Between Debt and The Devil - Adair Turner
High level summary
“(private creation is) far too important to be left in the hands of the private sector”- H. Simons
the privatization of credit creation is a significant problem because commercial banks consistently over-lend by underestimating the risk of assets, especially of real estate, this is caused by factors such as:
longevity -> global savings glut -> depressed bond yields -> lower discount rate for asset pricing-> asset bubbles
inequality + high propensity for rich to consume real estate + crashes after which mostly the rich retain assets -> inequality -> inequality
urbanization leading to limited supply of urban land
Moore’s Law + growing capital investment -> accelerated growth in non-IT capital investment such as real estate
securitization ($400t market) is inherently destabilizing thanks to shadow banking, which sees money market funds prone to investor runs hold long-term illiquid assets, and practices such as mark-to-market pricing, which creates self-reinforcing prices
to save ourselves from the balance sheet recession we’re in, Turner posits that a simultaneous unfunded electronic drop of money and raising of banks’ reserve requirements (to prevent excessive credit creation) might work
we need a way to write off debt; Turner suggests rewriting sovereign bonds held by central banks to be perpetual and non-interest bearing – as if the Fed would allow that!
measures to reign in finance:
increased capital requirements
reduce tax bias for debt
shadow banking regulations
restricting consumer borrowing and encouraging enterprise lending
counter-cyclical capital buffers
greater global financial fragmentation
avoidance of sustained current-account imbalances
In more detail
Reading the blurb, you get the idea that you’re tuning into the stream of consciousness of a radical: “public policy needs to manage the growth and allocation of credit creation, debt needs to be taxed as a form of economic pollution, real estate lending needs to be regulated, printing money to finance fiscal deficits is OK (and in fact, sometimes necessary), as is monetizing government debt.”
In most cases, what Turner suggests goes against the basic principles of the Economics 101 we’ve been taught: market forces are good; don’t touch them. Turner, chairman of the UK’s Financial Services Authority from 2008 until its abolition in 2013, during which time he had a front-row seat and hand in the recapitalization and recovery efforts of the UK, persuasively argues that it is exactly this attraction to argument by axiom that we need to avoid.
Credit, and our leaving it to private creation, he maintains, is what caused the greatest financial crisis since the Great Depression, i.e. the Great Recession (2009). A little history lesson is given: historically capital investment mainly took the form of equity, until the popularization of debt contracts in the 19th century, without which many of the British Empire’s most entrepreneurial and risky endeavors would not have been funded. Debt contracts offer both specific returns and specific repayment schedules, and certainly without it, much of today’s capital resources wouldn’t be available. Its specificity is what causes banks to prefer debt over equity. However, it’s a double-edged sword, Turner continues, as banks fundamentally underestimate the risk of their aggregate debt, leading them to over-lend. Even if the debt is “good” (re-payable and sustainable at the micro level), it causes destabilizing asset-bubbles at the macro level.
While this applies to both developing and developed nations, it is especially cause for concern in developed ones because at the heart of all financial instability is the relationship between the infinite ability of banks to produce credit and the inelastic supply of irreproducible urban land. In this sense he vindicates Buffett’s famous “to fix the economy, first fix the housing market” statement. Turner’s trenchant analysis also uncovers the relevance of seemingly unrelated factors such as urban density, inequality, longevity, Moore’s Law, and securitization. These factors have led banks, which in textbooks are said to redirect capital towards their most efficient allocation, i.e. enterprises, to instead fund what is essentially speculation. In 2012, only 14% of UK bank lending went to non-real estate businesses. Banks love lending to fund real estate because their very funding makes what is already a seemingly “risk-free” (it’s a debt contract with a physical asset that can be seized) asset even more risk-free (the market and thereby the asset appreciate thereafter).
Although, regulation that allows imputed rent (the benefit an owner derives from being able to live rent free in their own property) and interest rate deductions on mortgages haven’t helped to cool the market, recent UK legislation on buy-to-let is a step in the right direction.
