Debt, Money and Mephistopheles: How do we get out of this mess?

Cass Business School6 February 2013

Adair Turner

2

Money finance as normal procedure: Friedman and Simons

‘Under the proposal, government expenditures would be financed entirely by tax revenues or the creation of money, that

is, the issue of non-interest bearing securities… The chief function of the

monetary authority [would be] the creation of money to meet government deficits and

the retirement of money when the government has a surplus”

“The powers of the government to inject purchasing power through expenditure and to withdraw it through taxation, i.e. the powers of expanding and contracting issues of actual money and other obligations more or less serviceable is money – are surely adequate to price level control.… in other words, the monetary rules should be implemented entirely by, and in turn should largely determine, fiscal policy.”

Milton Friedman, A Monetary and Fiscal Framework for Economic Stability, America

Economic Review, Vol 38, June 1948

Henry Simons, Rules and Authorities in Monetary Policy, The Journal of Political Economy, Vol 44, No. 1, February 1936

3

Helicopters and old bottles: Friedman and Keynes

“Let us suppose that one day a helicopter flies over this community and drops an additional $1000 in bills from the sky, which is, of course, hastily collected by members of the community”

“If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines… and leave it to private enterprise on tried principles of laissez faire to dig the notes up again… there need be no more unemployment… and the real income of the country… would then become a good deal greater than it actually is.”

Milton Friedman, The Optimum Quantity of Money, Chapter 1, (1969)

John Maynard Keynes, The General Theory, Chapter 10, Section 6 (1936)

4

Levers and effects

Aggregate Nominal Demand = Nominal GDP

Prices

Real output

Central Bank private credit support: - US “credit easing”- UK “FLS”

Macro-Prudential policy:- Bank capital and liquidity standards

Monetary policy: - Interest rates- QE- Forward guidance

Fiscal policy: deficits or surpluses

Macro-Prudential policy:- Bank capital and

liquidity

5

Levers and effects

Aggregate Nominal Demand

Prices

Real output

Central Bank private credit support: - US “credit easing”- UK “FLS”

Macro-Prudential policy:- Bank capital and liquidity standards

Monetary policy: - Interest rates- QE- Forward guidance

Fiscal policy: deficits or surpluses

Macro-Prudential policy:- Bank capital and

liquidity

O.P.M.F.

6

Levers and effects

Aggregate Nominal Demand

Prices

Real output

Macro-Prudential policy:- Bank capital and liquidity standards

Division determined by• Spare capacity in labour or physical capital• Flexibility of price setting processes in

labour or product markets

7

The “independence” assumption

Aggregate Nominal Demand

Prices

Real output

Central Bank private credit

support

Macro-Prudential policy:- Bank capital and liquidity standards

Monetary policy

Fiscal policy

Macro-Prudential

Division of the effect between prices and real output is independent of the

tools used to stimulate nominal demand

O.P.M.F.

8

Possible contraventions of “independence”

Aggregate Nominal Demand

Prices

Real output

Central Bank private credit

support

Macro-Prudential policy:- Bank capital and liquidity standards

Monetary policy

Macro-Prudential

Supply enhancement?

Supply enhancement?

Expectation channel?Fiscal policy

O.P.M.F.Unconventional monetary policy or O.P.M.F. create

expectations of future price effects?

Fiscal expenditure or credit support targeted to achieve supply increase as well as

demand?

9

Friedman’s 1948 proposal: a simple illustration

Suppose: Nominal GDP = 100 and money supply = 50

Sensible aim is to grow nominal GDP at 4% per annum, allowing for 2% real growth and 2% inflation

Then: Equilibrium money supply growth might be around 4%

Appropriate increase in money supply is achieved by running fiscal deficit of 2% of GDP, financed entirely by money

Money supply grows by 2 (=4% for 50)

10

From fractional reserve to 100% reserve banking

100% Reserve Banking

Notes & Coins

Reserves

Central Bank Commercial Banks

Money supplyA L

Reserves

Reserves Deposits

Deposit money = Reserves at central bankTotal money supply = Base money

Deposit money = Multiple of reserves at central bankTotal money supply = Multiple of base money

Fractional Reserve BankingCentral Bank Commercial

BanksMoney supplyA L

Notes & Coins

Reserves Notes &

coins &

bank deposits

A L

Reserves

Loans

Deposits

Notes &

coins &

bank deposits

11

Laissez faire economics and the banking exception

“in the very nature of the system, banks will flood the economy with money substitutes during booms and precipitate futile effects at general liquidation afterward”

“private initiative has been allowed too much freedom in determining the character of our financial structure and in directing changes in the quantity of money and money substitutes.”

