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

It is time to add another victim to the ever-growing list of institutions (Bear Stearns, Lehman Brothers) and theories (value at risk, fair value accounting and originate to distribute) which have been tested by the financial crisis and found wanting. The central bank practice of inflation targeting — the jewel in the crown of modern monetary economics — has palpably failed.

Over the last two decades, inflation targeting has emerged as the most popular strategy for monetary policy among the world’s major central banks, and become something of a state-of-the-art choice among theorists and central bankers.

Even the Fed, long skeptical, considered announcing a formal target for inflation last year. Senior officials considered whether it would be a useful way to counter the threat of deflation by providing an “anchor” for expectations about future prices. In the end the central bank ducked the decision and decided to press ahead with long-term inflation forecasts instead, as a form of “soft” targets.

But the experience of major central banks over the last five years — both those pursuing formal targets and those like the Fed which have been employing “shadow” ones — suggests inflation targeting has failed and will need to be overhauled once the immediate crisis has passed.

CENTRAL BANK PERFORMANCE

Controlling inflation has been the central objective for monetary policy for the last 30 years. But using interest rates to target the inflation rate directly emerged only in the early 1990s. In many countries, it was something of a default choice after strategies targeting intermediate variables (such as the money supply and the exchange rate) had been tried and failed.

In its own (narrow) terms, inflation targeting has been successful. In the United Kingdom, consumer prices have increased broadly in line with the Bank of England’s target since the central bank was given operational independence to set interest rates in May 1997.

Evidence from the United States is more mixed. The Fed has long insisted it does not have a formal inflation target (preferring to retain flexibility for what it calls a “risk-management” approach). But senior officials have defined the “price stability” component of its dual mandate as an inflation rate of about 1.5-2.0 percent per annum.

Both the all-items consumer price index and the core index excluding food and energy have consistently risen faster than the Fed’s implied target since 1997. Access PDF here.

In fact, the performance of inflation and the Fed’s interest rate decisions suggest the Fed has actually been targeting a core inflation rate of about 2.25 percent per year, or an all-items rate of 2.50 percent.

While this is slightly faster than officials have been prepared to admit publicly, it is still respectable by historical standards.

The real problem is that a narrow obsession with hitting inflation targets blinded central bankers around the world to the build up of other problems, including bubbles in the bond and real-estate markets, as well as the build up of excessive levels of household and corporate debt.

Moderate growth in each month’s consumer price numbers provided false comfort even as distortions built up in other parts of the financial system (overvalued asset markets) and economy (a gaping trade imbalances and surging commodity prices).

If the ultimate purpose of inflation targeting was to provide a stable economic framework for long-term decision-making by households and businesses, it has failed. Bubbles and over-indebtedness have caused far greater output losses when they collapsed than any amount of moderate consumer price inflation.

FLAWED THEORY

The excessively narrow focus of inflation targeting reflects conceptual shortcomings.

In 1952, Professor Jan Tinbergen proved that to achieve two independent policy objectives simultaneously, policymakers must employ two independent policy instruments.

Tinbergen’s rule implies monetary and fiscal policy work best when coordinated to achieve the optimal joint outcome for inflation and growth, or between internal balance (inflation-growth-employment) and external balance (the trade deficit and exchange rate).

But in a curious inversion, modern economics has sought to separate them, assigning monetary policy the role of pursuing price stability, while leaving fiscal policy to worry about growth and employment.

It reflects the impact on the discipline of Milton Friedman’s famous comment about inflation being “always and everywhere a monetary phenomenon,” amplified by the impact of the rational expectations revolution, which seemed to indicate monetary policy could not have an enduring impact on the level of business activity and employment, only on prices.

From this stemmed the idea monetary policy should focus on choosing a desirable (low) rate of inflation, leaving other aspects of demand-management and employment policy to fiscal policy.

The discipline has gone further, and sought to implement an institutional separation between the fiscal and monetary authorities. Most theorists have supported establishment of “independent” central banks able to set monetary policy at arms length from the fiscal authorities.

This reflects a mistaken view that monetary policy is essentially a technical academic exercise that can and should be insulated from other aspects of the policymaking process.

Reflecting this technocratic approach, modern monetary economics has been dominated by a debate over rules versus discretion — with a rule-based system generally held up as superior.

The history of the discipline since the late 1970s can be summed up as the perfect monetary “rule,” specifying how much the central bank should adjust the instruments under its control (reserves and interest rates) to achieve some intermediate variable (money growth and the exchange rate) or direct target (consumer prices) and ensure the ultimate goal of price stability is met.

PRACTICAL SHORTCOMINGS

But focusing monetary policy on consumer prices encouraged central banks to ignore signs of growing instability in other parts of the financial system (such as asset prices and lending). The target was too narrow and needs to be broadened in future.

It was a mistake to separate monetary policy and fiscal policy and assume monetary policy could somehow operate in isolation from tax and spending decisions and other interventions in the economy. Macro management would be more effective if monetary policy and fiscal policy were coordinated.

Elsewhere, I have suggested the authorities might need to go further and supplement existing monetary and fiscal policies with a third, distinct policy to govern the quantity of credit and build up of debt to ensure that internal balance, external balance and financial balance can all be achieved simultaneously.

Finally, it was a mistake to pretend monetary policy is a technocratic exercise. Decisions about interest rates have distributional effects (between savers and borrowers, more and less growth, more and less employment) and are inherently political.

This is not an argument for interference. But it is an argument for greater honesty about the social trade offs involved.

It is also an argument for allowing discretion back in. Rather than mechanically applying rules targeting a single variable such as consumer prices, central banks need freedom to respond to changing circumstances. That means freedom to cut interest rates dramatically in response to a financial panic. But it also means freedom to raise them during a boom to prevent wider distortions in the financial system even when there are no obvious signs of consumer price inflation.

Inflation targeting needs to be reworked in favor of a more holistic approach that gives central bankers more discretion to pursue a complex set of goals (including financial stability. But they must also be held more accountable, and accept this not just a technical exercise but one which involves difficult choices for society as a whole.

