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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

1

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

6

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

8

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

15

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

18

The Dilemma

19

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

20

Three conceptually distinct functions of lending

21

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

22

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

24

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

26

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

28

29

Shifting leverage: Private and public debt-to-GDP

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?

30

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

31

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’.

32

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”

33