Wednesday, January 28, 2009

Confessions of a Financial Merchantilist

The Gord's most recent speech has talked about the dangers of financial merchantilism. For those who don't know what this means, it basically means that governments are encouraging their banks to lend to domestic customers over and above foreign customers. I've got to say that I completely disagree with him on this point, I find the idea of financial merchantilism very appealing. I prefer, for example, that Icelandic banks should take deposits from Icelandic savers and lend to Icelandic customers over and above the idea that Icelandic banks should take deposits from British savers in order to purchase American financial instruments.

I would go further and argue that the increase in international lending in recent years has damaged the functioning of the market by removing some of the normal self correcting signals.
As an example, imagine a country with a level of savings decides to go on a borrowing based spending binge, the effect of this will be to lower savings as money normally put aside for savings is instead put towards debt repayment. Since bank lending depends on savings a decline in savings will act as a signal to banks to reduce their lending.

If instead, the country's banks are able to obtain money from another source (say another country), they can continue to lend regardless of savings levels and any market signal on debt will kick in far later and the consequences will be far more severe (as we are witnessing at the moment).

Debt is not limited by any availability of natural resources, it doesn't come in different colours and one country can not make better debt than another. In fact, as I've pointed out in the past, locational mismatch often means that foreign debt is almost always worse than domestic debt. There are very few reasons (in my opinion at least) to really justify the current scale of international lending1, so a move towards a financial merchantilism is fine by me.

1. I'll add the caveat that at the moment since a number of countries (UK very much included) are dependent on international lending that going cold turkey would be a bad idea, but long term I think it's preferable.

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