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

Even after its recent decline, the U.S. equity market does not look especially “cheap” or “undervalued” when viewed over time; the bear market has simply brought valuations back into line with long-term trends.

At a fundamental level, equity is a claim on a corporation’s residual cash flow after wages, interest, taxes and other costs have been paid.

In aggregate, the total value of equity outstanding cannot grow faster than nominal GDP (which is simply the economy-wide sum of cash flows). Otherwise, corporations and their owners would need to capture an ever-increasing share of national income at the expense of everyone else.

For four decades between 1952 and 1992 this stable relationship between equity valuation and nominal GDP did indeed seem to hold in the United States.

Click here for PDF

The chartbook shows how U.S. GDP, as well as profits, debt, interest rates and the market value of equity capital evolved between 1952 and September 2008 (the latest date for which full data is available).

Between 1952 and 1992, the value of outstanding equity rose at much the same rate (8.5 percent per year) as nominal GDP (7.5 percent).

But from 1992 onwards, the relationship broke spectacularly. The market value of equity has risen almost twice as fast (9.5 percent per year) as nominal GDP (5.4 percent) (Chart 1).

As a result, the value of outstanding equity, which had been stable for four decades at 40-80 percent of GDP, doubled to 160 percent of GDP at its peak in Q1 2000 (the height of the millenarian boom). It has remained above 100 percent of GDP for most of the current decade (Chart 2).

THREE FACTORS

Rising equity valuations relative to nominal income were underpinned by three factors:

(1) Profits began to rise as a percentage of GDP from the early 1990s onwards as corporations succeeded in retaining more of the value of output in the form of surplus/profits and reduced the amount captured by employees (wages), government (taxes) and other investors (interest payments on debt). Between 1992 and 2006, the share of corporate profits in national income increased from 7 percent to 13 percent (Chart 3).

(2) In an increasingly integrated world, U.S. corporations derived a growing share of profits from operations and subsidiaries abroad. Profits overseas are tied to GDP growth in foreign countries rather than the United States. Since developing countries have grown faster than the United States over this period, the foreign component of corporate profits could (and did) increase faster than domestic profits or U.S. GDP. As a result, the proportion of foreign profits in total earnings has risen from 16 percent to 26 percent (Chart 4).

(3) Because equities are a claim on profits in future as well as the present, valuations are sensitive to the discount rate used to convert future profits back into current values. By lowering the discount rate, the steady fall in long-term U.S. interest rates between 1982 and 2007 as part of the “Great Moderation” made these future profits much more valuable, driving up equity prices even further (Chart 5).

But two of these factors (a rising share of profits in GDP, and a reduction in the discount rate) could not be sustained indefinitely. To some extent they represented a one-off structural shift.

The share of profits in GDP cannot rise forever at the expense of wages, interest charges and tax payments. The discount rate applied to future profits cannot fall below zero.

So for a time, equity valuations could grow faster than nominal GDP as the market moved from a low-profit high-discount rate equilibrium to a high-profit low-discount one.

Once the transition was complete, however, it was inevitable that the rise in equity valuations would again be limited to the rate of nominal GDP growth (albeit from a higher baseline).

HIDDEN LEVERAGE

The rise in equity valuations was also sustained by a massive increase in borrowing and indebtedness. Share buy-backs, management buyouts and the debt-funded acquisitions by private equity firms substantially increased the amount of debt in the corporate capital structure and reduced shareholders’ equity (the leverage ratio).

In effect, the long period of sustained expansion during the 1990s and the early 2000s, characterized by a mild business cycle, together with falling interest rates, increased risk appetite, and falling borrowing costs made firms comfortable taking on more debt relative to their cash flow than before.

Some of that debt was used to retire outstanding equity, heightening the leverage ratio further.

Because leverage is measured as an increase in debt (liabilities) relative to equity (residual assets) the strong rise in equity prices masked the real increase in underlying leverage.

Between 1952 and 1992, corporate debt, like equity valuations, rose roughly in line with nominal GDP. But after 1992, corporate debt, like equity values, accelerated sharply (Chart 6).

So long as equity values continued to rise, the leverage ratio remained unchanged. In fact, strong growth in equity values cut the ratio from almost 100 percent to less than 50 percent between 1987 and early 2007 (Chart 7).

But the capital structure became increasingly vulnerable to any setback in equity prices; the borrowing boom could only be sustained as long as interest rates fell and the share of profits in GDP rose.

The U.S. economy and capital markets were thus set on an unsustainable course. And as President Richard Nixon’s chief economic adviser Herbert Stein noted in the 1970s, if something cannot continue indefinitely, it will eventually stop. That is what happened when the mortgage crisis erupted in the summer of 2007 and the music suddenly stopped playing.

Once rates and spreads had reached ultra-low levels in the mid-2000s they could not be reduced any further. In fact the Federal Reserve began to lift short-term interest rates, cautiously, from mid-2004, putting gentle upward pressure on longer rates. Losses on imprudent subprime lending became apparent from 2006.

Suddenly the cheap-credit dynamic that had previously supported increases in both corporate debt and equity valuations stalled and went into reverse.

The high-debt, high-equity valuation equilibrium proved immensely unstable. As the economy stalled and nominal growth fell, credit availability and costs rose, and the equilibrium fell apart. Looming deflation threatens to wreak even deeper destruction, because it would push nominal GDP growth below zero.

Suddenly the highly valued equity that supported an immense pile of debt has been re-valued downwards, sending leverage ratios soaring and exposing the underlying vulnerability.

The economy-wide leverage ratio reported by the Federal Reserve jumped 16 percentage points from 41 percent to 57 percent in just 15 months between June 2007 and September 2008. Recent declines in share values will push the ratio closer to 100 percent when data for Q4 2008 and Q1 2009 become available in the next few months.

In some sense, the sharp drop in equity valuations over the last six months has restored the historical relationship between equity values and nominal GDP. It has undone much of the “structural shift” in equity valuations to GDP experienced in the last 15 years (Chart 8).

Whether equity prices settle here or recapture some or all of their previous level depends on what caused that structural shift; how much of it proves sustainable; and how much is now reversed.

