Credit creation and social optimality

In this paper the author asks how confident we can be that the quantity of bank credit supplied and demanded, and the allocation of that credit to different sectors or activities will be socially optimal, if we leave the credit creation and allocation process to free market mechanisms, subject only to the indirect levers of static prudential controls and interest rate based monetary policy. The answer is: not very confident. In that case, what are the implications for public policy? The paper adopts a quantity theory of credit perspective as a tool of analysis. Credit creation for financial transactions drives asset prices, but the process is unsustainable. Interest rates and other conventional policy levers cannot prevent such booms. Equally, downswings are self-reinforcing and not easy to end with interest rates as key tool. A new macroprudential policy is hence required to focus on this aspect. This needs to get far more involved in the details of credit capacity and even of the sectoral allocation of credit, than has been practiced for several decades. If the allocation of credit can be biased in a sub-optimal fashion by asset price effects, by organisational and behavioural biases and by imperfect information, then we cannot exclude the need for policy interventions which offset the bias, whether by restraining some categories of credit or favouring others. This could be important not just to manage the conjunctural impact of the credit/asset price cycle, but also to ensure that important investment priorities are funded. The creation of the Green Investment Bank is predicated on such logic.