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.