Central banks can do more to stabilise economy: Expert

Sir Howard Davies says growth can be sacrificed for stability. Photo / Mark Mitchell

Central banks need to be willing to lean against asset price inflation, even if it means sacrificing some economic growth, says Sir Howard Davies.

They should also be able to raise banks' capital requirements to moderate the economic cycle, and not just to preserve banks' financial soundness.

Davies is the director of the London School of Economics. He is a former deputy governor of the Bank of England and, until 2003, chaired Britain's financial regulator, the Financial Services Authority. He was in Wellington yesterday to deliver a public lecture marking the Reserve Bank's 75th anniversary.

Former Federal Reserve chairman Alan Greenspan used to argue that central banks could not know in advance if they faced asset price or credit bubbles and so could not do much about them, but Davies rejects this.

"In monetary policy there are an awful lot of things you don't know with any certainty ... [and] there are some triggers that will give you a clue as to whether your asset prices are unsustainable. In housing markets you can't look at price-to-income and loan-to-value ratios."

A timely response can mean a growth trade-off, Davies acknowledges.

"But that would have been worth doing if you could have as a result moderated the depth of the downturn. People quite like stability. They don't like doing quite well for four years and then absolutely catastrophically in the fifth," he said.

When would a central bank raise banks' capital requirements instead of increasing a policy interest rate, like the official cash rate?

"I think you would do it particularly if you thought there were certain parts of asset markets that were going crazy.

"So if you felt it was concentrated in domestic property it would be rational to impose an additional capital requirement on banks in the mortgage market."

Another lesson from the crisis is the need for regulators to take a less permissive and more sceptical approach to financial innovation, Davies says.

He cites the explosive growth in the market for credit default swaps. They were invented to allow investors, like the custodians of pension funds, to shed risk at the expense of a slightly lower yield.

"But the market took on a life of its own. When I was last a regulator in 2003, there were $3 trillion of credit default swaps in existence. By the end of 2006, there were $63 trillion and the market was generating risk not offsetting it."

The regulatory response was likely to be to require the big banks trading such instruments to hold more capital.

Improved governance will also be needed. "There will be a need for greater independence, greater expertise and greater scepticism on financial firms' boards in the future. Finally, borrowers need to take some responsibility for the "astonishing" run-up in household debt."

HOWARD DAVIES

* Sir Howard Davies is director of the London School of Economics.

* Between 1998 and 2003 he was chairman of the Financial Services Authority, the UK's single financial regulator.

* He had served for two years as deputy governor of the Bank of England after three years as director-general of the Confederation of British Industry. From 1987 to 1992 he was controller of the Audit Commission.

* He has worked for McKinsey and Co, HM Treasury and the Foreign Office.