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Can policy ever control the credit cycle?

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Paul Mason | 20:35 UK time, Saturday, 20 November 2010

UK Credit Cycle 1870-present

The Bank of England will soon be in charge not only of the UK's monetary policy but also its financial stability and its banking system, both of which involve macro-prudential regulation.

Tonight the bank's financial stability chief Andrew Haldane has given a speech at Columbia University, NYC outlining the Bank's latest work on modelling the credit cycle (with Aikman D and Nelson B). See Bank of England website.

Haldane et al argue: self-regulation is not enough to curb the credit cycle; therefore the state needs to intervene to depress lending during a boom: monetary policy is not enough to achieve this, and indeed may be counter-productive, because if the credit boom is an excrescence on a fairly modestly growing real economy, monetary intervention can needlessly flatten growth.


"systematic, across-the-system actions are needed to curtail effectively credit booms and busts"

Two things follow from this: there needs to be internationally co-ordinated macro-prudential action (as signalled at Pittsburgh) and the "regulatory boundary" has to be moved so that the so-called shadow banking system, which is now as big as the official system, is brought under macro-prudential regulation.

This has massive implications. It means the Bank of England is going to, quite soon, set about trying to flatten out the credit cycle, with tools that are untested and on a system whose genetic predisposition to regulation is flight, escape, denial, resistance.

And then try and block the escape mechanism.

To get a sense of the complexity of the escape mechanism - aka shadow banking - have a look at this poster produced by the New York Fed (hat tip to Gillian Tett inside the FT's firewall for this). It looks like the wire-diagram of the Star Ship Enterprise's matter/anti-matter assembly.

I would like to know not just how the Bank proposes to bring the shadow banking system into macro regulation.

I would also like to know Haldane et al's prediction as to what will happen to the credit cycle should this prove impossible to do. One logical conclusion would be that the credit cycle is uncontrollable. Indeed a graph in the Haldane et al paper (top of this page) shows it to be relatively immune to policy since financial capital emerged in the 1870s.

Haldane concludes:

"The state of macro-prudential policy today has many similarities with the state of monetary policy just after the second world war. Data is incomplete, theory patchy, policy experience negligible. Monetary policy then was conducted by trial and error. The same will be true of macro- prudential policy now. Mistakes will be made. But as experience with the other arms of macroeconomic policy has taught us, the biggest mistake would be not to try."

Haldane's intervention follows Mervyn King's Buttonwood, New York speech where he thought aloud, loudly, about a Glass Steagall solution for British banking. Like the 19th century master of Oundle School, FW Sanderson, Britain's central bankers have decided to "think in a spacious way; think on a grand scale".

The problem is spacious thinking - given the scale of the challenge - leaves open a lot more questions than it answers. Newsnight stands ready to ask those questions should Britain's central bankers decide one day to start giving press interviews as well as lectures in New York.


  • Comment number 1.

    By Jove! I think someone in the BoE has actually cracked it!

    Link to the press release:

    Paul – please emphasise how fundamental this is. Bernanke and the Neoclassical school deny that credit is anything but a transfer of holdings between one party and another, and therefore is irrelevant to their models of the world!! Despite the Bezemer article in 2009 demonstrating that those economists who did forecast the crisis all acknowledged the role of credit. He identified four common elements:
    1) a concern with financial assets as distinct from real-sector assets,
    2) with the credit flows that finance both forms of wealth,
    3) with the debt growth accompanying growth in financial wealth, and
    4) with the accounting relation between the financial and real economy.

    On the one side were the Austrians (Schiff etc.) and on the other we had the Keensians (e.g. Steve Keen and others who embraced the Minsky Instability Hypothesis).

    The reason that these people were able to foresee the problems is because they all recognise the fact that money used in day-to-day exchanges can in fact get separated from reality. Excessive credit, brought about by over-optimistic expectations of future growth is by far the most plausible explanation of why the cycles occur.

    The Credit cycle oscillations represent the inherent elasticity of the capitalist system to encourage & stimulate expansion when conditions permit, and to contract & consolidate when reality might bite back. Crises represent the culmination of this excessive euphoria brought on by new technological (and therefore productive capacity generating) capabilities:

    Perez is correct to diagnose that Capitalism permits excesses but eventually punishes over-exuberance. Unfortunately, we lost sight of the tenets of true (Schumpterian) capitalism when the Anglo-Saxon world refused to take the reality check from the latest big upswing.

    All four previous surges were brought about by substantial changes in REAL productive capability (i.e. Industrialism). The 5th wave has been surfed by the Neoclassical school, heralding the end of boom & bust. How ironic given that the technological revolution has done little more in 40 years than to provide the means and the motive for stimulating excessive consumption activity. This was achieved by over-blowing the merits of the "knowledge economy" and masking rising debt levels through deceptive financial practices.

