credit falls.

The problem with endogenous credit control policies (like endogenous interest rate policies) is that they do not work well around cyclical turning points.  In the summer of 2007, an endogenous contra-cyclical policy would probably still be tightening conditions in response to the explosive credit growth in 2004-H12007 rather than loosening them to forestall the calamitous collapse of credit that occurred later in the year.

INSTITUTIONAL REACH
In practice, credit is hard to define, measure and restrict. Conventional bank lending is only one element of an increasingly complex and diverse credit-creating system.

Finance companies, commodity brokers, special investment vehicles, and even hedge funds, all of which are increasingly active in wholesale money markets, may be engaging in credit-creating processes.

The question of what types of credit to control is analogous to the debate during the 1980s about what measure of the money supply to target. Moreover, Goodhart’s Law suggests any statistical or economic relationship between the chosen target measure and the wider economy will tend to break down once pressure is applied for control purposes.

In fact, as soon as the authorities decide on which forms of credit are subject to regulation and control, there is an immediate incentive to create other forms of credit in other institutions that are not subject to control and therefore more profitable. This was precisely the reason for the huge growth in the “shadow banking system” during the 1990s and 2000s.

To have any chance of being effective, the new credit policy will need to cover the whole range of institutions which create credit, not just commercial banks, and need to be applied on a fairly international basis, to prevent this sort of institutional and jurisdictional arbitrage.