CENTRAL BANKING AND MONETARY POLICY AFTER THE CRISIS

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1 CENTRAL BANKING AND MONETARY POLICY AFTER THE CRISIS Adair Turner OMFIF City Lecture London, 9 December 2014 The basic new Keynesian model lacks on account of financial intermediation, so money, credit and banks play no meaningful role (Mervyn King, Twenty Years of Inflation Targeting, Stamp Memorial Lecture, 2012) * ** In retrospect the economics profession s focus on money meaning various subsets of instruments on the liability side of bank balance sheets in contrast to bank assets - turns out to have been a half century long diversion which did not serve our profession well (Benjamin Friedman, Monetary Policy, Fiscal Policy and the Efficiency of our Financial System, 2102) * ** Ahead of the 2008 crisis, modern macroeconomic theory and central bank practice had gravitated towards the assumption that low and stable inflation was not only a necessary objective but sufficient to ensure macroeconomic and financial stability. It paid little attention to the details of the financial system, or to balance sheet aggregates such as the total amount of credit extended or the resulting level of private sector leverage. It rejected any idea that macroeconomic policy could or should distinguish between the economic function and benefit of alternative categories of credit provision. By contrast I will argue today that both the level of leverage and the mix between different categories of debt are fundamental determinants not just of financial stability narrowly defined, but of overall macroeconomic stability. Monetary and macro prudential policy together must therefore play a role in constraining and influencing both the quantity and the allocation of credit within the economy. And new policy approaches must build on new theoretical foundations. A focus on the demand for money tells us little; instead we need to focus on the impact of different categories of credit a disaggregated quantity theory of credit as it were. And we need to replace Wicksell s concept of the natural rate of interest, with a recognition of multiple different expected rates of return, varying by sector of the economy and potentially volatile over time. Discriminating between different categories of credit clearly contradicts pre-crisis orthodoxy. But several central banks are now doing so. (Exhibit 1). The Bank of England s Funding for Lending Scheme (FLS) has incentives deliberately skewed to boost SME lending but not mortgage lending. The ECB s new long-term repo facility, introduced in September, is similarly skewed; so too was the lending package introduced by the Bank of Korea in June. And earlier this year PBOC, seeking to support 1

2 growth but without further exacerbating the credit and property boom, made reductions in the required reserve asset ratio which are targeted on agriculture and particular categories of business. Many central bankers, I suspect, believe and hope that such discrimination is a regrettable necessity under extreme circumstances, and that we will eventually get back to a more neutral approach. My argument today is that no such return will or should occur, because different categories of credit perform different functions within our economy, with very different implications for macroeconomic stability. Leverage and pre-crisis orthodoxy I start my argument with an assertion to which I will return later and then justify. The most fundamental reason why the 2008 financial crisis has been followed by such a deep and long-lasting recession is the growth of real economy leverage across advanced economies over the previous half-century, with private sector credit to GDP growing from 50% in 1950 to 170% on the eve of the crisis (Exhibit 2). Of course the crisis itself was triggered by multiple dangerous developments within the financial system itself by excessively leveraged banks, dangerous maturity transformation, and by deficiencies within the complex set of developments we label shadow banking. But it is excessive leverage in the real economy of households and companies, and the resulting postcrisis debt overhang, which explains why six years of interest rates at close to the zero bound have only been able to produce slow and weak recovery. Ahead of the crisis, however, this growth in leverage rang few alarm bells. Rather indeed it was treated as either positively benign or simply neutral. The benign assessment dominated among finance theorists, and appeared to be supported by economic history and econometric results. Finance theory explains why the existence of debt contracts which promise an apparently fixed return facilitate a more effective intermediation of capital from savers to businesses/entrepreneurs than would be possible if only equity contracts existed. [Townsend 1979] And empirical analysis suggested that financial deepening - including in the specific form of increasing private credit to GDP was positively correlated with growth. [Levine 2004 ]Any concerns were therefore focused on countries such as India where private credit to GDP seemed too low. Any idea that private credit can grow to too high levels was largely absent. Modern macroeconomic theory and central bank policy analysis, meanwhile, tended to treat the growth of leverage as simply neutral. Indeed to a quite striking and surprising extent, it largely ignored the details of the financial system. Major textbooks of new Keynesian monetary theory say little about the role of banks and financial intermediation [Woodford 2003]. Central bank models used to inform policy-making so-called dynamic stochastic general equilibrium models had little or no role for the financial system itself. As Mervyn King put it The basic new Keynesian model lacks an account of financial intermediation, so money, credit and banks play no meaningful role. [King 2012] As Olivier Blanchard, chief economist of the IMF summed it up: We assumed that we could ignore much of the details of the financial system. 2