    "the story of the last 40 years for America and much of the OECD: debt has grown faster than GDP, and much of the debt has financed speculation rather than investment"

    The graphic at the top of this blog fails to fully demonstrate that the amplitude of these oscillations are getting greater and greater. The extent of credit in the current system must be orders of magnitudes greater than in the 1930s / 1970s and even 2000s.

    We have climbed an awful lot higher up the pyramid of credit, and consequently I suspect that we have an awful lot further to fall.

    Very important stuff from Mr Haldane (as always!), but alas he might be trying to lock the stable door after the horse has well and truly bolted!

  • Comment number 2.


    Are you giving away glossy A2 posters of this circuit diagram to the first 5 people to post a comment on your blog? ;-)

  • Comment number 3.

    I have just skim-read the NYF paper (I really must get out more). The document essentially states that about half the banking sector assets (in the US) are handled through the shadow banking system, and that most of this follows the "originate to distribute" model, a.k.a. Securitisation.

    "Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities."

    Totally correct synopsis. However, this means that either they have discovered alchemy, or they have been fraudulently mis-representing these risks and transferring responsibility to gullible counterparties (e.g. the tax-payer).

    It is further evidence that Securitisation is at the very heart of the problem. And (unlike the upbeat assessment of this paper) I have serious concerns that it can never be tamed:

    "modern banking practices such as securitisation disguise the underlying levels of risk and pass the problem along the food chain. Therefore, permitting risk transfer practices (in the form of securitisation) is tantamount to condoning sub-optimal lending activity"

    Considerably less than 81 pages, and without any fancy wiring diagrams, the attachment (ICB Submission) concludes with this prescient advice from Peter Warburton from 1999 (Debt & Delusion)

    "the aggregate supply of credit is effectively un-regulated… (as)… central banks have turned a blind eye to the dangers of credit creation…. If stability means anything, then it must apply to the surveillance of credit quality" Warburton p.45.

    Haldane has missed the boat by at least 15 years. The banks were left alone to take the responsibility to regulate credit quality, however they have increasingly transferred this to the markets, and when this has gone wrong, to the state.

    A sorry tale of Capitalism on the way up, but ("we're all in it together, honest") socialism on the way down.

  • Comment number 4.

    Paul, come on who is pulling whose plonker here. Inventing money is the stuff of childhood fairy tales, everybody knows that. Oh yes it is. The pantomime season is almost upon us. Who believed that credit could be manufactured out of debt in the first place. How can so many academics spend so much time researching and arguing about the blindingly obvious? We, the tax-payers are up the creek until the funny money created by them, the rip-off merchants, is paid off by our democratically elected leaders from the taxes they impose on us. And don't let it happen again. Right.

    Enjoy your Christmas and don't make a fool of yourself on the picket line again, it harms your credibility.

  • Comment number 5.

    Why don't reporters ever 'doorstep' the likes of Mervyn King? After all they do it to politicians, celebrities and sports stars. He has plenty to answer for after all, and he is unarguably more powerful than many of our elected representatives. Somehow the free press is never allowed anywhere near him.
    I can't think of another example of someone who holds so much power over all our lives being treated with such kid gloves.
    It is understandable that he might not want to answer difficult questions, but not so understandable that, in a democracy, they are never even asked, and no one bothers to try.

  • Comment number 6.

    Paul, First point to make - is a reflection of your sense of humour to release such a momentous blog at half past eight on a Saturday night - are you trying to compete with X Factor?

    Second if it is now suggested that you cant run a modern economy by leaving the MPC to sort out the regulation of finance through the economy so what it has been obvious to me and others for a long time. Banks need supervising not regulating and governance covering treatment of risk needs statutory force. Government must manage their economies and not outsource affairs to anoraks in chummy committees.

  • Comment number 7.

    Do you prefer new ideas or Rupert Murdoch at the IEA October 2010 defending the economics of 1920: “you succeed by having the confidence to defend those ideas when they are under assault – and to see them through when the experts are counseling compromise…we will vigorously pursue the truth…many rightly applaud the coalition government for maintaining a tough fiscal line. We must be clear why this toughness is necessary…but unless you stay the political course, you will be neither robust nor popular…as Margaret Thatcher long ago foresaw: "Adam Smith's 'invisible hand' is not above sudden, disturbing movements. Since its inception, capitalism has known slumps and recessions, bubble and froth; no one has yet dis-invented the business cycle, and probably no one will; and what Schumpeter famously called the 'gales of creative destruction' still roar mightily from time to time…in the short term, a government that is generous with other people's money – and prints more of its own – dangles the promise of a comfortable life, where all the essentials are taken care of. We are again learning, the hard way, that this is a false security. The only real security is the security of opportunity…cynicism by the traditional elites…small thinkers.”
    I vote New Keynesian.

