It appears that many people fear a contraction in the economy – and are determined to bring to justice any factors that could lead to such a situation.
As of late, one such factor was the “credit crisis”, which has lead to a sudden freeze in lending and potentially to a contraction in economic growth in many of the worlds largest economies.
Given that it was a seemingly inevitable freezing in the credit market that has caused this reduction in economic activity many people state that it we should have regulated the credit market more – to prevent this sort of contraction from happening.
However, even if we do take the current slump in the credit market as inevitable – I am not convinced that this type of regulation would have improved the situation.
Remember that the ultimate goal of policy is not to prevent credit freezes in the economy – the ultimate goal is to ensure that we maximise happiness in society over time. Now, if we believe that there is a trade-off between economic growth and credit market flexibility, and if we believe that greater credit market flexibility increases the chance of a “credit freeze” at some point then we have to decide what is the optimal level of flexibility in society. In such a case there is no assurance that either extreme (no or complete flexbility) is the right way to go.
In the current situation there are two things I think we should think about when analysing the credit freeze:
- If credit had not been as flexible in the past, growth may have been restrained. As a result, it is very likely that even if the economy contracts in many countries, it will still be stronger than it would have been if we had regulated credit markets more strictly from the start,
- Social welfare also depends on the variability of output – so even if output is higher than it would have been, the fact that it rose quickly and then fell is less valuable to society than the same output being produced at a gradual pace. Therefore there are direct costs from the credit squeeze.
Overall, this tells us that the freezing up of world credit markets is a concern – however, it does not tell us that the a more regulated environment would have got the world economy into a better position.
There are some areas where regulation could have been advantageous, but current events do not justify the mass roll out of government regulation in the credit market now. Just remember there is likely to be some sort of trade-off between risk in the credit market and growth – a trade-off we want to avoid if possible.