Share valuations may rise from current levels, but higher credit costs and a lower share of profits in GDP will almost certainly ensure valuations do not regain their previously elevated level in relation to the rest of the economy.

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

The commodity boom and bust in the last 5 years suggests there is a natural limit on how much investment money these markets can absorb before price-setting mechanisms become distorted and prices unmoored from supply and demand fundamentals.

Exchange operators and dealers have a strong interest in increasing turnover and volume, since it boosts income from fees and commissions. But most also argue that increased turnover makes markets more efficient because it sharpens price discovery and makes them more liquid.

In this “more is better” view, increased participation by investors works in the interests of producers and consumers.

By bringing more participants to the market, prices incorporate a wider range of views, and the market is more likely to find the “correct” equilibrium price quickly, improving the price discovery function.

It’s also more likely that producers and consumers wanting to execute hedging transactions will find a willing counterparty to take the other side of the trade, making it easier and cheaper to transfer unwanted price risks from industry to investors, boosting liquidity.

Economists and regulators have largely endorsed this view. Policymakers have been reluctant to take any steps that would restrict the number of participants in commodity futures markets or the size of the positions they may run.

But there are signs that a rethink is underway. In particular, regulators are beginning to ask whether the massive influx of investment money into commodity futures over the last five years actually distorted prices and reduced liquidity for other market users rather than increasing it as was expected.

In a letter to Senator Carl Levin ahead of his confirmation hearing, President Barack Obama’s nominee to head the Commodity Futures Trading Commission (CFTC) Gary Gensler acknowledged that “rapid growth in commodity index funds was a contributing factor to a bubble in commodities prices that peaked in mid-2008″.

POSITION LIMITS INEFFECTIVE

Classic theory assumes futures markets are competitive. Prices are determined by interactions among a multitude of buyers and sellers running relatively small positions and unable individually to have a material impact on the outcome.

Protecting the market’s competitive nature has always been the justification for imposing position limits and banning participants from attempting to establish squeezes or corners.

Under CFTC oversight, the New York Mercantile Exchange (NYMEX) has established position accountability levels restricting market participants to no more than 10,000 light sweet crude oil contracts for any one delivery month, and no more than 20,000 for all months.

The limit becomes tighter and more binding in the last three days prior to contract expiry, when it becomes a firm limit and drops to 3,000 contracts. Similar limits exist in other contracts and exchanges.

But accountability levels have always been “soft” limits. NYMEX can grant exemptions for producers and consumers who need to run larger positions than this to hedge their physical exposures. In recent years, NYMEX has also granted exemptions to banks and swap dealers who run commodity indices and exchange-traded commodity funds so they can hedge their obligations to their clients out onto the public markets.

Position limits have become more theoretical than real:

(1) Congressional enquiries into the failure of U.S. hedge fund Amaranth Advisors in 2006 revealed it had amassed positions in U.S. natural gas contracts amounting to more than half the outstanding open interest for certain delivery months.

(2) When the CFTC was forced to correct its commitment of traders’ data last summer, after misclassifying some positions, it revealed one trader held more than 320,000 contracts for light sweet crude oil. Not only was that far above the 20,000-contract accountability level, it amounted to more than 10 percent of the entire open interest in one of the world’s most important commodity markets.

(3) In a letter to the CFTC last summer, investigators from the House of Representatives’ Energy and Commerce Committee demanded to know why NYMEX had granted 117 exemptions to the normal position limits in the light sweet crude oil contract alone since 2006.

The committee noted: “Of the 117 exemptions granted, 48 were given to 18 companies based exclusively on swaps exposure, another 44 were issued to 24 companies for combined hedge/swap positions, but only 25 were granted to 11 companies based on a bona fide hedge exposure” (Read pdf here.)

NYMEX has granted so many exemptions some commentators wonder whether the accountability levels have any meaning at all. In his pre-confirmation letter, Gensler promised to review them all to ensure they were appropriate.

(4) One existing beneficiary is the United States Oil Fund, which sells units linked to the price of NYMEX light sweet oil. The fund’s website discloses that it currently owns almost 50,000 contracts for NYMEX light sweet crude oil in the April 2009 delivery month, far in excess of the normal accountability level and amounting to 18 percent of all contracts outstanding for that date.

The fund’s holdings are so large it cannot hold them all on NYMEX. So it holds another 30,000 lookalike contracts for light sweet oil on the IntercontinentalExchange (ICE).

ABSORBING NOT ADDING LIQUIDITY

The problem is not the overall amount of money that investors have poured into commodity markets, but its concentration at certain points along the futures curve, and the fact investors have tended to behave as a herd, all trying to go long at the same time. As a result, the influx of investment money has tended to absorb rather than provide liquidity to the rest of the market.

In theory, rising commodity prices should have encouraged commodity producers to sell production forward, ensuring the market remained balanced. In practice, it simply encouraged producers to discontinue hedging programs and accept spot prices, in expectation prices would rise even further.

So as oil prices climbed relentlessly, buying interest from investors was met by less selling interest from producers, and less willingness from dealers to take a short position against the trend. Liquidity declined, prices became discontinuous and the market began to “gap” higher.

Even after prices have fallen, the concentration of investor positions in certain parts of the curve is still causing distortions. The need to roll the Oil Fund’s contracts and those of commodity indices forward each month (selling existing holdings in the nearby month and buying contracts for the next one) is keeping the market locked in a deep contango.

Contracts which the Oil Fund and the indices need to sell are locked at a permanent discount to the ones they need to buy, as the rest of the market preys on forced sellers. In the process it is inflicting substantial roll losses on index and fund investors even though oil prices have been steady over the last three months.

The solution is to enforce position limits more vigorously and restrict exemptions to genuine hedgers rather than dealers running commodity indices and exchange-traded funds.

Dealers would still be free to run indices and exchange-traded funds, drumming up business from pension funds and other investors wanting exposure to commodity prices. But only a relatively small part of this extra investment business could be “dumped” onto the public exchanges, creating an upward price spiral.

The rest would have to be warehoused in the dealers’ own books. Unless dealers wanted to be net short, it would give them a sharp incentive to go out and find willing sellers to match the number of new buyers they are bringing to the market.

