The centrifugal governor

What went wrong in the UK banking crisis of 2008?  According to George Osbourne it was a catataxis – although he does not use that word. The confusion of roles between the Bank of England and the FSA meant that a key role was not being done properly: macro prudential regulation. The Bank of England’s remit was to keep inflation under control. They were responsible for setting interest rates so that inflation would not breach 3%. The Bank of England was looking at the big picture. The only trouble is it was the wrong picture . The FSA was busy regulating the City on a micro level, making sure that no one broke the rules. They were examining each financial firm in turn, going through a checklist to make sure that procedures were being properly followed. The FSA was the micro regulator but where was the macro regulator? This function fell between the two stools. Both organisations were interpreting their remit too narrowly.  Rules were being applied but at the wrong level: this is catataxis. There needs to be someone who will lock up the drinks cabinet just as the party is getting good. According to George Osbourne’s proposed reforms, there needs a to be a regulator but at the macro level. Thats why he is abolishing the FSA and replacing it with a new body.

We have been here before. Back at the dawn of the industrial revolution James Watt invented a device to make steam engines run more smoothly. It was called  a centrifugal governor.  Two balls rotating around a spindle. The faster the spindle rotates, the further out the balls get flung. But the further out the balls are, the more work it takes to rotate the spindle which will therefore slow the system down. A big flywheel with a lot of inertia will smooth out an erratically firing engine.  But this is a dynamic flywheel: the distribution of the weight changes with speed. Its damping down the acceleration. In other words, it is regulating the second derivative. It is macro prudential regulation. Having led the world in the steam age, maybe the new reforms will help Britain’s global competitiveness in the financial age.

A centrifugal governor