The Economist recently described the Governor of the Bank of England, Mervyn King, and his executive director for financial stability, Andy Haldane, as follows:
Mr King and Andy Haldane, the author of some imaginative papers on finance, are radicals.
This, I think, is interesting. About two years ago, Willem Buiter, perhaps the authority on things financial at the time, wrote in the Financial Times:
Returning to London from Reykjavik last night was like coming home from home. Allowing for the differences in the scale of the Icelandic economy and the British economy (the UK population is more than 200 times larger than Iceland’s Coventry-sized population), there are disturbing economic parallels. The excesses in Iceland during the past decade were greater than in the UK, but not qualitatively different. In both countries, the regulation of banks was laughably lax. The UK’s much-touted light-touch regulation turned out to be soft-touch regulation. Relaxation of regulatory norms was consciously used by the British government as an instrument for attracting financial business to London, mainly from New York City. Fiscal policy in both countries became strongly pro-cyclical during the boom years preceding the financial crisis. Households were permitted, indeed encouraged, to accumulate excessive debt – around 170 per cent of household disposable income in the UK, over 210 percent in Iceland.
Well, The Economist did notice the role that household debt played in the economy and wrote in 2005:
The Bank of England’s aggressive interest-rate policy would, it was hoped, take some pressure out of the bubble before even more consumers got themselves dangerously indebted.
This bit says that it was at least understood that higher interest rates were used to fight bubbles. While regulators were doing their job with a hands-off approach, there were no radicals around. By the way, here are some of Buiter’s ideas regarding financial reforms from back then:
(3) Regulation should only relate to variables and criteria that can be independently verified by third parties. This means that Basel-type risk-weighted capital ratios as currently construed should be out, as the risk weightings depend on the internal models of the banks. These internal models are private information of the banks and the banks cannot be trusted to use them objectively, impartially and in the spirit of the regulations. That probably means going back to simple leverage ratios (debt-to-equity) as constraints on HLI balance sheets.
(4) Regulation should not depend on information provided by private, profit-seeking and possibly conflicted rating agencies.
The flaws in the system were known two years ago: Wrong incentives and sky-high leverage. While the financial system was created over the years, faith in markets had been high – so high that some people speak of those who initiated these reforms as market radicals. Mervyn King, however, seems to be a very clever economist. Here is what was wikileaked a couple of weeks ago:
Earlier this month we learned that the Bank of England governor had some naughty things to say about the then-future UK chancellor and prime minister. Now we find out that as early as March 2008 — before Lehman Bros collapsed that September — King was thinking of mobilising wealthy countries to recapitalise the world’s banks.
King and Andy Haldane are in a position which is very delicate. They are fighting to regulate an industry which has a huge influence on policy makers and the media. Their proposal of a 100% money requirement might sound radical, but to my knowledge nobody has ever been able to compute the optimal reserve ratio of banks anyway. Leverage would be restricted if banks have to hold high reserves, and impossible if these reserves would be 100%. Letting a regulator start the negotiations with the banks at 100% seems reasonable to me, not radical.