Tougher position limits would force them to become two-way dealers again, rather than simply commodity-investment promoters. It would also help ensure the influx of investment money does not overwhelm the regular price-setting and hedging needs of physical users.

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

President Barack Obama’s first budget puts climate change at the heart of the administration’s long-term economic plan. But despite the clear theoretical advantages of a simple carbon tax, he seems set to follow the EU and California in opting for a cap-and-trade system.

The budget plan commits the administration to work with Congress on an economy-wide emissions reductions program, based around cap-and-trade.

It also anticipates almost $650 billion in revenues over 10 years from selling these yet-to-be-agreed pollution permits, and proceeds to spend it on investment in clean technologies ($120 billion) and rebates for vulnerable families, businesses and communities ($525.7 billion).

In a sense the budget is a “wish list”. While federal law requires the president to submit a unified budget, there is no obligation for Congress to consider it line by line, or even use it as a starting point in the annual tax-writing and spending process.

Prudently, the administration has been careful not to rely on permit auction revenues it may never be able to collect. The projections do not anticipate spending any money raised from the permit program
until October 2012.

Revenues from permit sales have also been earmarked to fund clean technology and new tax offsets. If auctions do not occur, or raise less money than expected, these spending commitments can be cancelled without affecting the rest of the budget.

Nonetheless, by putting a cap-and-trade into the budget document, and anticipating how the revenues could be spent, Obama has given a strong personal commitment to seeking comprehensive climate change legislation this year.

Legislation will need to be sent to Congress within the next few months to stand any chance of being enacted in time for regulators to draw up scheme details and arrange an auction before the end of 2012.

TAXES OR CAPS

The budget confirms the president’s campaign commitment to achieve reductions via cap-and-trade rather than a carbon tax.

Most commentators agree it is cheaper to reduce carbon emissions through an “incentive-based” system (establishing a market price for greenhouse gas emissions) rather than old-fashioned “command-and-control” administrative regulations.

But there is much less agreement about whether to implement incentives through a carbon tax or cap-and-trade scheme.

The non-partisan Congressional Budget Office (CBO) published a comprehensive assessment of the alternatives last year, and concluded that in most cases a straightforward carbon tax would achieve the same emissions reductions at lower cost (read pdf).

In an analytical sense, carbon taxes and fixed caps are very similar. Both raise energy prices and discourage consumption of goods and services made by burning fossil fuels in favor of less energy-intensive items made with cleaner ones.

The principal difference lies in a trade-off between two types of uncertainty: uncertainty about the quantity of emissions reduction versus uncertainty about the cost.

A carbon tax establishes a single, transparent and certain price for burning fossil fuels, and therefore the ultimate cost of emissions reduction.

Households and firms have an incentive to take steps which increase energy efficiency and reduce fossil fuel use if the cost is less than the tax rate, but not if the costs exceed it. If the rate is set at a level which reflects the benefits to society of avoiding potentially catastrophic climate change, a tax would encourage households and firms to take only those mitigation actions which yield a net benefit.

The great advantage of a tax is that it gives households and firms certainty about how much reduction will cost. It also ensures there is no compulsion to undertake very expensive mitigation strategies for which costs far outweigh benefits.

But the disadvantage, especially in the eyes of climate-change activists, is there is no guarantee it will reduce emissions by a specified volume in any given year. Over a multi-year period, this is less of a problem. The rate can be varied if the volume of emissions reduction turns out to be smaller or greater than originally anticipated. Presumably it would also rise over time to force progressive improvements.

Cap-and-trade has the virtue of creating greater certainty about the volume of emissions reductions — but the disadvantage of huge uncertainty over the cost for households and businesses.

In a binding cap-and-trade system, permit prices can rise to any level to ensure the cap is achieved, even if the marginal cost of reductions proves very high, and far outweighs the benefits.

Massive volatility in permit prices is a major drawback of the cap-and trade-system.

Experience with other pollution trading programs in the United States such as California’s RECLAIM nitrous oxide program, as well as the EU’s Emissions Trading Scheme (ETS), suggests permit prices would be far more volatile than equities, making long-term planning very difficult.

The problem, as CBO notes, is that “the cost of cutting emissions by a given amount could vary from year to year depending such factors as the weather, the level of economic activity, and the availability of low carbon technologies”.

In fact, cap-and-trade risks exacerbating the already high volatility in energy prices. Trading programs are dangerously “pro-cyclical”. In a cold winter or a hot summer, when air conditioners are on full, rising fuel consumption pushes up the price of energy directly. But in a cap-and-trade system, it would also send the cost of permits soaring, pushing up the price of fuel even further.

In the 2000 heatwave, California power generators’ demand for extra trading credits under the state’s RECLAIM program sent the cost of permits up ten-fold from $4,000 per tonne to almost $45,000, contributing to high wholesale electricity prices during the period and the state’s energy crisis.

Conversely, in a downturn, slumping consumption would depress the cost of permits, and risks removing any incentive to invest in energy efficient technologies such as hybrid cars. Permit prices in the EU’s ETS have fallen from 30 euros per tonne last summer to a low of just 8 euros earlier this month, largely removing efficiency incentives.

Trading schemes can be designed to limit the acceptable range of prices. By auctioning permits rather than giving them away free, the scheme administrator can set a minimum price floor. The administrator can avert sharp spikes by setting a price ceiling and offering to auction an unlimited number of permits at that price to satisfy excess demand.

Some schemes try to limit short-term volatility by allowing surplus permits to be carried forward (”banking”) to meet demand in future years (when caps are likely to be tighter); or brought forward from the future to the present (”borrowing”) to relieve temporary shortages.

At the limit, if the price cap is brought low enough, and the floor is raised sufficiently, the trading scheme is identical to a tax.

Most real trading schemes allow far more volatility than this. The EU’s ETS is progressively moving to an auction system, but imposes no real upward limit on volatility. California’s proposed Western Climate Initiative (WCI) would auction allowances, and set a minimum reserve price for them to help establish an effective floor, but again there is no upper limit.

