There seems to be near-lunatic policy inconsistency between the employment of the controversial and potentially dangerous policy of quantitative easing to boost broad money and credit, and the regulators’ desire to raise the capital and liquidity requirements of the commercial banks. The latter will almost inevitably cause banks to both restrict the size of their total balance sheets and substitute government debt for private lending within their diminished total asset books.
There is a parallel here with the argument in supply-side economics that the announcement – or even mere expectation – of future tax increases would cause a supply withdrawal well before the tax change was implemented. If I was the general manager of a clearing bank, I would already be giving instructions to reduce lending to the private sector so as not to be caught short of capital and/or liquidity when the new regulatory controls currently being discussed were imposed. Indeed, regulatory shocks imposed by international agreement may cause the entire global banking system to take a similar view, leading to a synchronised global downturn that would be similar to, but worse, than the US recession that followed President Roosevelt’s misguided decision to double the reserve asset requirements of US banks in 1936.
The solution to the ‘too-big-to-fail’ problem is to use existing anti-monopoly legislation to break up the big banks, or at least those dependent on state guarantees, not to pile new legislation on new legislation until the whole global and domestic credit creation processes grind to a halt.
Addendum: According to the Financial Times, Lloyds Banking Group is planning to reduce its asset base by more than £180 billion to fill the £25 billion capital hole that regulators have demanded as the price for leaving the government’s toxic asset insurance scheme.
Professor David B. Smith is Chairman of the Shadow Monetary Policy Committee.