Arnold Kling

Countercyclical Regulatory Policy

Arnold Kling, Great Questions of Economics
Previous Entry Next Entry

Paul McCulley points out that the Federal Reserve tends to tell banks to tighten credit at exactly the point in the business cycle when the economy most needs a relaxation of credit restrictions.

But how can the Fed get banks to re-engage in underwriting corporate default risk when they don't want to, you ask? The answer, it seems to me, is quite straightforward: just tell them to do it! But will they listen, you ask? Yes, they would, I submit, particularly if Mr. Greenspan were to declare that he is also instructing his bank examiners to act counter-cyclically, not pro-cyclically, in evaluating capital and credit-reserve policies. As an additional incentive for banks to unclog their lending pipes, Mr. Greenspan should publicly call for Congressional investigators to call off their find-a-crook dogs.

The time for bank regulators to get tough is when times are good, not when times are bad. They didn't, of course, during the bubble years, but that is not a rational justification for getting tough now. If counter-cyclical is good for Fed funds policy, then counter-cyclical is good for bank regulatory policy, too. Interestingly, famed economist Henry Kaufman applied this logic just this week5 in calling for a cut in margin requirements for stocks, after having been a fellow traveler with me and Bob Shiller in advocating a hike in margin requirements during the bubble years.

Discussion Question. If regulatory policy should "lean against the wind," and if house prices may be in a bubble, should regulators be telling lenders to tighten their rules on granting mortgage credit?

Return to top