SUPERVISION by

ANDREW GRAHAM *

1. Why Regulate: Objectives and Theoretical Perspective

a particular activity we need: In order to answer the question why one should regulate or deregulate

some objectives a t which we are aiming: and 0 a theoretical framework which links the objectives to the functioning

There is general agreement on most of the ultimate objectives- economic growth, price stability, a high and stable level of employment, and equilibrium in external payments-but perhaps less agreement on how far the goal should be to equalise the distribution of income and wealth or to eliminate poverty. Moreover, it is in the nature of finance that it affects all industries and all spending decisions, so that questions about the efficiency of the financial institutions inevitably concern these macro-objectives, as well as choice and allocative efficiency.

This matters when we look at the issues involved in deregulation, since some of the differences of opinion simply reflect that society does not agree on the relative importance of these different considerations and objectives. For example, the Martin Committee put macroeconomic stability first on its list, whereas the Campbell Committee put allocative efficiency at the top and macroeconomic stability next to last.

Differences of opinion can, however, also be traced to differences in theoretical perspective. In the debate on deregulation there are two linked theoretical frameworks that have been extremely influential- monetarism, and a resurgence in the belief in Adam Smith’s “invisible hand”. These two beliefs undoubtedly go together, not just in the sense that the macroeconomics of one complements the microeconomics of the other (though this is true), nor just in the sense that most monetarists are free-marketeers and most free-marketeers are monetarists: but in the deeper sense that some of the key propositions of monetarism depend on belief in the invisible hand. For example, the all-important claim of the monetarists that money affects prices and only prices, depends on belief in the natural rate of unemployment: but this idea, in its turn, depends on

of the economy.

* Lecture given to the Economic Society in Canberra on 9 May 1984. At the time, Andrew Graham was a Visiting Fellow at Griffith University, Brisbane. He is a Fellow and Tutor in Economics at Balliol College, Oxford, and was a member of the Wilson Committee (1977-80). the UK equivalent of Australia’s Campbell Committee.

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a particular, and particularly optimistic, version of competitive markets and the perfect working of the invisible hand.

The relevance of these theories for deregulation is twofold. First, and most obviously, the renewed belief in the virtue of markets is

the major reason why deregulation is on the agenda. The very first sentence of the Campbell Report highlights the extent to which the assumptions of the free market now permeate many people’s thinking:

The Committee starts from the view that the most efficient way to organise economic activity is through a competitive market system which is subject to a minimum of regulation and Government intervention. Second, and slightly less obviously, it is clear that the case for

deregulation is much stronger if all that governments can sensibly do, and all that they need to do to reach their various macroeconomic objectives, is to control the money supply. After all, within a monetarist framework it is argued that control of the quantity of money guarantees control of the price level while, if the exchange rate is freely floating, the balance of payments can be left to itself. At the same time, levels and rates of change of output, employment, and productivity a re assumed to be determined by “natural” factors. As Friedman and Schwartz say in their recent book comparing the UK with the USA: “The results a r e consistent with a simple quantity theory which regards price changes a s determined primarily by monetary change and output by independent other factors” (quoted in Bank of England (1983) p. 18; emphasis added). In this case there is simply no point in governments concerning themselves with output and employ- ment a s objectives.

I shall argue that neither the invisible hand nor monetarism can be justified as a framework within which to look a t the decisions concerning deregulation, and that there is a quite different standpoint which casts a different light not only on why and when one might want to regulate, but also on how and what one might want to regulate.

The Invisible Hand Economics has come a long way since Adam Smith, but the extra-

ordinary resurgence in recent years of belief in the overall efficiency of markets suggests that we have made a bad job of explaining what we have found. The following two propositions would today be accepted by most serious theorists:

First, it can be shown that if all markets a r e complete; if there a re no externalities and no public goods; if no individual has market power; if all individuals act consistently, self-interestedly, and independently of all other individuals; if there a re no economies of scale large relative to the economy; and if all firms act to maximise profits a t prevailing prices, then there exists a set of prices consistent with equilibrium.