Henry Simons, Rules versus Authority in Monetary Policy, Journal of Political

Economy, Vol 44, February 1936.

12

Leverage in the real and financial sectors

Source: Oliver Wyman

UK debt as a % GDP by borrower type(1987-2007), Debt Liabilities on B/S

Household

Corporate

Financial0%

100%

200%

300%

400%

500%

600%

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

USA debt as a % GDP by borrower type(1929-2007)

Household

Corporate

Financial

1987

1929

1935

1941

1947

1953

1959

1965

1971

1977

1983

1990

1996

2002

2007

10%50%

100%150%200%250%300% 1987

13

Private non-financial corporate deposits and loans: UK 1964 – 2009

Source: Bank of England Tables A4.3, A4.1

0%

5%

10%

15%

20%

25%

30%

35%

40%

1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

% o

f GD

P

Securitisations and loan transfers Deposits Loans

14

Household deposits and loans: UK 1964 – 2009

Source: Bank of England, Tables A4.3, A4.1

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

% o

f GD

P

Securitisations and loan transfers Deposits Loans

15

Private credit to GDP ratio and growth

Source: S. Cecchetti, BIS Working Paper No. 381 "Reassessing the impact of finance and growth"

16

Lending to UK business

Source: Bank of England “Trends in Lending”

-20

-10

0

10

20

30

40

50

1964

1970

1976

1982

1988

1994

2000

2006

2012

All currency loans

Percentage changes on a year earlier

17

Lending to individuals

-5

0

5

10

15

20

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Percentage changes on a year earlier

Secured

Unsecured

Individuals

Source: Bank of England “Trends in Lending”

18

Japan-policy rate vs credit growth per annum

-8

-4

0

4

8

12

16

Dec

-85

Dec

-87

Dec

-89

Dec

-91

Dec

-93

Dec

-95

Dec

-97

Dec

-99

Dec

-01

Dec

-03

Dec

-05

Dec

-07

Dec

-09

Dec

-11

Private credit growth (%pa) BoJ Policy rateSource: Datastream

%

19

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

Source: IMF, Bank of Japan Flow of Funds Accounts

-15

-10

-5

0

5

10

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

PNFCs Government

20

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

Banking lending to non-financial corporates General Government debt

21

Shifting leverage: private and public debt-to-GDP

Source: ONS Note: PNFC = private, non-financial corporates; Public = central and local government

UK

0

20

40

60

80

100

120

140

Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

% G

DP

Household Public PNFCs

Source: BEA Note: PNFC = private, non-financial businesses; Public = federal, state and local government

US

0

20

40

60

80

100

120

Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

% G

DP

Household Public PNFCs

Source: ECB Note: PNFC = private, non-financial corporates; Public = central and local government

0

20

40

60

80

100

120

140

160

Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

% G

DP

Household Public PNFCs

Spain

USUK

22

Alternative possible targets

Exclusively price focused Price and real output / employment focused

Alternative inflation rate measures (e.g. excluding “one-ff” tax or commodity price effects

Higher inflation rate (permanently or for a period of time)

Guidance implying loose policy even after inflation rate back on target

Price level trend

Circumstance contingent future guidance (loose policy till unemployment below x%)

Money GDP growth rate (as permanent rule or temporarily)

Money GDP level trend

Blanchard et all

Federal Reserve, Autumn

2012

Woodford, August 2012

Carney, December

2012

23

UK inflation: Bank of England forecasts and actual

%

0

1

2

3

4

5

6

2009

Q3

2009

Q4

2010

Q1

2010

Q2

2010

Q3

2010

Q4

2011

Q1

2011

Q2

2011

Q3

2011

Q4

2012

Q1

2012

Q2

2012

Q3

2012

Q4

2013

Q1

2013

Q2

Aug 09 Projection Aug-10 Aug-11 Actual CPI Inflation target

24

Public debt to GDP: US and UK

0

50

100

150

200

250

300

1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980

% G

DP

Source: DMO, ONS

National debt as % of GDP

25

GDP Growth rates 1950 – 1970

0 2 4 6 8 10 12 14 16

Japan

France

Germany

UK

US

0 2 4 6 8 10 12 14 16

Japan

France

Germany

UK

US

% p.a.

