Creating Money: for what purpose?
Towards a Sustainable Financial System
Adair Turner
Senior Fellow, INET
London School of Economics 21 March 2014
www.ineteconomics.org | www.facebook.com/ineteconomics
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
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Theory: Money creation and debt
Empirics: Rising leverage and the policy conundrum
Categories of credit
Implications
2
Banks create credit, money and purchasing power
Loan to
entrepreneur
100 Credit to
entrepreneurs
deposit account
100
Bank
3
Two (closely related) issues
Bank credit, money and purchasing power creation
Debt contracts – whether bank or non-bank
4
Credit creation as enabler of adequate demand growth
• Money supply constrained by precious metal resources
• Real growth may require downward flexibility of wages and prices
• Pure ‘hoarding’ possible
Pure metallic money
• Pure fiat money creation: unfunded fiscal deficits
• Private bank (or other) credit extension
• Funded fiscal deficits
Alternatives / complement
5
Alternative ways to stimulate nominal demand
Pure fiat money: unfunded fiscal deficits
Private credit and money creation
Funded fiscal deficits
New money
Increase in private NFA
No New money
But increase in private NFA
And future public debt liability
New money • And future private debt
No increase in private NFA • But maturity transformation
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Fiat money creation
Private credit creation
Always possible
Public authorities can choose optimal quantity
Allocation is political decision
Tendency to excessive use
Allocation determined by market disciplines
Is the amount created optimal?
Implications of resulting debt contracts?
Advantages Disadvantages
7
Banks create credit, money and purchasing power
Loan to
entrepreneur
100 Credit to
entrepreneurs
deposit account
100
Money Rate of Interest
Natural Rate of Interest (MPC)
=
Wicksell’s thesis:
Bank purchasing power creation optimal if:
Bank
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Credit to businesses/entrepreneurs/other investors in real capital
Skews demand toward investment, not consumption
“Forced saving”
“An increase in capital creation at the cost of consumption, through the granting of additional credit without voluntary action on the part of the individuals who forego
consumption, and without them deriving any immediate benefit”.
(Friedrich Hayek, The Monetary Theory of the Trade Cycle, 1929)
9
Credit driven “forced saving”
More rapid rate of growth
Japan/Korea “financial repression”
models of development
Over-investment cycles
Macro-economic imbalance
– Growth sustained by yet more credit
Potential Benefit
Potential Disadvantage
10
Two (closely related) issues
Bank credit, money and purchasing power creation
Debt contracts – whether bank or non-bank
11
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
12
The pre-crisis orthodoxy
Central Banks / monetary theory
Finance theory
Low and stable inflation objective
Financial system a veil – “money, credit and banking play no meaningful role”
Implicitly Wicksellian
Debt contracts essential
General confidence that free markets will produce optimal balance
Main concerns about insufficiently high credit ÷ GDP ratios
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
Theory: Money creation and debt
Empirics: Rising leverage and the policy conundrum
Categories of credit
Implications
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Dynamics of real GDP and credit (Year on year % change)
Source: Monthly Bulletin, European Central Bank, January 2014
Real GDP Real credit to households Real credit to NFCs
United States United Kingdom
16
Private domestic credit as a % of GDP: 1950 – 2011
Advanced
Emerging
Source: Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, C. Reinhart & K. Rogoff, 2013
17
China: total social finance to GDP
100
120
140
160
180
200
220
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
% o
f G
DP
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The Dilemma
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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
Theory: Money creation and debt
Empirics: Rising leverage and the policy conundrum
Categories of credit
Implications
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Three conceptually distinct functions of lending
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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
Categories of debt: 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
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Credit and asset price cycles
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
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 %
GD
P
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
Index:
2000 =
100
Spain US UK Ireland
Source: Ministry of Housing (Spain), S&P (US), DCLG
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Inequality, demand and credit
Rich have higher
marginal propensity to
save than poor
Rising inequality
Deflationary impetus – growth of NGDP falls
Deflationary impetus offset: • NGDP growth
maintained • Growth in credit
intensity
•Rich lend to poor •Central bank facilitates
Savings not matched by investment
+
25
Global current account balances as a % of world GDP
-2
-1.5
-1
-0.5
0
0.5
1
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
United States Germany+Japan Developed Rest
OPEC Developing Rest China
Source: IMF BOPS
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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
27
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
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Fiat money creation
Private credit creation
Always possible
Public authorities can choose optimal quantity
Allocation is political decision
Tendency to excessive use
Allocation determined by market disciplines
Advantages Disadvantages
Optimal amount ensured by policy interest rate?
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Market misallocation possible
• Overinvestment cycles
• Existing asset price cycles
No, because of heterogeneity of interest rate elasticity
Ongoing debt contracts rollover and overhang effects
Theory: Money creation and debt
Empirics: Rising leverage and the policy conundrum
Categories of credit
Implications
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Policies required to achieve more stable growth
Reduction in inequality or at least reduced pace of increase in inequality
Reduction in global current imbalances between surplus and deficit nations
Remove biases to credit creation in deficit countries
Remove biases to excessive savings in surplus countries
Integrated set of monetary, macro-prudential and fiscal policies to lean against ‘too much of the wrong sort of debt’.
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Specific policy options and issues
Constrain level as well as rate of growth of leverage
But no precise threshold for ‘Too Much’ leverage
Constrain level as well as rate of growth of leverage
Constrain level as well as rate of growth of leverage
Increase capital risk weights for real estate finance above IRB estimates
LTV and LTI limits in real estate lending
Banks with dedicated focus on non-real estate business finance
Social optimal weights privately optimal
Address externality and bias
Borrower constraint since lender constraints imperfect
To avoid “crowding out”
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