RDP 8605: On Some Recent Developments in Monetary Economics 6. Innovation and Deregulation

Changes in regulations may be sufficient to produce shifts in simple money stock – money income relationships; they are not the only cause, however. Regulations by their nature impose costs on either buyers or sellers (or often both) in the regulated market. There is therefore always an incentive to circumvent regulations, typically through innovation. When the cost of innovation falls below the cost of compliance, innovation can be expected. Examples from the financial markets are numerous. The growth of so-called “non-bank financial institutions” helped to satisfy the demands that regulated banks did not; banks themselves created new instruments, both on and off balance sheets; and so on. The pace of innovation was slow in the 1960s but increased in the 1970s. Rising inflation was raising the costs of compliance; at the same time, the advance of computing technology was lowering the costs of innovation.

As a result, innovation began to erode the existing regulatory framework. Old relationships began to break down. This reflected in the increased concern over the definition of money, as substitutability between the traditional money and other assets increased. Most importantly, the erosion of the policy framework led gradually to an increase in pressure for deregulation (or, at least, new regulations).

It is, of course, very difficult to generalise about this experience, which has varied widely across countries. Figure 1 summarises the cases of Australia and the U.S. Both countries experienced substantial inflation during the 1970s and have seen both extensive financial innovation and deregulation. One message of figure 1 is that the changes in Australia's financial markets have been concentrated in a much shorter period than for the United States.

Britain's experience has been analysed extensively by Goodhart (1984). One particularly important feature was that the removal of lending controls on the banks (the “corset”) in the late 1970s led to major problems in determining the stance of monetary policy. Certainly the major indicators gave differing signals at this time.

In Japan financial deregulation and innovation have proceeded relatively slowly; Suzuki and Yomo (1986) provide an interesting set of papers on the subject. Germany and Switzerland have seen fewer changes in financial regulations in recent years. It is our impression that innovation has proceeded more slowly, and that conventional money demand functions have been less unstable, in these countries over the past decade or so.

These conjectures and impressions require careful testing. Relevant tests will need measures both of innovation and changes to regulations, as well as appropriate tests of the stability of money demand functions.

However, it seems to us that major episodes of innovation and deregulation must be interpreted as significant changes in the policy framework. In the wake of major financial deregulation, therefore, it would be expected that the old relationships between money and income could break down: the simple relationships which held in the regulated framework will not also hold in the new. They will be useful only until individuals adjust their expectations and behaviour to the deregulated framework.

This point has not been well recognised. For example, there is an extensive literature on the effects of moving from a pegged to a floating exchange rate. This literature suggests that under the floating exchange rate monetary policy will be more powerful than before (relative to fiscal policy). However, the models which make up this literature typically are based on simple aggregate relationships, assumed to be invariant to the switch of exchange rate regime. Such models may therefore be misleading as guides to the longer term.

These problems are compounded by the possibility that such a change in policy regime takes place simultaneously with changes in other regulations (exchange controls, for example). The various changes in financial regulations in recent years have produced a blurring of distinctions between types of financial intermediary and between types of financial asset. This has brought about a rise in asset substitutability, and has made the meaning of money in a practical sense much less clear.^[17] Within the concept of money, the time-honoured distinctions between transaction and saving balances and, in a more subtle way, between domestic and foreign currencies, are also becoming clouded. Market-related rates of interest are now paid on deposits which recently attracted no interest at all; and advances in transaction technology have increased the liquidity of traditional savings deposits.

Increased substitutability has led to a closer relationship between rates of interest on different financial instruments. It has not necessarily led, however, to an increased sensitivity of aggregate financial flows to the overall level of interest rates. Indeed, with innovations such as floating-rate loans diffused widely, this sensitivity may have lessened.

The rise in asset substitutability has also increased across currencies, giving exchange rates (or net currency flows if exchange rates are managed) a greater role in the transmission mechanism of monetary policy. The theoretical importance of the degree of mobility of capital has, of course, long been recognised in even the simplest models of open economies.

The process of change is continuing, and will do so for some time yet. This has increased substantially the difficulties of system-wide models and the evaluation of macroeconomic policies using such models. Indeed, some would argue that such exercises are futile and may never be possible. On this view (which we think is extreme), the monetary macroeconomics of the 1960s may turn out to be a unique product of its age. We would agree, however, that future models will have to account for a wider spectrum of substitutable assets with flexible prices, and have financial innovation (and “defensive” changes in regulations) as a feature.

One possible foundation exists in the portfolio approach to monetary theory developed by Tobin in the 1960s. Of course, there is a long way to go, not least in linking the portfolio model to the real economy and in endogenising innovation and policy response.

Here, however, we have a range of models on which to draw. Some are predicated on equilibrium, with large numbers of markets for contingent commodities. These models were of limited use in practical economics because such markets were lacking in the actual economy; however, deregulation and innovation have begun to expand the range of futures and risk markets available. These equilibrium models may yet have much to teach us.

At the same time, advances in disequilibrium theory may offer insight into the effects on the economy of missing or imperfectly operating markets, and perhaps also into the processes of adjustment to changes in markets.

Footnote

See Bank for International Settlements (1985), pp 57–59, and Reserve Bank of Australia (1984/1985). [17]