CENTRAL BANKING AND MONETARY POLICY AFTER THE CRISIS

Adair TurnerSenior Fellow, Institute for New Economic Thinking

OMFIF City Lecture

10 December 2014

www.ineteconomics.org

300 Park Avenue South | New York, NY 10010

22 Park Street | London W1k 2JB

Recent central bank actions

Federal Reserve

2

Targeted reserve requirement reductions for lending to agriculture and small business

Bank of England

Purchase of MBS

FLS with “incentives for lending skewed towards SMEs”

Targeted LTRO: for non-mortgage bank lending ECB

PBOC

Bank of Korea Stimulus package: finance for SMEs

Private domestic credit as a % of GDP: Advanced economies 1950 – 2011

3

Source: Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, C. Reinhart & K. Rogoff, 2013

Debt contracts: The finance theory perspective

Non-state contingent contracts overcome “costly state verification” advantages over equity contracts in business finance

Essential to mobilisation of capital

Empirical evidence of benefits of financial deepening, i.e. bank credit ÷ GDP

4

Pre-crisis orthodoxy: monetary policy

5

Mervyn KingTwenty Years of Inflation Targeting,

The Stamp Memorial Lecture, 2012)

We assumed that we could ignore much of the details of the financial system Olivier Blanchard

Chief Economist of the IMF, October 2012

The dominant new Keynesian model of monetary economics

lacks an account of financial intermediation, so that money,

credit and banks play no meaningful role

Wicksell’s logic: I

Credit extended to entrepreneurs/businesses to fund capital investment

6

Marginal productivity of capital = Natural rate of interest

If Policy/Market rate < Natural rate Mal-investment and inflation

If Policy/Market rate = Natural rate Optimal investment and price stability

Wicksell’s logic: II

Natural rate is unobservable

7

But if Policy rate varied to ensure price stability

Then Policy/Market rate Natural rate ͠͠??

Inflation targeting objective Credit creation and leverage optimal if price stability achieved

Three conceptually distinct functions of lending

Finance of new capital investment

• Enabling inter-temporal shift of consumption within life time income

Finance of purchase of existing assets

Finance of increased consumption

• Non-real estate• Commercial real estate• Residential real estate• Human capital

• Real estate• Collectibles• Existing business assets – e.g. Leveraged

Buy Outs

8

Categories of bank lending: UK, 2009

9

227

1235

243

232 Primarily productive investment

Some productive investment and some leveraged asset play

Mainly purchase of existing assets

Pure life-cycle consumption smoothing

Other corporate

Commercial real estate

Residential mortgage (including securitizations

and loan transfers)

Unsecured personal

£bn

But also achieves life-cycle consumption smoothing

Share of real estate lending in total bank lending

10

Rat

io o

f re

al e

stat

e le

ndin

g t

o to

tal l

end

ing

18

80

18

84

18

88

18

92

18

96

19

00

19

04

19

08

19

12

19

16

19

20

19

24

19

28

19

32

19

36

19

40

19

44

19

48

19

52

19

56

19

60

19

64

19

68

19

72

19

76

19

80

19

84

19

88

19

92

19

96

20

00

20

04

20

08

20

12

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

10%

20%

30%

40%

50%

60%

70%

Source: The Great Mortgaging, Jordá, Schularick and Taylor, 2014

11

“With very few exceptions, the banks’ primary

business consisted of non- mortgage lending to

companies in 1928 and 1970. By 2007 banks in

most countries had turned primarily into real

estate lenders. The intermediation of

household savings for productive investment in

the business sector – the standard textbook

role of the financial sector – constitutes only a

minor share of the business of banking today.”

(Oscar Jordá, Moritz Schularick and Alan Taylor,

The Great Mortgaging, 2014)

Credit and asset price cycles: upswing

12

Expectation of future asset

price increases

Increased credit extended

Low credit losses: high bank profits• Confidence reinforced • Increased capital base

Increased asset prices

Increased lender supply of credit

Favourable assessments of

credit risk

Increased borrower

demand for credit

Credit and asset price cycles: downswing

13

Expectation of future asset price falls

Less credit extended

High credit losses: low bank profits• Confidence dented• Reduced capital base

Falling asset prices

Restricted lender supply of

credit

Cautious assessments of

credit risk

Reduced borrower

demand for credit

Credit extension and house prices

House prices 2000 – 2007 Household debt as a % of GDP 2000 – 2007

Source: BEA; ONS; ECB

0

20

40

60

80

100

120

Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007%

G

DP

US UK Spain Ireland

0

50

100

150

200

250

Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007

Ind

ex:

20

00

= 1

00

Spain US UK Ireland

Source: Ministry of Housing (Spain), S&P (US), DCLG

14

15

Real estate a dominant risk in advanced economies – even without leverage Real economy debt overhang the crucial driver of post crisis recession – not just impaired financial system

Excessive credit growth may never result in excessive inflation

1700

1750

1810

1850

1880

1910

1920

1950

1970

1990

2010

0%

100%

200%

300%

400%

500%

600%

700%

800%Net foreign assetsOther domestic capitalHousingAgricultural land

Capital in Britain 1700 – 2010

16

% n

ation

al in

com

e

Source: Capital in the Twenty First Century, T. Piketty (2013)

Desirable urban land: a market without equilibrium?

17

Indeterminate price – is there

an equilibrium?