More pertinent, however, are the following factors:
1) Urban density means that countries with the fewest population centers are most vulnerable to housing bubbles, compared to say Germany which has a more even spread across its urban centers.
2) Inequality requires unsustainable credit growth to maintain economic growth because the rich have a lower propensity to consume (“Let them eat credit” is R. Rajan’s summary of how governments have dealt with downward social mobility), but this credit growth itself exacerbates inequality because demand for real estate is income elastic (YED>1) meaning that the richer take the bulk of the credit to buy up the bulk of real estate. The end result is both catastrophic and inevitable: the deceleration of credit growth leads to deleveraging and a balance-sheet recession (not unlike what we’re in now) and further consolidation of financial assets into the hands of the few.
3) Increasing longevity -- but a lack of a commensurate increase in the retirement age -- in many modern economies has resulted in a greater “ex ante” desired savings relative to “ex ante” desire investment. This is especially true in China (although that is more due to government regulation than demographics). The resultant increased appetite for savings has depressed global bond yields (not helped by QE), which in the past decade have been lower than throughout the previous history of modern capitalism, allowing for, and even encouraging homeowners and investors to borrow more to fund more speculative real estate purchases.
4) Moore’s Law, the most seemingly unrelated factor, is in fact one of the most contributive. It has resulted in the falling cost of ICT (30% cheaper relative to goods and services in the period 1990-2014, IMF), which constitutes a growing share of capital expenditure, meaning that growing capital investment has caused accelerated growth in non-IT capital investment, namely construction of real estate.
5) Securitization in principle allows economic agents to hedge their positions. However, in excess (does $400t sound like excess? That was the nominal value of all interest rate derivatives in 2007) it turns into destabilizing speculation. Economics 101 argues that securitization improves liquidity in capital markets and allows for more optimal risk transferal. Economics 101 is wrong again because as Turner argues, even with more advanced risk management systems, securitization is a beast we cannot hope to fully control:
market prices don’t accurately reflect credit prices and provide information about risk because markets are characterized by self-referential cycles of irrational exuberance and economically-destructive despair,
real-time exposure calculations based on a mark-to-market basis doesn’t provide better risk management because when new prices are used to calculated changing collateral requirements, price movements become self-reinforcing: depreciation leads to asset liquidation to cover increasing collateral requirements, which in turn cause more depreciation,
our misplaced belief in the powers of science to predict the future blindsided us to the reality that the future cannot be predicted,
and while in theory a securitized credit provision system allows for greater maturity transformation, in practice this hasn’t proven to be true: a 30 year mortgage-backed security (and all its many, many derivatives) might be held by a money market fund, which investors could liquidate at any moment
These combined effects have created the debt overhang we now face; so we’ve been drinking the free-market Kool-Aid for far too long, Turner proves. The cornerstone of Economics 101 is the Rational Expectations Hypothesis (REH), which posits that economics agents act rationally to new information. Turner convincingly shows us that while individually, agents may act rationally, collectively their actions prove disastrous. This shouldn’t really be news to us: we’ve always known that in some instances the market fails and externalities exist. (Recent economic work by D. Kahneman, R. Shiller, G. Akerlof, etc. has shown how many holes there really are in the REH.) What Turner has done, however, is to show that private credit creation is one of these cases, and accordingly it should be taxed and/or regulated.
The author brings to attention our economic amnesia: economists such as H. Simons and M. Friedman eschewed the fractional reserve system we have now, believing that private creation was “far too important to be left in the hands of the private sector”. Simons went even further, pushing in his Chicago Plan, for an imposition of 100% reserves on deposits. Turner is more realistic, and realizes that such a transition is both impossible from today’s standpoint and detrimental: private credit creation has its place in the world, but not as it exists in the modern banking system.
