System shock

When I sat down to write this article, the virus scanner on my computer started running.  With my computer unable to function for the next half an hour I sighed and went off to get a coffee. Although the virus scanner is needed to avoid vulnerabilities in my computer, the loss of performance I experience is undeniable.  The same logic holds true for the economy more generally the more we try to patch up vulnerabilities in the economy, the worse our overall economic performance will be.

In itself, the idea of preventing something being vulnerable sounds great.  I would love to be less vulnerable to a cold, to being in a car accident, and to losing my job.  As individuals we lower these vulnerabilities by taking out some form of insurance.

However, we all know insurance is not costless.  The insurance money I pay on my car over my lifetime is more than likely going to be greater than the amount that gets paid out to me.  I continue to pay up because in the unlikely event that I do crash the insurance will help to soften the blow during a tough period of my life.

When we look at the economy as a whole, one of the primary vulnerabilities currently on people’s mind is the fragility of the financial sector.  Following the global financial market collapse in September 2008 this now appears to be an important issue.

The fallout of the global financial crisis has shown people that there are very costly events we may want to "insure “against as a nation.  However, central banks, including our own Reserve Bank, were looking carefully at this issue year before the crisis struck.  As a result, in order to help provide this insurance, the Reserve Bank was already introducing the core funding ratio.

However, there appears to be growing calls for central banks to do more.  In the same way that people rushed into banks to sort out their house and contents insurance following the first Canterbury earthquake, a lot of people want to rush out and push up New Zealand's level of insurance against a meltdown in financial markets.

For example, it has been suggested that we need to increase the core funding ratio further, so that banks have to source more of their funds from New Zealand. At the same time people are suggesting that debt levels in New Zealand shouldn't be as high, so we need policies that directly reduce the amount of debt.

In part, both of these ideas are attempts to increase how insured New Zealand is from the events of a future financial crisis.

The thing is, just like the car crash example I mentioned before, a systematic collapse in financial markets is aware event.  And the whole rest of the time, we keep clocking up the cost of this insurance.

In the case of increasing the core funding ratio, or forcing households to save more, the cost falls largely on people who otherwise would have been borrowing and lending to each other.  There are people who want to borrow for something, other people who have cash and want to lend to them, and in order to stabilise the financial system we are stopping these people interacting.

Although this is a much harder cost to see or feel than an insurance premium we pay every month, it is just as real.  I fit wasn't for our determination to reduce the vulnerability of financial markets these individual would have been able to lend and borrow money in ways that would make both of them better off.

In the same way that my computer would run faster without a virus scanner, in the absence of viruses, the financial system helps to match borrowers and lenders better without intervention as long as people don't lose faith in financial institutions.

So how do we decide what the "right" level of insurance against financial market vulnerabilities is?  I would suggest that, at present, we have to rely on professionals to determine just how careful we need to be with the financial system.  In the same way that I trust the IT department to look after my computer given my complete lack of knowledge of anything technological.

However, in the same way that an IT department can be overzealous with their computer protection, a central bank will have the incentive to "over-insure" in order to avoid the abuse that would come if we did suffer a financial crisis.  As a result, eventually the right level of insurance would need to be set in a way that more evenly takes into account the costs and benefits of any such insurance.

So although recent events have made us feel that "something needs to be done" about the financial system, let's keep in mind that there are also costs to any policies we implement, and that these costs “ while they are hard to see should not be ignored.

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