The era of ‘soft’ central planning

More than a decade ago, The Economist (at the time still a classical liberal publication – how times change…) published an excellent article on ‘soft paternalism’:

But a new breed of policy wonk is having second thoughts. On some of the biggest decisions in their lives, people succumb to inertia, ignorance or irresolution. Their private failings – obesity, smoking, boozing, profligacy – are now big political questions. And the wonks think they have an ingenious answer – a guiding but not illiberal state.

What they propose is “soft paternalism”. Thanks to years of patient observation of people’s behaviour, they have come to understand your weaknesses and blindspots better than you might know them yourself. Now they hope to turn them to your advantage. They are paternalists, because they want to help you make the choices you would make for yourself – if only you had the strength of will and the sharpness of mind. But unlike “hard” paternalists, who ban some things and mandate others, the softer kind aim only to skew your decisions, without infringing greatly on your freedom of choice. Technocrats, itching to perfect society, find it irresistible.

A decade later, recent announcements and publications have made it increasingly clear that we are headed for ‘soft’ economic planning. The extract from The Economist above almost perfectly suits policymakers’ current view of the financial system. They now intend to use the existing banking regulatory framework to influence banks’ behaviour (or help them make the ‘right’ decision as The Economist of yesteryear would put it) and micromanage various economic parameters, in order to finally achieve the ‘stable’ and ‘sustainable’ society their mathematical models (or political visions) describe.

It should not come as a surprise: since the financial crisis, regulators have been speaking of using their discretionary powers to tweak rules and regulations to provide (dis)incentives and achieve specific targets. As I reported in a previous post, the European Commission declared last December that it “could lower capital requirements for environmentally-friendly investments by banks in a bid to boost the green economy and counter climate change.” The reception of this idea by regulatory bodies has been rather cold, let’s be honest. But now it looks like they are warming up to the idea and preparing the ground for similar regulatory announcements.

Indeed, a couple of weeks ago, the BIS published a new research paper adequately titled Towards a sectoral application of the countercyclical buffer: a literature review.

The main message of this paper is that, despite their largely untested nature and ‘scarce’ or ‘mixed’ empirical evidence, the literature ‘shows’ that there is a ‘justified need’ for the application of sectoral macroprudential tools. One can wonder how the authors of this paper managed to link the terms ‘scarce/mixed empirical evidence’ and ‘shows’.

I haven’t had the occasion to review all the paper referred to in this document but, as it is the case with most papers covering macroprudential regulation, those are likely to downplay the negative effects of such policies and overstate their benefits.

And indeed, a quick look at a couple of references shows that even most of the limited empirical evidence listed as ‘succesful’ by the BIS do not actually qualify as solid research or contain serious caveats:

• A Bank of England publication referring to the ‘effective’ implementation of sectoral macropru in Australia despite not providing any evidence of this claim and only referencing an Australian regulatory paper published…before the implementation of that very measure.
• Another BIS research piece reporting the positive effects of sectoral macropru on consumer and credit card loans in Turkey despite offering absolutely no robust statistical analysis, based on a sample of n = 2, and whose effects were most probably confounded by the sharp increase in reserve requirements that occurred at the same time.
• A paper that shows some pricing and volume effects of an increase of risk-weighted assets on certain auto loan LTV and maturities in Brazil but also shows a rebalancing, or ‘leak’, towards other maturities (and coincidentally providing some empirical evidence to my theory of credit misallocation through RWA differential).

But providing solid empirical and theoretical foundations was not the purpose of this paper; providing central bankers and policymakers with some sort of ‘research’ justifying the use of economic management tools was. (on a side note, in my experience most economic commenters seem to focus on abstracts and are unwilling to dig into the research papers they refer to, often reporting widely exaggerated results – a recent meta-analysis confirmed this impression, finding that “nearly 80% of the reported effects in these empirical economics literatures are exaggerated”, also see this presentation)

In reality, sectoral macroprudential policies suffer from the same flaws as general macroprudential policies, that is: there is little to no solid evidence of effectiveness, it cannot counteract monetary policy, it assumes away Public Choice and Hayekian knowledge dispersion issues (see here for a full critique of macroprudential policies). Sectoral macropru merely pushes this reasoning further: not only is it assumed that policymakers have the ability to spot and correct macroeconomic variables and imbalances in real time, but also that their macroeconomic omniscience allows them to do so on a sector per sector basis.

Worse, sectoral macropru also opens the door to interest groups and lobbying, which could result in politicians tweaking bank capital requirements to benefit (or penalise) specific industrial sectors. The European Commission proposal outlined above is a typical example of this (benefiting ‘environmentally-friendly’ industries – who gets to decide what firm is ‘environmentally-friendly’?). Or recently, Banque of France governor Francois de Villeroy de Galhau suggested instead (gated link) to “make it harder for banks to maintain exposure to industries perceived as contributing to climate change.” This is another example of sectoral macropru application, negative this time.

Just a few days ago, French president Macron rightly declared that “we have very strict bank rules with the result that banks lend less and less to small and medium sized companies.” This is a welcome admission by a top policymaker that Basel rules have distorted the allocation of credit and penalised smaller firms for no valid reason. Yet Macron falls into the same discretionary micromanagement trap: he then adds that governments could “modulate these rules for banks and insurance companies depending on the reality of the country and the economic cycle and that, when an economy recovers, we could guide banks’ targets – and that could be done by finance ministers and not only accounting and technical rules” (my emphasis).

This fits The Economist’s decade old description of soft paternalism marvellously. The state and its bureaucrats will subtly ‘guide’ banks’ targets, enlightening society. Unless their goal is the following election – though am I too cynical? In any case those bureaucrats will sooner or later find out that, for an economy to flourish, rules beat discretion hands down.

Another way central bankers can influence the allocation of capital in the economy is through stress-testing. Mark Carney, governor of the Bank of England, recently suggested the introduction of ‘carbon stress tests’. Those stress tests would obviously be designed to force the financial industry away from carbon-heavy industrial sectors. Is it a matter of time before ‘sugar stress tests’ or ‘alcohol stress tests’ are also unveiled?

Despite its numerous theoretical and empirical defeats, central planning keeps coming back under a form or another, armed with new (flawed) tools, often to satisfy the naïve targets of idealists, sometimes to satisfy the thirst for power of autocrats. Such a commitment to a misconceived idea is admirable. And dangerous. When will it finally die?

PS: Leland Yeager, one of my favourite economists (see this old post of mine in which I discussed some of his ideas), passed away a few days ago. He will be missed.

PPS: George Selgin and Bob Murphy debated fractional reserve banking here.

Picture credit: The Economist