Second, it can be shown that if all individuals a r e also well informed about the characteristics of goods, then, given the initial allocation of endowments, this equilibrium cannot be improved upon.

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These are the two fundamental theorems of general equilibrium and welfare economics. It can be proved given all the assumptions listed: (a) that a set of prices exists that clears all markets, and (b) that this outcome is Pareto optimal. In this sense the invisible hand is both clever and wise. However, there is a quite formidable set of special assumptions built into these two propositions. Indeed, a great deal of the fundamental theoretical effort of the economics profession in this century has gone into establishing precisely what assumptions a re required for a perfectly competitive economy to have the two properties just mentioned. And the subsequent list of assumptions has become more and more demanding. It is therefore particularly important to take on board two further propositions:

First, the elegant theoretical constructs of welfare economics not only do not, but could not apply to the real world. This follows from the fact that the invisible hand requires that markets be “complete”. In this context “completeness” means that one is not only able to trade all goods in all places and in all states of the world, but also that every conceivable future trade is possible-not only goods today for goods tomorrow, but tomorrow’s goods for those of the day after, etc. Certainly there a re forward markets for some commodities and there are insurance contracts for events that display risk-assessable regularity, but the simple fact of the uncertainty of the future makes this impossible for all commodities and all events. This is what Keynes pointed out in the 1930s and no subsequent theoretical advance has been able to prove him wrong.

The second fundamental point about the theory of general equilibrium is that the proof of the existence of a set of market clearing prices tells us nothing whatsoever about whether such a system is stable. Even granted all the demanding assumptions listed above, economic theory is totally silent on whether a perfectly competitive system will find the market clearing set of prices, and on whether it will return to this set of prices after a disturbance, or whether, instead, in the face of a random shock to the system, the economy will deviate further and further away from equilibrium.

In more everyday language, the first proposition says that any general claim to the overall superior merits of the competitive system as a way of organising activity is not justified. The second reminds us that the actual economy-even a perfectly competitive one-may be very unstable. As Roy Harrod once suggested, the economy may be likened to a ball lying on a grassy slope-once kicked it may roll all the way to the bottom of the hill.

None of this means that regulation is always a good idea. Showing that belief in the wisdom of the invisible hand is unfounded does not prove the wisdom of government intervention. What it does do, however, is to suggest that we ought to be much more open-minded to the issue of whether or not to deregulate than the Campbell Report, which seems to have made up its mind on many of the crucial issues on a priori grounds.

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Monetarism Since we cannot rely on the invisible hand, we clearly cannot rely on

the economy to be self-stabilising. Yet monetarists whose argument is that the economy is bound in the long run to operate at the natural rate of unemployment effectively make exactly this illegitimate claim. Further- more, they cannot afford to abandon this claim; if they did they would have to admit the logical possibility of involuntary unemployment. And, if there is involuntary unemployment, increased nominal expenditure will result partly, or wholly, in higher output and not just in higher prices. In other words, the monetarist argument that money affects prices, and only prices, falls at the first fence.

Consider second the other main plank of monetarism, that the velocity of circulation (or the demand for money) is stable. A rigorous, exhaustive testing of this claim was recently undertaken by Professor David Hendry and Neil Ericsson and published by the Bank of England in October 1983. Working on Friedman and Schwartz's own data, but using modern econo- metric techniques, Hendry and Ericsson state:

(Our findings a re not) consistent with a theory claiming a constant money demand equation, homogeneous of degree zero in prices. What is perhaps the most important single claim of Friedman and Schwartz has no empirical basis . . . (Bank of England (1983), p. 67). Why is this important? The reason is simple. If the very strong claims of

the invisible hand and of monetarism do not stand up, we cannot assume that all we need to do is to deregulate and to control the supply of money and that the market will then work for the best, in the best of all possible worlds.