Potentially infinite supply of credit

and private money

Highly income elastic demand

Capital gains motivation

Expectations prices expectations

Inelastic supply of

locationally specific land

Sectoral financial surpluses/deficits as % of GDP: Japan 1990 – 2012

Source: IMF, Bank of Japan Flow of Funds Accounts

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

-15

-10

-5

0

5

10

PNFCs Government

%

18

Japanese government and corporate debt:1990 – 2010

Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations

% G

DP

0

50

100

150

200

250

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 20010

Bank lending to non-financial corporates General Government debt

18

20

Shifting leverage: Private and public debt-to-GDP

Global debt excluding financials

Source: Geneva Report No 16 Deleveraging, What Deleveraging? ICMB / CEPR September 2014

100

120

140

160

180

200

220

240

260

280

01 02 03 04 05 06 07 08 09 10 11 12 13

Developed MarketsEmerging MarketsWorld

% o

f G

DP

21

Total German private sector leverage: 1991 - 2010

1991-Q1

1992-Q2

1993-Q3

1994-Q4

1996-Q1

1997-Q2

1998-Q3

1999-Q4

2001-Q1

2002-Q2

2003-Q3

2004-Q4

2006-Q1

2007-Q2

2008-Q3

2009-Q4

80

90

100

110

120

130

140

150

100

120

140

160

180

200

220

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

% of GDP

China: total social finance to GDP

22

% of GDP

Categories of credit creation and nominal demand

23

Stimulates nominal demandFinance of investment

Finance of consumption

Finance of existing asset purchase

Stimulates nominal demand but required just to offset impact of inequality ?

• No direct stimulus to nominal demand• Could just increase credit, money balances

and asset pricing• May stimulate demand via wealth effects and

Tobin’s Q effects• But not certainly proportional to credit

created

UK Credit, money and demand 2000 – 2007

Nominal GDP

Houshehold deposits

Mortgage credit

House prices

24

% change

105%

97%

79%

44%

Bank lending to real estate sector and prices: Japan 1981 – 1999

25

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%Commercial Land Price in

the Six Major Cities (L)

Bank Lending to the Real Estate Sector (R)

YoY%

Source: Japan Real Estate Institute; Bank of Japan; Profit Research Center Ltd; calculations by Prof. Richard Werner, Southampton University (see Princes of the Yen, Richard Werner, 2003)

Credit creation for GDP transactions and nominal GDP in Japan, 1983 – 1999

26

Source: Princes of the Yen, Richard Werner, 2003

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

00

-4

-2

0

2

4

6

8

10

12

-4

-2

0

2

4

6

8

10

12

YoY %

Cr (L)

Nominal GDP

YoY %

Explaining instability and secular stagnation | 27

Quantity theory of disaggregated credit*

NOT

But:

So that:

And:

∆M = ∆P. ∆Y

∆CR = ∆PR

∆CNR = ∆P. ∆Y

∆M = ∆CR + ∆CNR > ∆P. ∆Y

Velocity of circulation stable

… where CR = credit to finance real estate purchase+

PR = price of real estate

… CR = credit to finance GDP transactions P = prices of current goods and

services

Velocity of circulation falls

* See Richard Werner, New Paradigm in Macroeconomics

+ Or more generally to finance existing assets

28

Velocity of money circulation

Source: BoE, BoJ, Datastream

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Q4

1980

Q2

1982

Q4

1983

Q2

1985

Q4

1986

Q2

1988

Q4

1989

Q2

1991

Q4

1992

Q2

1994

Q4

1995

Q2

1997

Q4

1998

Q2

2000

Q4

2001

Q2

2003

Q4

2004

Q2

2006

Q4

2007

Q2

2009

Q4

2010

UK (M2) Japan (M2)

Velocity of Money (Nominal GDP/M4)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Q4

1980

Q2

1982

Q4

1983

Q2

1985

Q4

1986

Q2

1988

Q4

1989

Q2

1991

Q4

1992

Q2

1994

Q4

1995

Q2

1997

Q4

1998

Q2

2000

Q4

2001

Q2

2003

Q4

2004

Q2

2006

Q4

2007

Q2

2009

Q4

2010

Japan (M4) UK (M4)

Velocity of Money (Nominal GDP/M2)

Monetary aggregates matter

But not because excessive Money is a forward indicator of inflation

But because excessive Credit is a forward indicator of crisis, debt overhang, post crisis depression and deflation

29

Not one objective, one instrument

30

Low and stable inflation insufficient

Credit and asset price cycle and rising leverage can produce macroeconomic instability while never producing excess inflation

• Interest rate elasticity of demand for credit varies by category

• Contrary to Wicksell, there is no one natural rate

Interest rate tool insufficient

31

Arbitrage helps policy

Gets into all the cracks

Advantage

Heterogeneity and instability of expected

returns and elasticity of response

Disadvantage

Interest rates as primary policy tool?

Other policy objectives and tools

32

• Constrain both pace of growth of credit

• … and the level of private sector leverage

• Offset bias in system toward real state lending

• Much higher bank capital requirements

• Much higher counter-cyclical capital requirements

• Increase capital risk weights for real estate lending above IRB levels

• Loan to income constraints on borrowers

• Banks with dedicated focus on non real estate

Objectives Tools

Recent central bank actions

Federal Reserve

33

Targeted reserve requirement reductions for lending to agriculture and small business

Bank of England

Purchase of MBS

FLS with “incentives for lending skewed towards SMEs”

Targeted LTRO: for non-mortgage bank lending ECB

PBOC

Bank of Korea Stimulus package: finance for SMEs