  • Comment number 8.

    Never mind analysis of credit cycle spill overs etc...there's only one way to get effective banking regulation...KILL THEM!


    ‘In France, they are not wasting their time. They are organising themselves to withdraw their money on the 7th December 2010.’

    ...err...I might just draw mine out on the 6th December!

  • Comment number 9.

    #6 Watriler "...are you trying to compete with X Factor?" no competition, Paul is seeking the Why Factor.
    'Spacious thinking' I fear may not penetrate the recesses of greed and arrogance within the banking system. Is the question how do we regulate to a macro prudential standard when self regulation fails? Will regulation ever be capable of entering into bank organizations and throw light (even correct) assymmetries of information and mishandled risk? How do you regulate rating agencies when they have a financial stake in providing the opinion and not performing proper DD? If you read the detailed background to the advent of the crisis in credit markets, (in the "Big Short", for example, sorry to harp on - it is a real eye opener) the failures were preventable, but within banks and not by outside agencies. The shadow banking system grew up because of regulation and an unwillingness to recognise risk on banks' balance sheets, which would have curtailed the growth of bank profits and rewards. The banks were run so that incentives for senior executives overrode every sensible precaution. A few of the well known names in prison and recovery of assets more than just the trivial trappings of finery would, I put it to you, would mean much more in the long term than miles of red tape and the associated cost drag. The banksters greed is not yet sated, self evidently, and until this is addressed, regulation macro prudential or otherwise will be a waste of intelligent debate. The arrogance still allows them to impoverish the tax paying 'little people' to pay for their excesses. And never a word of contrition.

  • Comment number 10.

    Are we then returning to the old idea that government intervention can take the supposed irrational booms and busts out of capitalism? Isn't the collapse of this idea precisely what got us into all this trouble in the first place?

    I would have thought that the booms and busts in the trade cycle are a characteristic of capitalism itself and if the state has any role in this it is in protecting society at large from the worst excesses of booms and busts. There is no iron law which requires the state to take responsibility for the entirety of the excesses as currently expected.

    Alternatively, why have capitalism as an ideology of choice? There are many other -isms.

    Wouldn't we be better off with something that worked?

    There are many ways with which to address these issues. It would be better to use the full tool-box rather than just the more familiar screw-driver however useful it can be.

  • Comment number 11.

    Can policy ever control the credit cycle?
    Yes, in fact looking back on the past two years, it's mandatory that the powers that be find ways to control credit cycle risk.
    During the past two years, investors devoured mortgage-backed securities (MBSs), assuming what they thought was little risk. Competition for MBSs, as well as shear complacency about the risk, drove risk insurance premiums down even as the actual risk was increasing.
    This problem was compounded by bundling original loans into derivatives so that the original loan became burried among several other loans. It was time for buyer beware, but buyers did not beware.
    When house prices turned downward, many loans began to default, and those derivative bundles spread the risk helter-skelter, literally all over the place, including the EU, the UK, anywhere that they had been traded.
    The expectation was - with low initial payments — that house price appreciation would soon make refinancing possible. The situation got so loose that borrowers were often not even required to document their income. More and more home-buyers obtained loans for which they were not qualified.
    Then the lower-rated MBSs, neatly hidden in derivative bundles, were used for collateralized debt obligations (CDOs). And then CDOs were in turn used as backing for yet other CDOs, the so-called CDOs-squared. Mortgage insurance on loans provided “credit enhancement” for loan securitizations. Bond insurance put the bow on derivative bundles - MBSs and CDOs. Credit enhancement reduced the cost of funding a securitization by obtaining an AAA rating for the bundles deal that could never have been obtained if the seperate morgages were not bundled.
    Andrew Haldane of the Bank of England. estimated that a CDO-squared can ultimately rest on as many as 93,750,000 loans. This is mind-blowing! It would require a really sharp investor to read more than a billion pages of prospectuses. A bond insurer wrapping a CDO typically relied on the reputation of the "bundler", as well as the (artificial) credit rating.
    When the cycle turned (as it was bound to turn) the whole bundle spelled DISASTER!
    Mortgage insurers UNDER EXTREME PRESSURE relied much too heavily on originators’ handshake that lending guidelines had been followed. Often there was no time to audit.
    Both the originator of the product and buyers had become insufficiently attentive to credit cycle risk. Bad loans abounded.
    Central bankers and bank regulators must vastly improve the chances of something like this ever happening again.
    The Glass Steagall Act was set up a regulatory firewall between commercial and investment bank activities, both of which were brought under tight control. Banks were given a year to decide on whether they would specialize in 1. commercial or 2. investment banking. Only 10% of commercial banks' total income could stem from securities; however, an exception allowed commercial banks to underwrite government-issued bonds. Financial giants at the time such as JP Morgan & Goldman Sachs, which were seen as a HUGE part of the problem, were directly targeted, forced to cut their services. By creating this wall, the GSA was aiming to prevent the banks' using deposits to cover failed underwriting.
    In my opinion, the solution to controlling the credit cycle rests with a revamped but powerful type of GSA.