2. An Alternative Approach Where does this leave us? We cannot simply resort to pragmatism,

which is just a way of hiding our conceptions of how the economy works. In addition to the general point that economists need to be more aware of their own ignorance, there a re three points on which we might move forwards:

First, in a highly complex world, objectives frequently conflict, and Tinbergen's argument that we need as many instruments as we have objectives remains a s relevant today a s when it was first formulated. Thus, if we wished to set the interest rate on loans and the quantity of loans independent of one another it would be necessary to apply direct controls; if we wished the exchange rate and the interest rate to show some independence then one possibility would be controls on capital movements; and if we wished the budget deficit to have some indepen- dence from that of the current account, then controls on trade a re one way of moving in this direction.

Without advocating that Australia should pursue any such suggestions at this moment, it is pointed out that controls a r e part of the armoury of

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economic policy instruments and that it is only in the idealised world of monetarism and the invisible hand that they can be set permanently on one side.

Second, the insight of Adam Smith that most people pursue self-interest and that this is not always socially harmful is also highly relevant-in short, we neither can nor should forget the market altogether. In any case, in circumstances of uncertainty about how the economy actually works, it makes sense to adopt a mixed approach.

Third, our best guide to the future may lie in trying to give a coherent account of what Kaldor has termed “stylised facts”-those facts which most people would agree capture the salient features of the past and for which any theory or set of policies has to allow. They embrace on the one hand such generally observed features of the financial system as seem salient for the future, and on the other, the underlying behavioural assumptions which can be made about the participants.

Four styIised facts (i) The banking and credit conditions of market economies exhibit

periodic waves of expansion and contraction. Moreover, at relatively infrequent intervals the phases of contraction a re sufficiently deep and sharp to threaten the solvency of significant parts of the financial sector.

[ii) The community at large is sufficiently concerned by the crisis nature of some of the periods of contraction to require either that lender-of-last-resort facilities exist, or that some other form of rescue operation be launched. This elementary fact of economic history is critical since it is the all-pervasive nature of money and its fundamental importance to the rest of the economy that differentiates the financial sector from other industries. As Joan Robinson said, the price of money is not the same a s the price of a cup of tea.

[iii) Despite their tendencies to innate conservatism, bankers contain their fair share of greed and self-interest. As a result, they will inevitably attempt to get round any controls which cramp their activities and they will probably eventually succeed in this.

(iv) Partly a s a result of technical change, financial institutions in a wide variety of Western countries are undergoing considerable innovation. There are new financial markets, and new debt instruments. The Bankers Magazine noted that, in the single year June 1980 to June 1981, 13 new financial instruments were intro- duced onto the markets in London. At the same time, there is extensive diversification which is causing the traditional boundaries to be blurred. In New York security dealers such as Merrill Lynch a re moving into banking, and in London bankers a re merging with stockbrokers and jobbers.

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It would be easy to document further all four of these “stylised facts” but numbers (ii), (iii), and (iv)-the pressure for a lender-of-last-resort, the erosion of controls, and the innovation and diversification-are probably sufficiently familiar to be simply stated. The first point needs elaboration, however-the claim that banks over-extend themselves and then face severe and often disruptive contraction-since this may be more conten- tious and since it is this fact when conjoined with the others that has the most powerful implications for regulation.

The inevitable tendency of the banking system to over-extend itself The first and most important point about the tendency of the banking

and .financial system to over-extend itself is that it happens. Over the period 1720 to 1975, Kindleberger lists 30 major financial crises, or more than one every ten years. In this century, the years 1907, 1920/21, 1929, 1931, 1969, 1974/75 and perhaps 1982, stand out. Australia has been caught up in some of these as well as having its own “home grown” crises. The Royal Commission on the Monetary and Banking System of 1937 records the bank failures for 1931 (the Government Savings Bank of New South Wales, the Primary Producers Bank of Australia Ltd., and the Federal Deposit Bank Ltd.). Since then the two most notable events have been the extraordinary speculative boom and collapse associated with Poseidon in the late 1960s and the run on the Bank of Adelaide in 1979.

