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Political lies & bank regulation

February 4, 2012

We hope that Joe Hockey is a liar. We can understand why a politician would want to bash banks, and we can understand why a politician would want to promise more regulation to control the “naughty market”. Both of these are populist positions which hit the political funny bone, and score cheap points.

It is no surprise that Wayne Swan regularly complains about evil bank profits, and we’re sure the Greens (and other assorted reds) would eagerly agree to more regulation. But while we can understand the political desire for populism, when it actually comes to managing the rules for our economy, we can only hope that Hockey is not serious about his stated desire to have the RBA act as referee on interest rates.

We already know that Joe Hockey wanted to introduce a psuedo-national bank, and he wanted more regulation to ensure that banks gave more risky loans, and also gave fewer risky loans.

Now the issue is whether banks should be able to set their own prices for loans. To be fair, Hockey has only suggested that the Reserve Bank of Australia (RBA) should nudge banks, but given his track record on not understanding finance it’s a dangerous start. It hints very much towards government regulation of interest rates, which is price fixing of some of the most important prices in the economy.

If you’re like many other non-economists (ie normal people) then you might think that the government already does set interest rates. If you’re half an inch more informed, you might think that the independent RBA sets interest rates. That’s not quite right.

The RBA effectively does set one specific interest rate — the “overnight rate” for collateralised loans to major banks. Indeed, there is a big argument about whether they should even be doing that, but that’s a topic for another day. The overnight rate is an important price, but — and this is the most important thing to learn from this article — that is just one interest rate among thousands. All of the other interest rates are set by banks (and other money lenders) in a competitive market, following the laws of supply and demand.

As it should be.

The law of supply and demand can be frustrating sometimes. So can the law of gravity. But in both instances, you cannot legislate your frustrations away. When the government tries to “fix” the naughty market, there are three possible outcomes. Either the government sets the price too low and we end up with shortages (so banks will only lend to the privileged few) or the government sets the price too high and we have excess supply (ordinary people can’t afford to borrow), or the government sees a divine vision from the Virgin Mary, sings kumbaya with Mary Popins, and magically picks the perfect price, even though they have all the wrong information and incentives. What do you think is more likely?

We have learnt from 100 years of trial and error (mostly error) that the government is not good at setting prices. At least, that is what we should have learnt.

Some lefties and Bob Katter still want to set prices for things like milk and vegetables, and that is silly enough. But the idea of the government (or RBA) setting interest rates is another level of crazy. The reason, as we said above, is that there are thousands of different interest rates — depending on the reason for the loan, the collateral available, the length of the loan, the size of the loan, the liquidity of the consequent financial asset, the funding profile of the lender, degree of risk aversion and time value of money, the credit rating of the applicant, and many other variables.

You could try to find a benchmark or average interest rate, but that doesn’t really help our busy-body regulators. Getting the average right means nothing… just as standing with one arm in the fire and one arm in the freezer might give you a good average temperature, but it’s not a good idea.

Specifically, some financial institutions aim at a particular market, that might be more or less risky. That means they will have a totally different strategy, with different interest rates. Will the government be micro-managing their business strategies too, or just guessing at them?

And just to make it all worse, the public choice consequences of interest rate price fixing are also quite dangerous. Instead of being driven by competition, bank strategy and prices will increasingly become political footballs. That will mean some banks will reap windfall profits by playing good politics, while other banks will be sent to the wall due to bad politics. And the lack of price competition will mean less innovation and more lobbying and rent-seeking. That’s not how we want any business sector to work, least of all the all-important financial sector.

This is not good. As we said at the beginning, we can understand why populist politicians promise to run and ruin the economy. But what we really care about is whether they mean it. The two options are that they are liars who spruik populist crap and then become responsible when in power… or that the politicians have actually drunk their own kool-aid, and plan on destroying our economy. We hope they are liars.

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This article was co-written with Joseph Clark. All of the nasty parts of this article were written by Joe, and all the witty and wise parts were written by John. Except for this paragraph.

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  1. February 5, 2012 at 3:57 am

    Yeah, what they said.

  2. February 5, 2012 at 7:22 am

    Another great article. I always enjoy your wit.

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