Despite clear economic drawbacks compared with a simple carbon tax, the obvious attraction of cap-and-trade is political. It avoids the need for the government to set an explicit and unpopular price on carbon dioxide emissions; policymakers can hide behind a price determined by the inscrutable magic of the market.

In practice, by picking a quantitative level of emissions, federal regulators will also be setting a price, albeit indirectly and one subject to enormous volatility. But advocates of trading hope the lower transparency will reduce its political visibility and make it easier to implement.

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

After an 8-year period of remarkable stability, the ratio between gold and oil prices has broken down spectacularly.

The relative rise in gold is consistent with other indications that the market is bracing for a delayed upturn in inflation between 2010 and 2012.

From 2000 to 2008 one ounce of gold bought between 6 and 15 barrels of light sweet crude oil but for months the markets have been moving in opposite directions. In recent weeks, one ounce of gold has bought as many as 27 barrels of oil (https://customers.reuters.com/d/graphics/OILGOLDRATIO.pdf).

If both gold and oil prices encapsulate a view about prospects for the world economy and inflation, the divergent price moves present a seeming contradiction.

The surge in gold prices suggests investors are anxious to protect their capital against inflation, currency depreciation and bank failures. But weak or falling prices for oil and other commodities suggest investors are also bracing for a prolonged period of economic weakness and deflation.

How to reconcile these views?  They cannot both be right.

If the massive liquidity injections into the banking system as a result of rescue packages and quantitative easing causes inflation to pick up, oil prices reflected in the forward curve will turn out to be far too low. If the world economy falls into a long deflationary slump, gold will be too high.

In either event, it ought to be able to trade the ratio, selling expensive gold futures to buy cheap oil ones, and wait for the ratio to converge back to more “normal” levels.

But such trades are more dangerous than they look.

Ratios can be remarkably stable and show strong trend-reverting properties for long periods of time. But when they break down, divergences often go further and last longer than most anticipate.

John Maynard Keynes warned that the market can remain irrational longer than the average investor can remain solvent. All but the strongest investors with deep pockets will struggle to meet margin calls until the ratio corrects and profits are made.

Moreover, it is impossible to be certain until afterwards whether the shift in the ratio represents a temporary divergence that will be corrected in time, or the start of a fundamental structural break.

TIMING DIFFERENCES

In any case, the current divergence in gold and oil prices may not be as irrational as it looks. It probably reflects differences between institutional and retail investors about the timing of future inflation rather than the probability.

Both types of investor have recently shown interest in commodities as a hedge against inflation, currency depreciation and bank insolvencies.

But unlike large institutional investors, who can protect themselves from inflation and currency risks through inflation and currency swaps, inflation-protected government bonds, or futures positions in oil and industrial metals, retail investors have fewer options. Owning physical gold is one of the few ways they can protect capital in an inflationary environment.

Much of the heightened interest in gold has come in forms favoured by retail investors, such as coins, bars and holdings in exchange-traded funds (ETFs) (which give private investors an opportunity to “own” physical gold more or less directly through shares in a trust vehicle quoted on equity exchanges).

Different views about inflation embedded in gold and oil futures may therefore mark different views between retail and institutional investors, with the retail base more worried about an upturn in inflation, and professional investors more sanguine.

It probably also captures differences about timing. The whole objective of quantitative easing is to generate more inflation over time to counter the deflationary tendencies within the economy as a result of the slump.

But an upturn in consumer prices is unlikely to occur until a cyclical recovery is well underway, and could therefore be several years away.

Less sophisticated retail investors focused only on the longer-term inflation threat risk piling into commodities too early, paying several years worth of storage and financing costs (contango, or negative roll yield) before seeing an eventual upturn. Institutional investors seem content to wait until signs of a cyclical recovery and pick up of inflation become more imminent.

Gold is also a much more convenient and cheaper way than crude oil to buy medium-term protection from inflation.

Because of the huge storage charges, the cost of buying cheap oil at the bottom of the cycle and financing and storing it until prices and inflation pick up in two or three years time, is prohibitively high.
Gold is much easier and cheaper to store. The cost to buy gold or gold futures now and hold them until inflation picks up is little more than the cost of finance, which in a world of near-zero interest rates is almost nil.

For both retail and institutional investors, gold has therefore emerged as the vehicle of choice for protecting capital against a deferred break out in inflation rates in 2010-2012.

The stretched oil-gold ratio is a perfectly rational reflection of timing differences (deflation in the short term, inflation in the long term) and storage charges (high for oil, low for gold).

The current constellation of commodity prices does indeed send a carefully coded warning about the prospects for a pick up in inflation — but not for another 2-3 years.

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

The volume of excess reserves commercial banks are holding with the Federal Reserve System has declined by $275 billion (31 percent) over the last five weeks, in what could be the first sign of stabilization within the core of the banking system (https://customers.reuters.com/d/graphics/RESBAL.pdf).

Reserve holdings are still at exceptionally high levels, but a clear downtrend has emerged since the start of the year.

Average holdings in the week ending Feb. 11 ($603 billion) were $58 billion lower than the previous week ($662 billion) — the lowest level since the middle of November last year, and well down from the recent peak ($878 billion) at the turn of the year.

There has not been any offsetting increase in commercial banks’ other assets (Treasury securities, private securities and commercial credits) over the same period. So lower reserve holdings seem to be a sign of reduced fear and increasing confidence, as the immediate sense of crisis passes and banks feel comfortable holding lower liquid balances.

Bank reserves have not, so far, been drawn down to buy additional Treasury debt.

If excess reserve balances continue to fall in the next few weeks, it would herald the start of a cautious recovery in the heart of the financial system.

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

Every budding economist is taught the distinction between nominal variables (expressed in terms of contemporary cash values) and real variables (adjusted for inflation and expressed in constant-dollars).

An oil price of $50 per barrel in 1980 is not the same as an oil price of $50 a barrel in 2009 because inflation has steadily eroded the purchasing power of the currency in the intervening years. Moreover, economists are taught that real values are more important than nominal ones — because “money is a veil” (to use the phrase of the Austrian economist Joseph Schumpeter).

