Combating Debt Addiction

Adair Turner

Senior Fellow, INET

The Swedish House of Finance Global Utmaning

22 May 2014

www.ineteconomics.org

300 Park Avenue South | New York, NY 10010

22 Park Street | London W1k 2JB

2

Escaping the Debt Addiction: Monetary and Macro-prudential Policy in the Post-crisis World. Center for Financial Studies, Frankfurt, 10 February 2014 http://ineteconomics.org/blog/institute/adair-turner-escaping-addiction-private-debt-essential-long-term-economic-stability

Credit, Money and Leverage: What Wicksell, Hayek and Fisher Knew and Modern Macro-economics Forgot. Stockholm School of Economics Conference “Towards a Sustainable Financial System", 12 September 2013, http://ineteconomics.org/blog/institute/adair-turner-credit-money-and-leverage

Wealth, Debt, Inequality and Low Interest Rates: Four big trends and some implications. Lecture at Cass Business School, London 26 March 2014http://ineteconomics.org/wealth-debt-inequality-and-low-interest-rates-four-big-trends-and-some-implications

Reference:

3

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

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

4

Shifting leverage: Private and public debt-to-GDP

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 20130

50

100

150

200

250

300

Source: International Monetary Fund; Bank for International Settlements

Private and public leverage: G7 + BRIC

6

China: total social finance to GDP

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013100

120

140

160

180

200

220

7

Dynamics of real GDP and credit(Year on year % change)

Source: Monthly Bulletin, European Central Bank, January 2014

Real GDPReal credit to householdsReal credit to NFCs

United States United Kingdom

8

The Dilemma

Pre-crisis path of nominal GDP growth

Pre-crisis path of credit growth

! 4% - 5%

! 10% - 15%

If central banks had raised interest rates to slow credit growth…. this would presumably mean slower nominal GDP growth?

We seem to need Ċ ˃ NGḊP to ensure adequate NGḊP… but this produces financial instability and post-crisis recession

@ 2% real growth

@ 2% inflation

9

The Dilemma

We seem to need credit growth faster than

GDP growth to achieve an optimally growing

economy, but that leads inevitably to crisis

and post-crisis recession.

10

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

11

Pre-crisis orthodoxy: monetary policy

Low and stable inflation as sufficient for macroeconomic stability

- Implicitly Wicksellian(natural rate = money rate of interest)

The dominant new Keynesian model of monetary economics lacks an account of financial intermediation, so that money, credit and banks play no meaningful role

Mervyn King, ‘Twenty Years of Inflation Targeting’, The Stamp Memorial Lecture, 2012)

* * *

12

“A growing body of empirical analyses […] demonstrate a strong positive link between the functioning of the financial system and long-run economic growth […] better developed financing systems ease external financing constraints facing firms”

Ross Levine: Finance and Growth: Theory and Evidence. Handbook of Economic Growth, 2005

Positive correlation between growth and:

• Liabilities of financial system ÷ GDP

• Bank credit to private enterprise ÷ GDP

• Turnover of equity markets ÷ market capitalisation

Pre-crisis orthodoxy

13

The problems with debt

Cycles of over-supply and over-demand

‘Local thinking’Upswing

Downswing Bankruptcy and default

Rollover need and impaired lending capacity

Debt overhang

14

Textbook descriptions of banks and bank lending

Banks take deposits

of money from

savers and lend it to

borrowers

Banks lend money to ‘entrepreneurs/ businesses’, thus allocating funds between alternative investment projects

15

Banks create credit, money and purchasing power

Loan to entrepreneur

100 Credit to entrepreneurs deposit account

100

Bank

16

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

17

Categories of bank lending: UK, 2009

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

18

The dominance of real estate in bank lending

Total bank credit to domestic

private sector% of GDP

Mortgage credit

% of GDPMortgage credit

as % of total

129% 74% 57%

206% 131% 64%

155% 78% 50%

175% 101% 57%

122% 78% 64%

130% 91% 70%

+ Commercial real estate at

typically around 20% - 25% of total

lending

Source: Jordá, Schularick and Taylor, “Betting the Home”, forthcoming 2014

(*Bank and non-bank combined)

*USA

AUS

ESP

NLD

SWE

DNK

19

Share of real estate lending in total bank lending

Source: The Great Mortgaging, Professor Alan Taylor, University of California, Davis

20

“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)

21

Credit and asset price cycles: upswing

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

22

Credit and asset price cycles: downswing

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

23

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

24

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 %

nati

onal

inco

me

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

Desirable urban land: a market without equilibrium?

25

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

26

Average income increases US (1980=100)

0

50

100

150

200

250

300

350

bottom 20% top 5% top 1%

Sources: US Census Data, The World Top Incomes Database

Source: US Census Bureau; World Top Incomes Database

27

Inequality, demand and credit

Rich have higher marginal

propensity to save than poor

Rising inequality Deflationary

impetus – growth of NGDP falls

Rich lend to poor

Deflationary impetus offset:

• NGDP growth maintained

• Growth in credit intensity

Savings not matched by

investment

+

28

Dynamics of real GDP and credit(Year on year % change)

Source: Monthly Bulletin, European Central Bank, January 2014

Real GDPReal credit to householdsReal credit to NFCs

United States United Kingdom

Interactions between credit categories and effects

Increased apparent wealth

Reduced saving:

increased consumption

Increased price of

existing real estate

Increasing credit supply

/ demand

Equity withdrawal mortgage supply & demand

Boom in new real estate

construction

Increased prices for new real

estate

Borrower and lender net worth, confidence

and expectational effects

30

?

Two questions:

Why does this growth in leveraging matter?

How is it possible without stimulating inflation??

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

%

31

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

33

Shifting leverage: Private and public debt-to-GDP

34

Categories of credit creation and nominal demand

Stimulates nominal demandFinance of investment

Finance of consumption

Finance of existing asset purchase

Stimulates nominal demand offsetting 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

35

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

-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)

36

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

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 | 37

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

38

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)

39

Not one objective, one instrument

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

40

Other policy objectives and tools

• Constrain both pace of growth and 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