• So Much for Liquidity – Now Let’s Have a Serious Approach to Inflation

    The Reserve Bank’s announcement of new provisions to improve the trading banks’ liquidity in the face of the world-wide credit crisis will be widely and justifiably welcomed. It is just a pity that the Reserve Bank is not similarly proactive when it comes to the battle against inflation.

    Any liquidity problem for our banks is, of course, prospective rather than actual or immediate. It nevertheless makes sense, both for current confidence and as a practical response to the possibility of problems ahead, to ensure that the banks have a wider base of liquidity on which to operate. As the Reserve Bank makes clear in its Financial Stability Statement, we cannot assume that a banking system that relies heavily on borrowing from overseas will remain immune forever from the problems that threaten the liquidity of overseas financial institutions.

    While the Reserve Bank deserves a tick for its foresight in this respect, it is less deserving of plaudits when it comes to other areas of its operations. It is reassuring that it has moved promptly to forestall liquidity problems, but this contrasts sadly with its failure to exercise effective prudential supervision over non-bank lenders. The failure of so many finance companies over the past year or so – at a cost to investors of over $1 billion – has left the Reserve Bank seeming more concerned with the viability of the banks than with the savings of ordinary New Zealanders.

    Perhaps we should not be surprised at this apparent peculiarity in the spectrum of the Bank’s concerns. The Reserve Bank is, after all, a bank. It owes a particular loyalty to and has a particular concern for the interests of other banks. It has acted quickly, and properly, to ensure that the banks are able to maintain their operations – something that is very much in everyone’s interests of course – but it has been much less assiduous in meeting its other responsibilities.

    That criticism applies with even more force if we look at a field of operations that is even more significant than the viability of the banking sector or the prudential supervision of finance companies – the Bank’s role in controlling inflation. It is now apparent to everyone that the Reserve Bank is struggling – and failing – to keep inflation under control except at a price that threatens the rest of us with recession.

    The search is therefore on for counter-inflationary policy measures that are both more effective and less damaging than the single blunt instrument of constantly raising interest rates. The Reserve Bank went so far in 2006 as to commission a report on what it described as “supplementary stabilisation measures” – in other words, on further measures that might be taken in addition to what we are usually assured is a policy instrument to which there “is no alternative” – while the Finance and Expenditure Select Committee is currently engaged in a similar exercise in preparing its report on the future monetary policy framework.

    In neither case, however, is it likely that the Reserve Bank or those who advise them will notice what is staring them in the face – that the most obvious (and easily dealt with) cause of inflation in our economy is the high and fast-growing volume of bank lending. Private sector credit has grown by six times over the last twenty years, from $44 billion in 1988 to $266 billion in 2008; the largest and fastest-growing element in that credit growth has been bank lending on mortgage for the purpose of buying residential property.

    Current interest rate policy actually makes matter worse. As interest rates have risen, the banks have had to market their lending more and more aggressively – and they have protected themselves against the consequent risk of lending inappropriately by concentrating especially on the housing market where they can at least take adequate security over people’s houses.

    Why has the Reserve Bank not focused immediately on this and imposed limits on the banks’ freedom to inflate the economy in this way? If the key to controlling inflation is to limit the growth in the money supply, why not deal with the fastest-growing element in that money supply? If the Reserve Bank is ready to improve the banks’ liquidity at times of credit stress, why do they not intervene to restrain that liquidity at time of inflationary pressure? Why destroy the viability of large parts of our productive economy, but leave the banks free to do as they please?

    The answer is that there is a perhaps unconscious and certainly unstated bias in the way the Reserve Bank looks at these issues. They are unwilling to act against the banks, and would rather burden the rest of us with the responsibility for grappling with inflation. They see measures such as regulating capital requirements or loan-to-value ratios for bank lending – as amended and sometimes extended by the Basel II international agreement – as appropriate for prudential supervision and for ensuring adequate bank liquidity but not for controlling inflation. This point is made explicitly by the Bank’s External Monetary Policy Adviser in his submission to the Select Committee.

    The Bank gets away with this bias because the bank economists who dominate the economic policy debate in the media have a vested interest in diverting attention away from it. It is time that the darker corners of this debate saw the light of day and that the banks were brought within the purview of counter-inflation policy.

    Bryan Gould

    8 May 2008

    This article was published in the NZ Herald on 16 May 2008

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