Brian Fallow: Cold turkey for credit addicts

Excess credit growth has allowed us to spend more than we earn. Photo / Michael Craig

You can have too much of a good thing, they say. Maybe credit is one of those things.

For almost all of the past decade private sector credit - lending from both banks and non-bank financial institutions - has been growing faster, much faster, than the real economy plus the inflation target.

But what has that excess credit growth bought us?

It allowed a housing bubble to develop as prices were bid up to socially destructive levels.

It allowed growth in consumer spending to outstrip growth in incomes, to the point that by 2007 households were spending $1.13 for every $1 they earned.

It has been reflected in a blowout in the current account deficit that has pushed the country's net external liabilities, mainly debt, to nearly 100 per cent of GDP.

And in the process the dollar has been for long periods at levels painfully high for the tradeables sector.

More than once during the boom, Reserve Bank Governor Alan Bollard voiced frustration at the difficulties of running an independent monetary policy for a small open economy in an era of huge globalised financial markets, in particular of trying to tighten when the rest of the world was awash with cheap money.

For three-and-a-half years he drove the official cash rate higher, dragging the exchange rate with it, but gaining little traction in the mortgage belt as banks borrowed cheaply abroad to meet borrowers' avid demand for credit.

The problem of how to keep inflation in bounds without inflicting collateral damage on exporting and import-competing firms has vexed policymakers for several years.

A search party of officials was sent out to look for "supplementary stabilisation instruments" but they came back pretty much empty-handed. A long parliamentary select committee inquiry into the issue was no more fruitful.

But now Wellington economist David Preston is proposing a change to the monetary policy regime which he argues will address these issues.

In a paper to a New Zealand Association of Economists conference yesterday, Preston advocates giving the Reserve Bank an additional target and an additional instrument to meet it.

If monetary policy were operating effectively it would be reasonable to expect the trend rate of growth of credit to the private sector to be somewhat similar to the trend rate of growth in real output plus the target for price movements, he says.

Over the past 10 years the trend growth rate has been around 3 per cent a year and the inflation target 1 to 3 per cent, so a first stab at what private sector credit should be expanding by is 4 to 6 per cent.

But only for a year, in 2000-01, and of course lately as the global recession hit, has it come close. Indeed between 2004 and 2008 it was running at double-digit rates.

"Since an expanded credit volume must impact somewhere, and this somewhere was not mainly on CPI movements, other consequences might be expected," Preston says.

They were asset price inflation especially in housing, a blowout in the current account deficit despite favourable terms of trade, an appreciating real exchange rate and consumer spending that outstripped output.

New Zealanders collectively always want to borrow a lot more than other New Zealanders want to lend. During the boom - the five years to March 2008 - growth in banks' foreign liabilities funded almost half of the increase in their lending.

And that has been an important source of demand for New Zealand dollars on the foreign exchange market.

Preston proposes that the Reserve Bank be given, in addition to its inflation target, a target for growth in a broad credit aggregate. He suggests private sector credit.

Like the inflation target it would be set in the policy targets agreement between the Governor and the Minister of Finance at a rate determined mainly in line with expected growth in output and target growth in prices.

He envisages the official cash rate would continue to be aimed at the inflation target.

"It becomes difficult if you try to use one instrument to target two things."

In any case, the past five or six years indicates the OCR on its own is unlikely to be sufficient to implement a credit control policy, Preston says.

Rather than try to operate simply on the demand side through interest rates you have to look at the supply side as well, he argues.

"The key problem which needs to be addressed is how to manage the monetary impact of huge swings in monetary capital inflows. Unless this can be done New Zealand cannot achieve a genuinely independent credit growth policy."

He accepts that there is no way the country can be completely insulated from international financial developments. "However, it can do better."

Preston proposes a system of mandatory deposit requirements for imported money. The Reserve Bank would be given the power to impose on banks (and other financial institutions covered by deposit guarantees) deposit requirements on specified sources of external funding.

Suppose the banking system started with $100 billion of foreign currency deposits. The Reserve Bank might require 2 per cent of that to be deposited with it, reducing the amount the banks had to lend from this source to $98 billion.

"Suppose then that $10 billion more in foreign currency flowed into the banking system in a situation where credit expansion was already at guideline limit rates. The mandatory deposit ratio could then be raised to 11 per cent. This would sterilise approximately $12 billion, a net increase of $10 billion, blocking additional credit expansion."

If more flowed in, the ratio could be raised again.

The Reserve Bank could invest these funds in AAA-rated short-term securities abroad, where possible in the same currencies, Preston suggests.

But the interest rate that would allow it to pay the commercial banks on those deposits would be relatively low, reducing the incentive for them to accept foreign currency deposits since they would gain very little from them.

The dreaded "carry trade" driven by the interest rate differentials would be, if not shut down, at least curtailed, moderating an upswing in the currency, he says.

So what might go wrong?

One risk Preston acknowledges is "dis-intermediation". Companies, the bigger ones anyway, could cut out the middle man and raise money directly in overseas capital markets.

More generally, standing between willing borrowers and willing lenders is an invitation to be bypassed, if not run over.

Working out ways to circumvent such restrictions on capital flows or otherwise game the system would probably only be a matter of time.

But even if the Preston model is not a silver bullet it is becoming increasingly clear that international thinking about how to avoid a repeat of this decade's enormously destructive boom and bust will focus on regulation of banks.