Real annual average GDP growth % Nominal annual average GDP growth %

Source: BEA (US), ONS (UK), FSO (DE), Cabinet Office (JP), Madison, FSA calculations

26

UK public debt deleveraging: 1945 – 1970

Public debt : GDP

0

50

100

150

200

250

300

1945 1950 1955 1960 1965 1970

% G

DP

Nominal value of UK public debt and GDP

0

10

20

30

40

50

60

1945 1950 1955 1960 1965 1970

£ bn

UK GDP UK public debt

Source: DMO, ONS Source: DMO, ONS

UK inflation and nominal interest rates

Source: DMO Note: CPI is derived from RPI after 1947 and the national accounts consumption deflator before 0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

1945 1950 1955 1960 1965 1970

%

Consumer price inflation

3 month treasury bill rate

27

Central Bank policy rates

Source: Central Banks

Data: excel 0

1

2

3

4

5

6

European Central Bank

Bank of England

Bank of Japan

US Federal Reserve

28

Central Bank balance sheets as %GDP

0

5

10

15

20

25

30

35Se

p-97

Sep-

98

Sep-

99

Sep-

00

Sep-

01

Sep-

02

Sep-

03

Sep-

04

Sep-

05

Sep-

06

Sep-

07

Sep-

08

Sep-

09

Sep-

10

Sep-

11

Sep-

12

Japan

0

5

10

15

20

25

30

35Se

p-97

Sep-

98

Sep-

99

Sep-

00

Sep-

01

Sep-

02

Sep-

03

Sep-

04

Sep-

05

Sep-

06

Sep-

07

Sep-

08

Sep-

09

Sep-

10

Sep-

11

Sep-

12

Japan

0

5

10

15

20

25

30

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

UK

0

5

10

15

20

25

30

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

UK

0

5

10

15

20

25

30

35

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

EU

0

5

10

15

20

25

30

35

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

EU

0

5

10

15

20

25

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

US

0

5

10

15

20

25

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

2009

Q3

2010

Q1

2010

Q3

2011

Q1

2011

Q3

2012

Q1

2012

Q3

US

Japan UK

USEU

29

Japan – 10 year nominal yield

0

1

2

3

4

5

6

7

8

9

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Source: Bloomberg

%

30

UK trends in lending: % 12-month growth rates

(% 12-month growth rates)

Source: Trends in Lending, data as of 04/01/2013

%

-10

-5

0

5

10

15

20

2007

200 8

200 9

201 0

201 1

201 2Q1

201 2Q2

201 2Q3

201 2Q4

Lending to UK businesses Secured lending to individualsConsumer credit

31

Gross lending to and repayments by UK non-financial businesses (£bn)

0

10

20

30

40

50

6020

11 Q

2

2011

Q3

2011

Q4

2012

Q1

2012

Q2

2012

Q4

SME gross lending LB gross lending SME repayments LB repayments

Source: Bank of England, Trends in Lending, January 2013

32

Post-facto money finance: US 1940 to 1951

Large wartime budget deficits ‘funded’ by government debt issues

Federal Reserve commitment to keep interest rates at 2.5% - buying bonds to achieve target

Source: Friedman and Schwarz, Monetary History of the United States

Post-facto permanent money finance

No subsequent reversal / ‘exit’

High powered base money

0

10

20

30

40

50

60

1940

1941

1942

1943

1944

1945

1946

1947

1948

1949

1950

1951

1952

1953

1954

1955

33

Japanese Government debt as % of GDP

Source: Bank of Japan, data as at end 2012, Japan Post Holdings accounts end March 2012

0

50

100

150

200

250

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Minus Bank of Japan

Minus Japan Post

Minus domestic commercial banks

46% of GDP

Gross debt minus Government + social security holdings

30.6% of GDP

33.7% of GDP

%

34Source: McCulley and Pozsar

34

y Leveraging "M M" Deleveraging

Conventional x

Rates "Z B" QEMonetary Policy

Private Sector

Deficits Surpluses

Stim

ulus

Defi

cits

Poli

cy

B"