Prices are important because they perform a signaling and allocating function, encouraging supply and rationing demand. What matter are relative prices not absolute ones.

If all prices and wages double, there is no impact on the distribution or quantity of production and consumption because the relative prices remain unchanged. Money is a veil and focusing on nominal values risks succumbing to money illusion — believing that purchasing power or wealth has increased simply because it is expressed in more units of a devalued currency.

When the US Department of Commerce releases its updated National Income and Product Accounts at the end of each month, investors focus on the real growth rate in GDP, adjusted for inflation. You would be hard pressed to find the nominal GDP growth rate on dealing screens, or for that matter in the Commerce Department’s press release.

But surely that doesn’t matter, because we are only interested in how much output is produced, how many cars, how many homes, not their selling value.

Wrong.

Because one set of important relationships in the economy is almost always expressed in nominal terms, not real ones: debt.

If household incomes double in nominal terms, and the price of a representative basket of goods also doubles, purchasing power has not changed. But the proportion of household income spent servicing and amortizing old debts is halved.

Nominal values become crucially important in a dynamic economy where time as well as price is important, and where debt contracts such as mortgages and firm loans are fixed in nominal terms rather than indexed.

Prices have two functions: a static function allocating resources among producers and consumers; and a dynamic function generating incomes, saving and a flow of payments on debt contracts. For the static function, what matters is real or relative prices. But for the dynamic one, nominal prices are more important because they determine the sustainability of the fixed debt contracts.

NOMINAL GDP GROWTH STALLS

The nominal income or cash flow received by households determines how easily they can repay debt contracts fixed in nominal terms. In the same way, the nominal income or cash flow received by companies determines how easily they can repay debt contracts in fixed currency.

At the most general level, nominal GDP is in some sense the “national cash flow” — and determines how easily the economy as a whole can support an overall debt structure fixed in nominal terms. Nominal GDP growth becomes exceptionally important, especially at times when debts are at a high level.

The attached charts show quarter-on-quarter and year-on-year growth in GDP in both nominal and real terms since 1947.

Chart 10 (below) shows the quarter-on-quarter growth in real GDP (expressed at annualized rates). Real GDP growth is very variable. Declines in real GDP during recessions are common. Real output has fallen in 37 quarters since 1947 (about 15% of the time) and risen in 207 quarters (about 85% of the time).

But look at Chart 11, which shows the quarter-on-quarter growth in nominal GDP. Nominal output has only fallen 13 times since 1947. The last quarter-on-quarter decline in nominal GDP was in Q3 1982.

Before that, you have to go back to Q4 1960 to find a quarter in which GDP declined in nominal terms.
Chart 12 shows nominal GDP growth on a four-quarter or year-on-year basis. Nominal GDP growth has not been negative year-over-year since Q1 1961.

From the late 1960s through until the current decade, relatively high rates of inflation ensured that GDP continued to grow in nominal terms even when it fell in real ones during cyclical recessions. Even during the deep recessions of the 1970s and 1980s, nominal GDP was generally growing because the decline in real output was more than offset by relatively high rates of price and wage inflation.

Payment ability for households which experienced unemployment and firms that experienced a sharp drop in demand for their products was often severely impaired. For these few, homes were often repossessed and individuals and companies could be made bankrupt.

But for the majority of households that remained employed, and for companies that experienced only a moderate decline in demand, wage and price inflation continued largely unabated, continued to raise their nominal cash flows, and make it easier to pay off debts incurred during the previous boom.

The combination of falling output with rising prices (labeled “stagflation” ) is usually seen as the worst possible outcome for the economy. Well, the worst except one: debt-deflation.

Because stagflation in the 1970s and 1980s ensured that, for most people, the real burden of debt remained manageable, or even improved, despite the recessions. The misery was borne by the minority of workers who became unemployed and the minority of firms that became insolvent. For the rest, inflation continued to boost nominal cash flows and increase debt-service capacity.

The strong, consistent growth of nominal GDP between the late 1960s and the late 1990s was mostly the product of persistent inflation. Before the mid 1960s, in the 1940s and 1950s, inflation rates were much lower, and nominal GDP growth was much more variable, turning negative on ten occasions between 1947 and 1960.

But in the current lower inflation world, the risk of nominal GDP turning negative has increased. During Q4 2008, nominal GDP growth turned negative for the first time in 25 years. Inflation (essentially zero) was not enough to offset the decline in output in real terms (-0.9% compared with the previous quarter).

Output looks set to decline further in Q1 and probably Q2 2009, and price inflation will probably turn negative. So at some point during H1 2009, nominal GDP growth will turn negative year-on-year for the first time since 1961.

NEED TO REKINDLE INFLATION

It is the sudden shrinkage of GDP in nominal terms which presents the greatest threat to the solvency of the banking system and the rest of the economy in the coming year. Because if GDP starts shrinking persistently in nominal terms, the already high burden of servicing debt contracts fixed in nominal terms will rise further.

Every job that is lost and every factory that is closed or put on short-time reduces real output. But every wage cut and price reduction is also reducing the cash flows which households and firms need to pay their debts, deepening the crisis.

Governments and central banks are now under intense pressure to sustain nominal GDP, and restart nominal growth, by boosting employment and fueling at least a modest pick up in inflation.

The target is shifting from restarting real growth to restarting nominal growth. Economist Samuel Brittan has written previously in the “Financial Times” about the need for the government and the Bank of England to have a target for nominal GDP growth (rather than a narrow focus on consumer price inflation). But the same is true for the other G20 economies.

Fiscal and monetary policy needs to create enough real demand and inflation; sustain employment and wage levels; raise output and prices.

In some sense, rekindling inflation has become a necessary and inevitable part of the solution to the current crisis.

Chart10: https://customers.reuters.com/d/graphics/Chart10.pdf
Chart11: https://customers.reuters.com/d/graphics/Chart11.pdf
Chart12: https://customers.reuters.com/d/graphics/Chart12.pdf

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

Yields on long-term U.S. Treasury debt continued to surge higher yesterday as the market braced for a future upturn in inflation and a tidal wave of long-dated issues that will be needed to fund the bank rescues and the emerging stimulus package.