An as yet unpublished paper by Stanford and Beale (1984) looks in detail a t the case of the Bank of Adelaide. It concludes that this case is indeed a clear example of the financial instability I am talking about. Walter Bagehot, writing in the 19th century, described the process succinctly and c olour fully:

One thing is certain. . . at particular times a great deal of stupid people have a great deal of stupid money. . . At intervals. . . the money of these people.. . is particularly large and craving; it seeks for someone to devour it, and there is a “plethora”; it finds someone, and there is “speculation”; it is devoured, and there is “panic”. (Essay on Edward Gibbon, quoted by Kindleberger, 1978)

Hyman Minsky (1982) describes the same thing in the 20th century.

A sharp rise in expected returns from real capital makes the economy short of capital overnight. The willingness to assume liability structures that are less defensive and to take what would have been considered, in earlier times, undesirable chances in order to finance the acquisition of additional capital goods means that this shortage of capital will be transformed into demand for financial resources.

Those that supply financial resources live in the same expectational climate as those that demand them. In the several financial markets, once a change in expectations occurs, demanders, with liability structures that previously would in the view of the suppliers have made them ineligible for accommodations, become quite acceptable. Thus, the supply conditions for

Commenting on the boom, he says:

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financing the acquisitions of real capital improve simultaneously with an increase in the willingness to emit liabilities to finance such acquisitions. (P. 1211

The slump comes about as follows: . . . tight money will be effective only if it brings such portfolio, or financial structure, experimentation to a halt. A reconsideration of the desirability of financial experimentation will not take place without a triggering event, and the reaction can be both quick and disastrous. (pp. 138-39) In Minsky’s analysis the primary factors causing this whole process

are the quite natural tendency of the institutions to adjust their behaviour to the circumstances of the time. In periods of reasonable stability, it becomes sensible to expect stable future income streams and to build up debt related to this expectation, but a s this occurs expansion begins which “justifies” a further slice of debt being added. Financial layering, as he calls it, is a t the heart of the process.

One can go further than this. The third “stylised fact” was that most bankers display self-interest, just like everyone else. In the years follow- ing a severe crisis, two aspects of the financial system and bankers’ atti- tudes will have changed. First, some of the “fringe institutions” will have gone to the wall, so competition is less severe for those who have sur- vived. Second, memories of the crisis will remain, with the result that bankers’ caution and self-interest coincide. But this state of affairs is not stable. As time passes, not only do memories recede, but new men seeking new reputations come to positions of influence and the trend to more aggressive behaviour begins again. Self-interest now dictates not caution but a more competitive stance if market share is to be preserved. This whole process is accelerated both in time and amount if new institutions enter the market.

Two further points need adding. First, the speculative boom and slump I described a re totally inconsistent with those versions of monetarism which embrace scFcalled rational expectations theories. Friedman’s only resort is to deny that such destabilising speculation ever occurs. Second, speculatiave booms and slumps a re consistent with the velocity of cir- culationnot being stable-and this is precisely what Hendry and Ericsson find.

3. The Implications for Deregulation What are the implications for regulatiodderegulation of the combina-

tion of arguments put forward so far? On the one side there is my rejec- tion of the perfect workings of the invisible hand and the smooth “automatic” nature of monetarism, and on the other side there a re my “stylised facts”.

The first and most important conclusion is that if Australia goes ahead with deregulation of interest rates, maturity structure, and market entry, this will need to be accompanied by greater, not less, supervision. In the

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absence of increased supervision, what will happen is quite clear. First, the tight regulation that has been in operation in Australia has acted a s a substitute for bankers’ caution. So if regulation is removed the system will expand. This expansion will be particularly swift if the context is a situa- tion in which the virtues of competition are being especially espoused, The tendency towards expansion will also be decisively reinforced by the presence of new entrants-no matter whether the new entrants are foreign banks or are “new” as a result of diversification into banking-like activities from institutions outside the traditional banks. At the same time, the more competitive environment will put pressure on profit margins. The result of this process will be that the system will eventually over-extend itself, unjustified risks will be taken and, when the optimistic expectations break, individual institutions will be in trouble that will bring with it demands for greater investor protection and increased supervision.

