The interview questions are:
Why do you think inflation has been low in US after the 2008 recession?
What is the most important thing economists get wrong about the way banks work? (this post)
What are your thoughts on NGDP targeting?
What are your thoughts on free banking?
FH: What is the most important thing economists get wrong about the way banks work?
JN: There are a lot of misconceptions about banking among economists. Those misconceptions vary by school of thought. The main problem with mainstream (neo, new classical and new Keynesian) economics is that they often forget banks altogether. Banks seem to merely represent a means of implementing monetary policy. Monetary policy seems to be considered in a vacuum. The issue here is that banking isn’t free. It is actually the most regulated industry on this planet. Bankers are market actors that react to incentives. This can lead to severely distorted economic effects.
For instance, Basel regulations have incentivised banks to extend credit for real estate purposes since 1988, triggering simultaneous housing booms all around the world. We know how this ended. Central banks, blinded by the inflation targeting dogma, believed that the financial sector would remain stable as long as inflation was stable. Inflation was indeed stable. But not the banking sector, which was over-lending and over-investing in the few asset classes favoured by Basel, which would then trigger the crisis: real estate, structured products, and sovereign debt. Once the crisis started, they also believed they could simply inject liquidity into the banking system, which would then channel it to productive customers (private companies) to sustain economic activity and dampen the recession. But Basel rules makes it more expensive to extend credit to corporations (i.e. it requires to maintain higher capital buffers), and with such high default risk involved in the middle of a recession, banks were unable, or unwilling, to implement monetary authorities’ will.
Now, imagine a banking system free of any regulatory constraint. Monetary policy would have been more effective. The lending channel would not have been distorted. Central banks could still have made policy mistakes (as they often do), but those mistakes would not have been further amplified by misguided regulation. Economists must awaken to the macro distortions originating in the microeconomics of banking.