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  • PD Jonson

Inflation, asset bubbles and financial reform

Updated: May 2, 2020

The Reserve Bank will increase cash rates today. The only question is whether this will be by 25 or 50 basis points, with 75 a long priced outsider and zero left at the gate.

The economic news has been mostly good since the board of the RBA last met. Most importantly, US GDP rose for the first time in a year. There are caveats of course – mostly the rise was due to the direct or indirect effects of government activity. Equally important, the US economy is still shedding jobs, the dark side of what is shaping as a substantial surge in productivity.

Europe is in an equally dire state. France and Germany both showed a small GDP increase on the latest numbers, and Norway raised its cash rates by 25 basis points. However, elsewhere, things are looking far less cheery. The UK reported falling GDP for the sixth quarter in a row, and Spain’s unemployment exceeds 17 %. On Henry’s direct observation, there is at least as much underemployment, and this is a feature of all developed nations. Japan is still experiencing deflation, but this does not seem to bother the Japanese.

China, however, is powering on, and carrying the rest of Asia with it. India is said to be considering interest rate hikes, and South Korea also. China’s latest GDP growth was reported at an astounding 8.9 %, a gold medal performance if there ever was one.

Everywhere, central bankers are debating three things. The public debate concerns inflation, and when to raise interest rates, and by how much. This discussion is broadly in the public domain, but the other topics are mainly put on the record by central bank watchers like Henry. Some of these watchers, the ‘trusties’, get private briefings by their central bankers but Henry can say without fear of contradiction this is not his lot in life.

The two issues debated mostly in secret conclave concern why the capitalist system almost imploded in 2008, and what needs to change in the setting of monetary policy, and on the structure of financial regulation.

On the setting of monetary policy, the first issue is the danger of very low interest rates, as created by Alan ‘Bubbles’ Greenspan in the US economy the last time there was a whiff of grapeshot on Wall Street. This is highly relevant as Ben Bernanke and many other central bankers are currently presiding over a monetary regime as unsustainable as that of Bubbles himself, to general applause.

So the question is how soon and how quickly can interest rates be raised from current emergency levels to more normal levels. ‘Not until employment stops falling’ is probably the general view, and Australia’s Glenn Stevens is to be congratulated for going sooner, and from a higher low, than virtually all his colleagues.

The closely related issue is how to avoid asset and lending bubbles and what to do about them when they appear to be in danger of occurring. ‘Take account of asset prices in your measure of inflation’ is Henry’s answer and this seems to have occurred to a number of other central bank watchers such the estimable Andrew Smithies of London, as reported in Henry’s Blog last week. Whether to expand the measure of ‘Inflation’ to include asset prices, or whether to introduce a set of asset prices in a ‘check list’ of inflationary indicators, is what the central bankers will be debating behind closed doors.

Then there is the issue of how to recast financial system supervision. So-called ‘Macroprudential’ supervision is generally agreed to be the central banker’s prime responsibility, and amounts to not letting a lending boom get out of control, and raising interest rates boldly when there is a lending or asset price boom is their relevant responsibility. The feeble objection that ‘no-one can tell if it is a bubble until it has burst’ has been swept away by the near meltdown of the world’s banking system.

Whilst acting with interest rates, a prudent central bank will presumably tell the financial regulation authority to do something about it also. One hopes such advice would be put on the record when it is offered.

The financial regulators have a bigger task. Many ideas have been floated. Systematically raising the capital to asset ratios as a boom developed is already agreed, as suggested above. Splitting current financial conglomerates into simple banks, investment banks and in some cases also freeing fund managers is a popular suggestion. Simple banks would be managed by simple souls paid simple amounts, but would be bailed out to the extent of protecting depositors balances if simple management failed.

Investment banks would not be bailed out if they got into trouble, and this would be made explicit in advance. Fund managers might also be split into two groups – simple (with customer assets protected by insurance) and ‘hedge funds’ to which the label ‘let the buyer beware’ would be emphasized by a sign over the door and a prominent note on every bit of paper sent to the hedge fund to its customers.

Henry would not object if investment banks owned hedge funds, so long as the combined entity was not so large that its failure threatened the entire financial system. Some global version of Australia’s ACCC could be given the task of deciding how big was too big, and preventing the mergers or acquisitions that threatened to create an entity ‘too big to fail’.

The changes outlined here would probably include higher required equity ratios even for regulated institutions in normal times. Unregulated institutions would be prudent to operate with even higher ratios, but that of course would be up to their respective managements.

Lest the followers of Ayn Rand, or more modern free market enthusiasts, object to all this as creeping socialism, Henry wishes to point out that the proposal to remove investment banks and hedge funds from any explicit or implicit guarantees, and to limit their size, is a big step in the direction of the perfect market, red in tooth and claw. More cautious types such as Henry are entitled to have whatever proportion of their assets protected, as much as anything can be protected, if they so desire.

Bolder types, Ayan Rand’s followers, and modern free market zealots, can put as much of their assets as they wish to work in the ‘free market’, and Henry will be the last to sympathise if they lose all their wealth, or to feel envious if they become enormously wealthy.

Glenn Stevens and his board have at least two strong reasons to move boldly today. The first is that most measures of inflation are too high (eg ‘underlying goods and services inflation) and rising (house prices and, with a recent correction, share prices.) Furthermore, the economy is surprising all the pundits with its strength, and current interest rates are far below a ‘normal’, meaning sustainable, level.

A 50 basis point rate hike today would be appropriately bold. The 25 basis point hike factored in by markets and reportedly supported by Treasury would be timid.

Over to you, Mr. Stevens.

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