Two events in the UK are a good illustration of this process. First, in the early 1960s a more competitive insurance industry was encouraged. The extra competition was not, however, accompanied by more supervision. As a result some of the new entrants wrote policies at very low premiums and, being very competitive, they grew rapidly. However, in 1966 and 1970 there were two spectacular collapses (Fire Auto & Marine and Vehicle and General) which led to changes in legislation and much more extensive supervision.

Second, a similar pattern was followed by the banks in the 1970s. A decision was taken by the Government in 1971 to encourage the banking system to move to a much more competitive environment. The cartel which had set interest rates was abolished and the inflow of foreign banks encouraged. However, no significant changes were made in the Bank of England’s supervisory arrangements. As is well known, the UK banking system expanded extremely rapidly from 1971 to 1973. Admit- tedly, part of this was the result of an unduly lax monetary policy, but the system also exhibited the features described by Minsky. Banks- especially some of the new “fringe” banks-made loans to property com- panies on conditions that would simply not have been considered earlier, and the traditional banks, keen to maintain market share, were forced to follow suit. We know, for example, that the clearing banks lent exten- sively to property companies. Moreover, the initial attempts that were made to tighten monetary policy had no impact on the demand for loans- expectations were far too buoyant for a change in the interest rate to make any difference. Then, in 1974 when the bubble burst, the property market dried up althogether and there were a series of banking failures in the ensuing scramble for liquidity. As a result the Bank of England had to bring in the emergency “lifeboat”. Subsequently the Bank of England carried out a fundamental review of its supervisory arrangements, and a new statutory framework was introduced regulating the entry of institu- tions into banking.

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The example of the UK and the work of the Wilson Committee also illus- trate some of the principles that follow from these arguments. At the time of our report, the least competitive sector was the building societies where a cartel system “recommended” the rate that should be offered on deposits and charged on mortgages. Our advice was that the “recom- mended” rate system be abolished. However, we coupled with this: first, a series of recommendations in favour of extending and strengthening the supervisory power of the Chief Registrar of Friendly Societies (who is the authority responsible for the building societies), and second, a recommen- dation that all building society deposits be given 100% protection.

On these two issues-that of supervision and that of investor protec- tion-what I am advocating departs somewhat from the approach of either the Martin or the Campbell Committee. It is therefore worth spell- ing out the differences.

In the case of supervision, both Campbell and Martin discuss the need for prudential controls in some detail. Campbell, in particular, documents a series of ratios and other standards with which the supervisory authorities might sensibly be concerned-the sGcalled “camel ratio” (Campbell, 1981, p. 301). Nevertheless, the Campbell Report remains schizophrenic, stating both that investors should have some risk-free outlets and yet that individual institutions should be allowed to fail (p. 293). Furthermore, neither Campbell nor Martin seems to recognise explicitly that greater competition, with its associated greater tendency to instability, will require more supervision. Indeed Martin, when reporting the advantages claimed for a market-oriented policy, stated that “It is sparing in its demand on the resources of monetary authorities, since no widespread supervisory function is involved.” (Martin 1984, p. 89, emphasis added). And nowhere does the Martin Committee itself explicitly argue the contrary.

It is on the need for supervision that I differ most. In a new competitive framework, qualified staff will have to take views on the quality of institu- tional business and not just on the quantitative amount. In other words the Reserve Bank will have to use more resources on supervision, not less-and these will have to be skilled resources.

I also differ on the question of investor protection. Campbell wants investors to have to judge the risks involved in placing money with par- ticular institutions. I regard this as quite unrealistic. It will be difficult enough for the monetary authorities, almost impossible for large business concerns, and quite out of the question for the personal sector. Greater competition must therefore be associated with greater protection for depositors. Personal deposits should have 100% guarantees and I would expect that business will demand, and probably receive, the equivalent cover.

Let me now turn to a second area where the “stylised facts” carry implications for regulation. Fact number (ii) was that the community demands lender-of-last-resort facilities. This is, after all, why central

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banks came into operation in the first place-not in order to control the money supply. Thus, in attempting to control the quantity of money, central banks have had to rely on controlling the demand for money by influencing the whole structure of interest rates. However, in the situation I have described it becomes rather a forlorn hope to expect that it will be possible simply to move gently along a stable demand for money. Either expectations of expansion will continue undeterred (in which case the demand for credit will appear very inelastic), or expectations will change and there will be overkill. This difficulty of controlling the quantity of money through price presents the major argument for direct controls. Note, however, that this is not saying that it is sensible to have such controls all the time. In a recession the controls can be removed safely. Moreover, because of market pressures-the third stylised fact- controls need to be removed every so often.

