jamesz

Madison on public choice

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If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. A dependence on the people is, no doubt, the primary control on the government; but experience has taught mankind the necessity of auxiliary precautions.

– James Madison (1788)

Matt Nolan

Careful what you wish for

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In a recent column Bernard Hickey suggested the following:

Taxpayers still face the risk of seeing bank losses socialised in future while today’s profits are privatised.

A more honest solution would be for the Government and the Reserve Bank to openly state that a bailout would not occur. Term depositers would demand a higher return to compensate for the higher risk, and it would remove the moral hazard that currently subsidises the profits of Australian banks.

Now lets be a bit careful here.  Yes there is an implicit government guarantee of banks – in fact the way to look at it is through the lens of a deposit guarantee, when it comes to the big banks the New Zealand government will not allow depositors to lose out.

The logic behind this is the fear of a bank run.  The reason we hadn’t had a financial crisis  on a global scale between the Great Depression and 2007 was largely due to the implicit deposit guarantees that soveriegn nations had put in place during the 1930s.  Even if these were not always “explicit” they helped prevent runs on the banking system, which engendered confidence and prevented financial crises.  One key reason for the GFC during 2007-2009 was the sudden change in behaviour by governments – where they were showing themselves suddenly unwilling to provide this insurance on the basis of “moral hazard”.  It is true that issues of moral hazard had helped to drive risky lending, but it was confusion around where the burden of debt fell and a lack of clarity around who was “implicitly insured by government” that led to a run on wholesale financial markets and the financial crisis.

The “solution” to any perceived issue in our banking system is not to get rid of deposit guarantees, and it is not to remove the implied subsidy that this may provide to the New Zealand banking system.  It is to ensure that banks in turn face this cost during the rest of the cycle.

The RBNZ’s desire to set up the OBR is based on a desire to prevent bank runs, while also making who bears the burden of a bank failure “fairer”.  They are trying to ensure that we don’t have a financial crisis, while minimising the cost associated with “moral hazard”.  This is preferable to forgeting the lessons of the Great Depression and GFC, which is what we would be doing if we were to completely pull away from the implicit back stop of the banking system.  Trust me, I don’t like implicit insurance for industries myself – but financial markets are one area where such things need to take place, and as Hickey says they have to take place in a transparent manner.

jamesz

TVHE is now international

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While Matt was busy lounging around in Colombia I packed my bags and moved to London. With agnitio in Auckland, that leaves Matt as the only remaining Wellington resident still blogging, although he makes up for that by writing 80% of the posts!

To celebrate my move to the UK it seems appropriate to reference football with this quote from the BoE governor, Mervyn King, in which he explains his ‘Maradona theory of interest rates’:

The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.

Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do. In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. They headed in a straight line for their goals. How was that possible? Because financial markets did not expect interest rates to remain constant. They expected that rates would move either up or down. Those expectations were sufficient – at times – to stabilise private spending while official interest rates in fact moved very little
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That pattern is sometimes described as “the market doing the work for us”. I prefer a different description. It is the framework of monetary policy doing the work for us. Because inflation expectations matter to the behaviour of households and firms, the critical aspect of monetary policy is how the decisions of the central bank influence those expectations. As Michael Woodford has put it, “not only do expectations about policy matter, but, at least under current conditions, very little else matters”. Indeed, one can argue that the real influence of monetary policy is less the effect of any individual monthly decision on interest rates and more the ability of the framework of policy to condition inflation expectations. The precise “rule” which central banks follow is less important than their ability to condition expectations. That is a fundamental point on which my later argument will rest.