  • Comment number 12.

    Is this why economists can't count ?

  • Comment number 13.

    #11 BluesBerry

    To paraphrase - it was a giant ponzi scheme built on the back of the World's biggest housing bubble.

    This, and this alone, is why the Western economies are bankrupt and whilst everyone is crossing their fingers hoping that this week's EU/IMF bailout of Eire will fool everyone... just a little bit longer.

    The UK being perhaps the nation with both fingers and toes crossed due to the fact that UK banks funded Eire's property ponzi to the sum of some 267 billion - it doesn't really matter whether that is Sterling or Euros - and the Government is now praying that our own housing bubble does not burst as the bad debts from British liar loan mortgages will make Irish banks look well-funded compared to British ones.

    This complete mess was not just created by the ponzi property bubble but it was, and has been, made worse by refusing to let housing markets crash and by refusing to allow bad banks go bust. You can't buck the markets, you can't buck Capitalism.

    The US has spent billions trying to prop up US house prices and they have collapsed. The Irish did the same with both property and banks and now Ireland as a country is broke.

    Everyone is naively following the advice of 'Helicopter Ben' and it has become a case of 'The Emperor has no clothes' where the politicians either do not have enough financial understanding to see that printy printy to save house prices, then banks and now countries is just creating a bigger economic disaster yet to, perhaps about to, explode... Or they are afraid that by pointing out that 'Helicopter Ben's' plan is a total disaster that they will be ridiculed for stating the obvious.

    The West, in the first decade of this century, seems intent on making a mistake and then repeating it... and then repeating it. We have done it in Iraq and Afghanistan and we are also doing it financially on a truly global scale. If you take a step back you can see what complete madness this all is - I guess, to those in the inner circle, everything seems completely reasonable and plausible. This is all about maintaining the status quo.

    The bottom line is that house prices should be allowed to plunge, so-called property developers go broke, people who are rich on paper become poor and bad banks, which made really bad decisions, should be left to the wolves and allowed to go bust. In turn, Capitalism will allow new banks, new businesses and new people to take the place of those who failed.

    The best thing that can happen to the people of Eire this week, and indeed to the people of the EU, is that the Irish people say no, that they default as a nation and bring about a global banking and sovereign debt crisis. Then, finally, something constructive will have to be done to bring in a new era of growth and prosperity in the West.

    Do I win a prize for the best use of ponzi, bubble, liar loans and the UK into one posting?

  • Comment number 14.

    #13. I can't go along with the ultra laissez-faire stance. Not because I don't want to. But because I think that the scale of the bust, if it were allowed to happen all at once, would be catastrophic.

    The choice for the western economies is to pick one of the three "flations" and to actively steer the economy along the chosen path.
    1. deflation - will end in violence
    2. inflation - will end in government overthrows
    3. stagflation - less violent, less risk of government overthrow, attritional

    Its a horrible choice but the only one with a chance of preventing Great Depression II is option3?

  • Comment number 15.

    #14 As opposed to the peoples of the EU, UK and US being put into poverty whilst the bankers, property developers et al sit back, gloat, count their money and laugh at having got away with it?

    Time for a new approach I think.

    Thank goodness the EU stress-tested the Irish banks a few months ago and they all passed with flying colours!

  • Comment number 16.

    #10 - stanilic

    "Are we then returning to the old idea that government intervention can take the supposed irrational booms and busts out of capitalism?"

    Are you suggesting that the BoE is not independent of government?


    Take that man outside and burn him at the stake.

  • Comment number 17.

    Tawse and Bluesberry, liking your posts at 11 and 13.

    In short,

    outlaw "originate to distribute" model
    outlaw synthetics
    regulate credit approvals (the old 3.5 times salary multiple for property loans)
    regulate consumer finance credit card limits, multiple credit cards etc.
    outlaw detaching credit risk from loans
    outlaw bank incentive schemes which promote reckless behaviour
    outlaw rating agency fees from the vendors of secuities
    just a start...

  • Comment number 18.


    I completely agree with all those policy suggestions!

    Slight problem is, that by implementing them you'll burst the mother of all bubbles.

    Bit of a quandry, eh?

  • Comment number 19.

    #18 Hawkeye_Pierce
    'burst[ing] the mother of all bubbles' reminded me of this little ditty...
    "hands that do dishes are as soft as your face, with mild green financial meltdown" Doesn't quite scan but you get the drift.
    Do I recall Ben Bernanke saying that it's easier to manage the bursting of asset price bubbles than to prevent them occuring? Really?


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