Yields on three-year notes are up by around 47 basis points from their mid-December low. But yields on ten-year paper have soared 82 points and rates on the 30-year long bond have surged 114 points. Long-bond rates have retraced more than half their decline since the autumn (https://customers.reuters.com/d/graphics/USTREAS.pdf).

Back-end yields would probably have risen even further were it not for persistent hints the Federal Reserve is thinking about buying longer-dated issues to cap them. But the market has started to call the Fed’s bluff.

MANIPULATING THE FRONT END

In the press statement accompanying its most recent interest rate decision, the Federal Open Market Committee (FOMC) gave a clear commitment it will keep short-term rates at “exceptionally low levels for some time.” In practice, the Fed will probably hold rates close to zero for the next two to three years until a cyclical recovery is well underway. But thereafter rates will need to rise to more normal levels to contain inflationary pressures.

The steepening yield curve reflects an assumption the Fed’s zero-interest rate policy will dominate the whole yield on debt maturing in 2009-2011, but have a diminishing effect on securities which mature further in the future.

LENGTHENING THE DEBT PROFILE

Federal debt held by the public has surged almost 25 percent in the last nine months, from $4.64 trillion at the end of March 2008 to $5.78 trillion at the end of December. Net debt is scheduled to increase another $1.0-1.5 trillion over the next twelve months as a result of the cyclical downturn and the huge $700-900 billion stimulus package being considered by Congress.

So far, almost all the increase in debt has been funded by issuing short-term instruments. The proportion of debt maturing within one year has climbed from 38 percent at the end of March to 43 percent at the end of December, and will climb over 50 percent within the next twelve months unless the government’s issuing policy changes.

By increasing the volume of debt that needs to be refunded regularly, the shortening profile is creating a dangerous new form of fragility within the system.

In effect, the federal government is now taking on the maturity-transformation role previously provided by commercial banks, corporations issuing commercial paper, and special investment vehicles (SIVs). Like them, it is borrowing short-term from the money markets to make long-term investments secured against tax revenues receivable over decades.

But like the private borrowers, the government will also face a liquidity crisis if at any point the market balks at rolling over the maturing short-term notes.

For the moment, a liquidity crisis is unlikely. The short-term ultra-safe instruments the Treasury is issuing are a good fit for the type of securities which investors want to hold.

But once conditions begin to normalize, investors are likely to want to withdraw some funds from the short-term Treasury market to deploy them more profitably in other assets. And overseas investors will eventually want to reduce their exposure to dollar-denominated assets.

At that point, short rates will have to jump to persuade investors to keep sufficient funds in the market to roll over all the maturity bills and notes.

This risks creating a highly unstable dynamic. Even the slightest sign of stabilization and recovery will trigger a sharp run up in short and medium term government bond yields, cascading across the rest of the bond market into higher borrowing costs on commercial paper and commercial loans.

With so much short-term debt needing constant refunding, the Fed would struggle to control the pace of future monetary tightening. Both the Fed and the Treasury therefore have a strong interest in lengthening the government debt profile.

A much higher proportion of forthcoming debt issues will be placed in the middle and at the back end of the yield curve, which is why debt prices at these maturities have been falling, and their yields rising fastest.

MANIPULATING THE BACK END

The Fed’s open market operations are normally restricted to short-term U.S. Treasury bills. But the central bank has already expanded them to include purchases of commercial paper and mortgage-backed securities issued by Fannie Mae and Freddie Mac. It will soon start funding third parties to buy securities issued by credit card companies, student lenders and motor manufacturers.

The FOMC has stated it is also “prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”

In effect, the Fed has said it is prepared to enter the market as a “buyer of last resort” for longer-dated Treasury securities if their prices fall too much and yields rise too high. Fed officials have talked about buying longer-dated Treasuries for several months. But so far the Fed has hesitated to pull the trigger, because buying long-dated bonds is fraught with danger.

The principal purpose of open market operations is to provide liquidity by making an active two-way market when other banks and institutions fail to do so in sufficient volume. To the extent the volume of open market operations increases, and the total quantity of securities owned by the Fed rises over time, the central bank is also printing money.

When the Fed first started to expand its open market purchases in early autumn, the cost was covered by additional deposits of Treasury money into the central bank. The Treasury issued short term cash management bills, deposited the proceeds with the Fed, and the Fed used them to buy private-sector debts. In effect, the Fed and the Treasury substituted private borrowing from the money markets for public borrowing, so the impact on the total money and credit supply was neutral.

The Fed and Treasury have since run down the supplementary financing program and allowed the cash management bills to mature without replacing them. The increase in the Fed’s balance sheet has started to expand the money supply. But the increase is mostly showing up in a rise in the volume of excess bank reserves, rather than lending, so the impact on business activity and inflation is muted.

There is more inflationary risk in future once conditions normalize and demand for cash liquidity falls. But at that point the Treasury could issue more government debt, or the Fed could sell some of the government and other securities in its portfolio, absorbing excess cash from the banks. In principle, the Fed is still swapping private debt (now) for government debt (later).

But once the Fed begins to purchase long-dated Treasuries it will be unambiguously creating money. It would be turning on the printing press and monetizing the federal government’s deficit.

Since all the Fed’s operations are ultimately backstopped by the U.S. Treasury, the Fed would be using the government’s own money to buy the government’s own debt. The Fed would find itself bracketed with Germany’s interwar Reichsbank and the central bank of Zimbabwe. This is most definitely not a comparison the Fed wants drawn.

The market would almost certainly respond by labeling a long-term Treasury purchase program “deficit financing” and brace for even higher inflation. The market-clearing yield on long-dated Treasuries would rise further. If the Fed wanted to continue holding yields down below this level, it would be forced to buy a substantial proportion — in the limiting case all — of the new issues.

As in the currency market, limited intervention risks backfiring, while large-scale intervention would stoke fears about inflation. So this is a policy the Fed must hope to hold in reserve, and never have to use.