Fisc

al "B

Surp

luse

s

Aust

erit

y

Unorthodox

"Fat Inflation Tails" Crowding Out

Inflation Risks "Crowding In"

"Fat Deflation Tails" Economic Depression

Deflation Risks No Crowding Out

Varying actual and appropriate policies: McCulley and Pozsar’s framework

35

35

Source: McCulley and Pozsar

Private and public leverage cycles

36

36

y Leveraging "M M" Deleveraging

Conventional Unconv. Radical Nuclear x

Rates "Z B" QEFMCMonetary Independence ~

Aust

erit

y

Poli

cy

B"

Fisc

al "B

Surp

luse

s

Private Sector

Deficits Surpluses

Stim

ulus

Defi

cits

Plai

n As

set

Purc

hase

s

Reve

rse

Volc

ker

Mome

nt

Heli

copt

erMon

ey-

Source: McCulley and Pozsar

Varying actual and appropriate policies: McCulley and Pozsar’s framework

37

Two Policy options

Several £100bns of QE with commitment to future reversal

Funding for Lending

Relaxation of bank capital and liquidity standards

+

+

Several £10bns of OMF of increased fiscal deficit (tax cuts or public spend increasing)… with commitment that this will be permanent

Option 1 Option 2

Which will:

Be most effective in stimulating nominal demand?

Have least adverse side-effects?

38

Fiscal adjustment required for long-term debt sustainability

Actual today Required for debt sustainability

Debt as % of GDP 2011

Cyclical adjusted primary balance

2011

Cyclical adjusted primary surplus 2020-2030

Required adjustment

Spain 69

UK 82

US 103

Italy 120

Japan 126

Gro

ss D

ebt

Net

D

ebt

-5.1

-3.7

-5.3

2.0

-7.7

5.5

5.7

7.5

12.6

7.6

+ 10.6

+ 9.4

+ 12.8

+ 20.3

+ 5.6

To get to 60% debt

to GD

P by 2030

To get to 80% debt to GDP

39

Money finance via Japanese banking system?

Close to money financing of deficits Closer still if government owns banks Which it does in case of Japan Post

Money claims of Japanese households & corporates

Current and deposit accounts at zero interest

Government bonds at close to zero interest

Commercial Banks

Government

40

Nominal GDP in four major economic areas: 2007 – 2011

GDP (Q1 2007 = 100)

85

90

95

100

105

110

115Q

1 20

07

Q2

2007

Q3

2007

Q4

2007

Q1

2008

Q2

2008

Q3

2008

Q4

2008

Q1

2009

Q2

2009

Q3

2009

Q4

2009

Q1

2010

Q2

2010

Q3

2010

Q4

2010

Q1

2011

Q2

2011

UK US EA JPN

Source: ONS, BEA, Eurostat, Cabinet Office (Japan)

Q1 2007 = 100

41

Developed economies’ GDP growth

Q1 2007 = 100

Source: McCulley and Pozsar

42

Break-down of NGDP growth from trough (2009) to peak

Δ Nominal GDP

Δ Prices (GDP deflator)

Δ Real output

UK: +8.1%US: +5.2%Eurozone: +3.8%

UK: +2.2%US: +6.5%Eurozone: +3.1%

UK: +10.4%US: +12.0%Eurozone: +7.1%

43

Breakdown of NGDP growth from trough: 2009 to 2012

% % % % % %0 20 40 60 80 100

Eurozone

US

UK

Share of NGDP change due to pricesShare of GDP change due to real output

44

Faust (Part II) and OPMF: how bad was it?

“Mephistopheles leaps to a single conclusion, that there has been too much deflation and austerity and what was lacking was money. There is, he says, plenty of gold and silver beneath the earth, and the Emperor simply needs to issue pieces of paper in the form of claims against the underground metallic treasure. The Emperor is suspicious of this clever advice.

But everything in the empire improves as a consequence of the introduction of paper money. The generals are pleased because the soldiers are paid once more, the treasurer finds that he can pay off all the debts, tailors are busily making new clothes, ladies become more willing to embark on well paid romantic adventures, the property market booms.”

Harold James, Germany should re-read Goethe’s Faust Part II, Financial News, October 2012