On Thursday 29th September, The European Conference on Banking and the Economy – with a head-line “Banking: Seeking a new paradigm” – took place in Winchester.
The conference was essentially a series of lectures on different topics surrounding banking, money, financial markets and the economy. Topics covered included Bank Regulation, Banks & Economy, Monetary Policy, Risk and Banks, Markets, Bank Behaviour, Local Banking, Bank Credit, Bank Efficiency, Interest Rates & Derivatives. As these titles suggest, many of the lectures were rather technical in nature, and might well have been indecipherable to non economists.
There were also two keynote speakers: Lord Adair Turner, head of the FSA , and Charles Goodhart, of the Bank of England and the LSE.
Whilst Goodhart focussed on the worthy topic of the technical, institutional and political issues facing banking regulation, what was really interesting was the speech given by Lord Turner on ‘Credit Creation and its Social Optimality’.
The main thrust of the Lord Turner’s speech was this: You can’t leave the banking industry to its own devices as the market will not efficiently allocate either the quantity or quality of credit. Essentially, the ability of banks to create credit at will was likely to result in too much credit being allocated to housing, leading to a self reinforcing boom followed by a bust. This of course resulted in massive negative repercussions for the rest of society. Moreover, traditional policy measures to try to constrain credit growth, such as interest rate rises, are usually ineffective.
He then went onto recommend a form of credit guidance for banks – limiting lending to unproductive areas of the economy that are prone to speculation. He also cautiously advocated the use of guidance not just to limit speculative booms, but also so that lending was socially optimal:
”The fundamental question which I have asked is: how confident can we be that the quantity of credit supplied and demanded will be socially optimal. The answer is not very confident. That implies that macro-prudential policy must be based on judgements about the optimal aggregate quantity of credit creation and that we need to consider carefully how far we can and should, make judgements about the economic value of different categories of credit, which in the recent past we have largely avoided.”
However, despite recognising that under a deregulated fractional reserve system credit allocation was unlikely to be beneficial to society, he rejected the idea that full reserve banking would be a solution (however, someone else made the interesting point that even if he did support full reserve banking he would never be able to say so due to the office which he holds).
Instead he claimed greater regulation is enough to make the system safe. It was here that the cracks in his argument began to show. Despite widely referencing the late economist Hyman Minsky’s analysis of the negative effects of financial market instability, he failed to include the most salient points of his analysis: that the stability the regulations he proposes would impart would eventually lead to their removal – stability breeds instability.
In the 1930’s the great depression led to a massive increase in regulation, which included the separation of investment and retail banking. However the stability which ensued led to bankers and politicians claiming that the system was safe and that the regulation was an unnecessary burden. A gradual removal of regulation followed, leading to ever greater occurrence of crises culminating in the great financial crisis of 2008-2009.
Unfortunately, the pattern of building up regulation after a crisis only to remove it again a few years later is likely to repeat itself again.
Only a banking system which takes the taxpayer off the hook, and which cannot continuously create money as debt has the characteristics which guarantee long term stability.
Read the full speech here