The Bank of England Investigates Credit Cycles and Macro-Prudential Policy

David Aikman, Senior Manager, Prudential Policy Division, Financial Stability Directorate, Bank of England, Andrew G Haldane, Executive Director, Financial Stability, Bank of England, and Benjamin Nelson, Economist, Financial Stability Directorate, Bank of England posted on Curbing the credit cycle at Voxeu.

They note, "Credit lies at the heart of crises. Credit booms sow the seeds of subsequent credit crunches. This is a key lesson of past financial crashes, manias and panics (See e.g. Minsky 1986, Kindleberger 1978, and Reinhart and Rogoff 2009). It was a lesson painfully re-taught to policymakers during the most recent financial crisis."

This is an important step forward. When Her Majesty the Queen asked her economists why they did not see the global financial crisis coming, they had no good explanation. In the neoliberal model, which holds that money is neutral, that is, does not impact the real economy, there was no indication that the world was headed for deep recession due to a financial meltdown. The only explanation for such an event in that model is external shock, and the expectation of the model is that the economy will right itself (return to equilibrium) automatically after the shock through the "invisible hand" of the market. Of course, this turned out to be wide of the mark when credit collapsed, bringing the debt-driven boom to an end. A "balance sheet recession" ensued as people struggled to deleverage, thereby curtailing demand.

It is therefore heartening to see representatives of the Bank of England recognizing the work of Hyman Minsky, which, incidentally, underlies MMT. According to Minsky's financial instability hypothesis, there is a financial cycle different from the business cycle. Aikman, Haldane, and Nelson investigate this cycle.

Whereas business cycles culminate in malinvestment and overproduction, financial cycles culminate in Ponzi finance, driven by price momentum. Whereas business cycles result in supply gluts that markets eventually clear, credit cycles result in bad debt that must be restructured or defaulted on. Depending on the level and quality of debt overhang, this can be difficult to clear without resulting in debt-deflation, which can lead to depression if not addressed by appropriate policy. In the recent global financial crisis, the level was high and widespread, and the quality of debt was low, since much of the lending had been imprudent.

Business and financial cycles are inherently different and require different policy responses when they emerge. It is also possible to head off credit cycles to some degree with macro-prudential policy.

Micro-prudential policy, aimed at tackling financial imbalances in individual financial institutions, may also be ineffective for dealing with aggregate credit cycles. That is because bank-specific actions will not, by themselves, internalise the spillovers that arise across banks over the credit cycle. They may even worsen them if they allow individual banks to steal a reputational march over their competitors.

This coordination problem suggests systematic, across-the-system actions are needed to curtail effectively credit booms and busts. This is one dimension of macro-prudential policy. To be effective, these policies need to increase the long-term cost of credit extension to banks during booms and, as importantly, to lower these costs during busts. These actions would help smooth out credit supply over the cycle. There are a variety of macro-prudential tools which could have this effect, including pro-cyclical capital and liquidity requirements, or remuneration packages that tie individual earnings more closely to long term performance (Bank of England 2009, Kashyap et al. 2010, G30 2010).

Credit spillovers occur across borders as well as across banks. This suggests macro-prudential policies need also to have an international dimension if they are to tackle credit externalities. This is recognised in the macro-prudential policy framework currently being discussed by the international regulatory community (BIS 2010). For example, judgements on local credit conditions determine the amounts of capital to be held by international banks on their exposures in those countries. This reciprocity feature should help to reduce the arbitrage risks posed by the internationalisation of the credit cycle.

Their post is short and worth reading in full. It is a welcome relief from the who-could-have-seen-it-coming excuses that have been proliferating up until now from "the experts," even though a few people did see it coming, and why, and said so some time before it arrived. One of these was Wynne Godley, ironically formerly of Her Majesty's Treasury and later one of its "six wise men," although he was long retired from his position there by the time of the GFC. The sectoral balance approach Godley developed at Treasury is integral to MMT. The gathering financial storm was also foreseen by UMKC professor L. Randall Wray, one of the developers of MMT and a student of Hyman Minsky.

Good to see the Bank of England catching up with things. Hopefully, MMT will follow their interest in Minsky.