Morning Must-Read: Simon Wren-Lewis: Macroeconomists, Not Bankers, Should Set Interest Rates

Simon Wren-Lewis: Why macroeconomists, not bankers, should set interest rates: “[The] interest rate… which closes the output gap…

[maintains] the level of output and unemployment that will keep underlying inflation constant… [is] the Wicksellian natural rate…. But, respond[s]… the BIS… monetary policy cannot afford to ignore the financial sector, and the risk of excessive lending and bubbles…. The implication is that a financial crisis only happens because interest rates are set at the wrong level…. The… deregulation of the financial sector in the decades before?–not an issue. The widespread misselling of subprime mortgages?–these things happen. All the other examples of misselling and fraud?–boys will be boys. An industry that profits from a massive implicit public subsidy?–we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s?–all the result of keeping interest rates too low. When those putting the BIS case tell you that macroprudential controls (a.k.a. financial regulations) are ‘untested’ and ‘uncertain in their impact’, what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low….

I like to praise the current UK government when I can. In setting up a Financial Policy Committee that is separate from the Monetary Policy Committee they did exactly the right thing. This formalises an assignment: macro prudential policy to control financial sector excess, and interest rates to control demand and inflation. Most macroeconomists know this makes sense. But the financial sector has a pecuniary interest in pretending otherwise. Those that get too close to that sector should be kept well away from setting interest rates.