He argues for:
1) increased reserve requirements (equity requirements of up to 30%), but more importantly, greater risk weighting for, and even ceilings on, real-estate lending;
2) reducing the tax bias for debt and promoting financially innovative products such as shared-risk mortgages and GDP-linked government bonds which offer a lower yield in recession years;
3) strict regulation of and restrictions on nonbank activities (shadow banking) such as “haircuts” in repo markets, effectively imposing capital requirements at the contract level;
4) restricting consumer borrowing and encouraging enterprise lending;
5) counter-cyclical capital buffers, which can be increased in credit booms and removed in credit crunches;
6) global financial fragmentation to reduce short-term bank-intermediated capital flows (which prove to be the most destabilizing), but Eurozone financial integration: the combined effect of countries being unable to run their own fiscal deficits, and their holding of sub-sovereign debt, whose risk drives up yields and thus crowds out investment, has had egregiously deflationary effects;
7) and avoidance of sustained current-account imbalances which have seen the transferal of leverage from deficit countries such as the US and Japan to surplus countries such as China.
It is for this last reason that the much-needed deleveraging since the Great Repression hasn’t occurred: today’s global debt at 300% stands higher than the 270% in 2009. While this is partially the fault of surplus nations whose inevitable transition from capital-investment to consumption-based growth Turner sees as needing to be carefully managed lest 2009 is repeated, it is also the fault of policies in the US and Japan which have run un-funded fiscal deficits and turned on the liquidity tap. Free liquidity has simply overseen a wealth transfer from the asset-poor to the asset-rich while not improving the situation because like 90’s Japan, the non-financial base of the US’ economy simply has no appetite for credit at the moment, and has led us into a liquidity trap: negative interest rates in a cash-based economy form the interest rate floor (at negative interest rates, economic agents would simply convert bank deposits into cash). Monetary policy, the Fed’s go-to solution, hasn’t worked.
So what’s to be done in the face of a structural deficiency of nominal demand and too much debt? Well, we can’t hope to grow out of or erode the value of our debt as we might have been able to in the past, and un-funded fiscal deficits wouldn’t work because of Ricardian equivalence: future debt servicing burdens would be created, implying future taxes, and deterring businesses and individuals from spending their purchasing power gains. The author, here, author turns to Bernanke’s resurrection of Friedman’s theory: a helicopter drop of money.
The key is to avoid hyperinflation and to depoliticize it (the method could be abused by politicians). So its implementation might involve a one-off increasing of required reserves of commercial banks at the same time as an electronic drop and by precisely the same amount. Otherwise, there’s a risk of the initial simulative effect of money finance being harmfully multiplied by subsequent private credit creation. Delevering, meanwhile, could be approached by negotiated debt write-downs, restructurings, and allowing some untenable debts to default to avoid future moral hazard. One particular method of debt write-off, Turner suggests, is that sovereign bonds held by central banks could be re-written as perpetual non-interest-bearing debt, thus removing the burden of interest repayments and therefore reducing the overall debt burden. (This might not be possible, however, in the US where the privately owned Fed has an interest in earning a return on its bonds.)
For far too long, pre-crisis orthodoxy has led us to believe that we can rely on one policy (low and stable inflation) and one policy tool (interest rates). The author convincingly shows us how this is undermined by the search for yield: leads banks and individuals towards speculation and harmful financial innovation; the globalized financial system: surpluses in other countries have prevented delevering from occurring in others; and how its had disastrous consequences: increased inequality and the risk of continued secular stagnation.
The title of this book comes from the story of Part Two of Goethe’s Faust in which Mephistopheles, agent of the devil, tempts the emperor to distribute paper money to write off state debts and increase spending power. The empire enjoys a boom, but inevitably falls into an inflationary spiral.
Jen Weidman, president of the Bundesbank, cited this story in a 2012 speech. Such a view isn’t uncommon, and such widespread economic consensus is rare. Printing money is considered taboo, irrefutably so, in economics – historical examples of the Weimar Republic and Zimbabwe still in living memory – and yet if we can accept that the Efficient Market Hypothesis, which the REH forms the basis of, might be fundamentally flawed; and that less liquidity and greater financial fragmentation, while initially deflationary could lead to a long-term stability dividend; then perhaps we should look more seriously into printing money. It might be the only way out of liquidity trap we’ve placed ourselves in.