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

Like a Byzantine emperor, a U.S. president’s every public move is scripted to send signals about his priorities to Congress, the electorate, business, and the vast federal bureaucracy that will actually be responsible for formulating and implementing decisions in his name.

Presidential politics is a theatrical performance in which the president takes a small number of important decisions personally, but is responsible for setting the tone and direction for many smaller ones that will never reach his desk. If he can reach out to voters and businesses he can also reshape national priorities.

So President Barack Obama’s high-profile speech on energy independence this week, and public signing ceremony for presidential directives on fuel economy and climate issues, was meant to provide a strong signal of his commitment to an ambitious and costly energy agenda, despite the mounting economic crisis and other pressures on both the motor manufacturing industry and the federal budget.

The speech was intended to reassure progressive supporters that crisis management will not distract the administration from pursuing longer-term transformational changes in energy policy. It was probably also designed to provide an early payoff to liberal voters, even as the president seems set to disappoint them in other areas.

But the president’s most important audience was the business community. By emphasizing the eventual goal of energy independence, however vague some of the specifics, Obama’s speech was meant to create a “planning horizon” for corporations and investors.

The intention is to guide investment spending towards fuel-efficient technologies and renewable sources of energy, sustaining expenditure on research, development and commercialization despite the slump in oil prices and global slowdown.

In effect, the administration is trying to delink spending on alternative energy and fuel-efficient technologies from the business cycle and changes in oil prices.

By convincing investors it is serious about shifting the pattern of energy production and consumption, and guaranteeing a market for these technologies in the longer term, the administration wants to persuade investors and firms to “look through” short-term cyclical weakness in oil prices.

CRISIS IMPACT ON ENERGY POLICY

The interaction between the financial crisis and climate and energy policies is complex. On the positive side, prolonged worldwide recession is cutting total energy consumption for the first time since the 1970s and reducing associated emissions of greenhouse gases (GHGs). The global slump will almost certainly reduce emissions in both 2009 and 2010 relative to 2007.

More important is the longer term impact. If the crisis, and the unsustainable accumulation of debt and inflationary pressure which preceded it, convince policymakers recent growth rates were unsustainable, and force them to revise down future global growth estimates, the result would be a permanent shift to a lower trajectory for both growth and emissions.

By mid-century, the world economy would be smaller than in previous projections, and fewer people would have been lifted out of poverty, but GHG emissions would also be lower.

So one effect of the crisis is that it may have bought policymakers an extra five or even ten years to roll out new technologies and programs to limit emissions and stabilize atmospheric concentrations of GHGs.

On the negative side, the cyclical drop in oil prices is blunting commercial incentives to develop alternative energy sources and efficient technologies, and risks delaying their adoption.
First-generation biofuels such as corn-starch ethanol need oil prices of $70 to be commercially competitive; more advanced biofuels such as cellulosic ethanol need even higher ones. In fact, all forms of alternative energy cost more than fossil sources when oil prices are at low to moderate levels ($30-60 per barrel).

Similarly, fuel-efficient technologies remain more expensive than conventional alternatives, especially in terms of upfront costs, and are unlikely to be adopted unless and until oil prices rise again. The decline in oil prices is stalling the switchover.

At the same time, the collapse in energy prices has undermined investors’ enthusiasm for start-up companies and experimental projects that aim to bring new sources and efficient technologies to market. Most of these technologies remain unproven and the risk of failure is high, so they depend heavily on venture capital funding and high-risk project financing from the banks.

Both markets are now closed. With oil prices likely to remain depressed for some time, the risk of technological failure is now compounded by an unfavorable commercial environment.

Venture interest is falling. Several conventional oil companies that were sponsoring alternative projects such as wind farms and advanced ethanol plants have scaled back their involvement.

Independent venture funds remain wary since the market for initial public offerings (IPOs), which they rely on to exit investments in alternative energy companies and elsewhere, remains closed; it is not clear when it will re-open and on what terms.

Even for promising technologies where the risk of technical failure is relatively small, the crisis has dried up sources of project finance. Bluefire Ethanol Inc warned investors last month it had been forced to postpone construction of a cellulosic ethanol plant because of problems with costs, permits and financing. Suncor has delayed expansion of a conventional corn-starch plant by more than a year to save costs.

GUARANTEEING MARKETS AND PRICES

The Obama administration’s task is to convince investors energy will be much more expensive in future (making alternative sources and efficient technologies competitive) and that for any level of energy prices it is prepared to prioritize non-fossil sources (using taxes, fees and subsidies if necessary).

In that sense, decisions announced earlier this week were minor. The president showcased loan guarantees for new power transmission lines; directed the National Highway Transportation Safety Administration to publish fuel economy standards for the 2011 model year; and instructed the Environmental Protection Agency to review its earlier decision to oppose attempts by the state of California to regulate carbon dioxide emissions.

The president did not make a final decision about fuel economy, or whether California and other states will be allowed to pre-empt federal regulation of greenhouse gases by introducing their own rules. He also shied away from controversial topics such as raising gasoline taxes or introducing a cap-and-trade program to curb carbon emissions and support other technologies.

The administration clearly intends to keep its options open and avoid opening up a controversial debate before it is ready and when the president is heavily engaged in other areas.

In the long term, however, the administration will have to contemplate all these things if it wants to raise fossil energy prices, boost alternative sources of supply and encourage conservation.
The importance of this week’s announcements therefore lay in their symbolism.

By reaffirming the president’s commitment to a transformative agenda, even in broad terms, they give greater certainty to senior executives at the automakers that will need to approve costly investments in fuel efficient vehicles that the federal government will guarantee them a market.

By indicating the administration is serious about pursuing transformative change, they also give investors greater confidence about backing long-term alternative fuel projects with highly speculative payoffs.

Lastly, by offering federal loan guarantees and concessional finance for upgrading the power grid, Obama indicated the federal government may have a role to play in helping bridge the financing gap between promising early stage technologies and full commercial adoption, by shouldering some of the development risk.

If the president’s public actions are important mainly for their choreography, Obama has sought to give clear commercial incentives for investors to start allocating capital to alternative energy and efficient technologies again.

– 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.