The reason why controls need to be removed is that they a re gradually eroded. This erosion takes two forms. First, profit-seeking financial institutions set up subsidiaries and disintermediation occurs. Second, the financial institutions innovate and create debt instruments that a r e close substitutes for those lying within the controls.

The ability of the institutions to innovate in this way has implications for how one should regulate. If the financial institutions a re innovating rapidly, the supervisorylregulatory authorities also need to be able to innovate. They need to be able to change equally quickly the categories and institutions that they a re controlling. It therefore follows that it will be counter-productive to try to specify the controls in detail within a legal framework. Controls enshrined in legislation are almost bound to become out of date. The authorities will need statutory powers but they should have considerable discretion on how these powers a re used. Naturally, the financial institutions will argue against any such system of discretionary controls on the grounds that they cannot operate within a n uncertain environment. This is unconvincing. Financial institutions handle many other uncertainties quite satisfactorily. But the more impor- tant point is that if controls are updated they may retain their m a c m economic usefulness. In short, provided the purpose of the controls is well conceived-and the major example I have in mind is controlling a specu- lative boom-then I see no reason why all the advantages should lie with the poachers and none with the gamekeepers.

4. Conclusions The argument on why to regulate has been in terms of rejecting the

idealised, automatically adjusting, perfectly competitive system in favour of a system given to over-extension and financial crises.

I have talked of what to regulate by pointing to the continuing need for prudential controls and above a11 for greater supervision and better investor protection as essential accompaniments to more competition.

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I have talked of when to regulate by stressing the need for direct controls on categories of lending when a boom is over-extending itself.

I have also talked of how to regulate by emphasising the need for discretion and innovation on the part of the authorities.

I have not, however, rejected the fundamental insights of Adam Smith, or the subsequent work of the general equilibrium theorists in identifying the potential areas of market failure. Indeed, my criticism of monetarism and my arguments on the need for investor protection arise directly from taking seriously the points that have been made about market failure. At the same time, the insights of Adam Smith have been used to reach the conclusion that a particular pattern of regulation will become inappro- priate.

The overall outcome, however, is that there is no precise set of rules that can be plugged in and applied at all times. I have never been able to understand why those who advocate monetary targets are willing to credit the monetary authorities with the intelligence to foresee the future, as is implied by setting a target now, but not with the intelligence to exercise discretion in the light of future events. I take a similar view of regulation.

Those who like clear-cut solutions may well find this compromise between the market and regulation unsatisfactory. But in a complex and uncertain world a compromise may be much the best design.

REFERENCES Australian Financial System, Final Report of the Committee of Inquiry (1981) (the Campbell

Committee]. AGPS, Canberra. Australian Financial System, Report of the Review Group (1984) (the Martin Group), AGPS,

Canberra. Bank of England (1983). “Monetary Trends in the United Kingdom”, Bank of England Panel

Paper No. 2 2 , October. Friedman, M. and Schwartz. A.J. (1982). Monetary Trends in the United States and the

United Kingdom: Their Relationship to Income, Prices and Interest Rates, 1867-1975, Chicago University Press, Chicago.

Kindleberger, C.P. (1982), Manias, Panics, and Crashes: A History of Financial Crises, Basic Books, New York.

Minsky. H.P. (1982). Inflation. Recession and Economic Policy, Wheatsheaf Books, Brighton. Report of the (Wilson) Committee on the Functioning of the Financial Institutions (1980).

Royal Commission on Banking (1937). Report, AGPS, Canberra. Stanford, J. and Beale. T.G. (1984). Financial Instability, Prudential Regulation and the Bank

Cmnd. 7937, HMSO, London.

of Adelaide Case, unpublished MS.

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