Monday, 22 December 2008
Robert Peston is looking back at the powers that the Bank of England should have had to help forestall the asset price bubble of the last few years. It's an interesting angle, because it also sheds some light on the question of what powers the Bank should have now.
He correctly points out that interest rates are too blunt a lever. When a central bank wants to be able to achieve multiple objectives - to do more than just target the inflation rate - it needs multiple tools.
Interest rates are a two-sided tool - they can be raised in peak times to moderate activity, and cut in a recession to revive it. It's instructive to ask of any proposed solution: "does it work in reverse?" to see whether it meets this standard of having symmetrical power.
The solution Peston discusses is adjusting the capital requirements of banks. In an asset boom, capital reserve requirements would be increased to reduce banks' ability or inclination to lend against assets. This would control prices.
The drawback of this solution is that it's hard to imagine us wanting to reduce capital requirements in a situation like today's. There are certainly some hints that banks should relax their criteria a little, lend more and therefore reduce the amount of capital they hold during the next year. But it's commercially and politically tricky to imagine the banks actually doing this.
An alternative solution which I'm exploring is to give central banks the ability to influence not just the amount of debt in the economy but also the amount of equity. If the Fed had the option to directly stimulate investment, this would help to address one of the problems in today's economy - that productive investment is potentially threatened. It could do this by making equity investment in certain private companies.
Government doesn't have a great track record of being an equity holder, so this would need to be done at arms-length through the central bank or another body. But if such a body did exist, it could potentially short equity assets in a price bubble (such as in 2000) as an automatic stabiliser, just as interest rates can be raised or lowered according to the projected inflation rate.
If the asset in question is property - as in 2005-2007 - then trading in debt instruments seems to have some effect. Currently we're seeing banks buying property-linked debt in the form of mortgage-backed securities, which should provide some support to the property market. Could we imagine them selling such debt in a boom? Quite possibly.
We'll never engineer a situation where each variable in the economy - consumer prices, asset prices, investment rates, saving rates - can be independently tweaked by adjusting a single dial. But mathematically, it makes sense that the number of variables to control is the same as the number of tools available to manipulate. The better our models are, the better we can predict which tool to adjust and by how much; but there's always going to be some trial and error.