3 The financial system was thus treated as a neutral veil through which monetary policy passed to the real economy, but whose size and detailed structure were largely unimportant. And as long as central banks achieved low and stable inflation through interest rate policy, the level and mix of credit created seemed of no macroeconomic importance. Modern monetary theory is therefore strangely silent about credit and leverage. But it still rests, at least implicitly, on a theory about the relationship between credit creation and inflation which goes back to the Swedish economist Knut Wicksell. [Wicksell 1898]. Wicksell noted the ability of private banks to create credit, money and purchasing power, and worried that if they extended too much credit to businesses/entrepreneurs harmful inflation would result 1. This would be the case, he argued, if market rates of interest were set below the natural rate of interest, i.e. the return which businesses/entrepreneurs can earn on new capital investment. But as long as the central bank ensured that market interest rates were broadly in line with the natural rate, the pace of credit creation would be optimal. In fact, as Wicksell also argued, the natural rate cannot be directly observed, so central banks cannot follow a rule under which they set policy rates in line with it. But what they can do, is to set policy rates to deliver low and stable inflation knowing that such stability will only be achieved if the policy rate and the natural rate are aligned. Low and stable inflation therefore itself seems to ensure optimal credit creation, and central banks do not need to pay direct attention to the amount or the mix of credit being created, let alone to the details of the financial system itself. Alternative uses of credit Finance theory thus assumed that rising leverage was positively beneficial: modern monetary theory that it was neutral in terms of its macroeconomic effects, but optimal because finance theory says so. But both of these conclusions rest on dangerously mistaken assumptions. Pick up almost any standard economic textbook, and if it describes the banking system at all, it will typically set out how banks take deposits from savers (such as households) and lend the money on to entrepreneurs/businesses, thus allocating capital between alternative investment projects. But as descriptions of what banks or indeed many debt capital markets do in modern advanced economies, this is a largely fictional account for two reasons: First because banks do not just intermediate flows of already existing money from savers to borrowers, but create credit, money and purchasing power ex nihilo Second because most lending in modern economies does not finance new capital investment Obviously credit can be used to finance new capital investment, whether for instance in plant and machinery, in real estate or human capital. (Exhibit 3) And in relation to that element of credit, it might be somewhat true that excessive credit creation will tend to result in inflation, and that controlling inflation will therefore constrain excessive credit supply. 2 1 See Turner September 2013 for a more detailed discussion of Wicksell s analysis. 2 The belief that credit-fuelled over-investment cycles must produce excess inflation was however contested by F.A. Hayek in his Monetary Theory of the Trade Cycle [Hayek 1929]. See Turner September 2013 for a discussion of the link between real estate construction cycles and price cycles in existing real estate. 3

4 But two other uses are also important: First credit can be used to finance increased consumption enabling households to consume now and pay back later. That may sometimes, as economic theory suggests, be welfare enhancing enabling a more efficient inter-temporal allocation of consumption within lifetime permanent income constraints. But it has nothing to do with the allocation of capital. And the quantity of such credit extended is in no way governed by a relationship between the market and the natural rate of interest. And second it can be and to a very large extent is used to finance the purchase of assets which already exist. Those assets could include for instance, existing companies with buyouts often accompanied by significant increases in leverage but no increase in investment. But by far the most important existing asset is real estate. And the majority of bank lending in advanced economies is used to finance a competition between households and companies for the ownership of existing real estate, and effectively for the irreproducible urban land on which it sits. Exhibit 4 shows some figures for the UK in 2009, with total bank lending divided between consumer credit, residential mortgages, business lending for commercial real estate, and non-real business lending. Mapping these figures against the three conceptually distinct purposes of credit cannot be precise since: Lending against real estate (whether residential or commercial) can finance either actual real estate construction (Category 1 on Exhibit 3) or the purchase of real estate that already exists (Category 3) And a residential mortgage can be used either or both to fund the purchase of real estate assets (Category 3) or to fund increased consumption through equity withdrawal (Category 2) But while the mapping can only be imperfect, it is clear that the majority of lending in the UK before the crisis fell into Category 3, with a large element of Category 2 as well. Britain had a large mortgage and house price boom, but without a major construction boom. And a large slice of commercial real estate lending also supports investment in existing property assets not new construction. As for lending to finance investment apart from real estate, it is clear that it accounts for no more than around 15% of all UK bank lending. That pattern moreover is not peculiar to the UK but found across the advanced economies. Oscar Jorda, Moritz Schularick and Alan Taylor have analysed the percentage of total bank lending devoted to real estate in 17 advanced economy economies from 1870 on. [Jorda, Schularick and Taylor 2014] Their results illustrates the relentless rise in the importance of real estate from 1950 onwards, with increased real estate lending being by far the predominant driver of the increase in leverage shown in Exhibit 2. (Exhibit 5). As they conclude With very few exceptions, the banks primary business consisted of non- mortgage lending to companies in 1928 and 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. So the textbooks are wrong. At very least therefore we should change them to reflect reality. But we also need to recognise that lending against real estate which is in somewhat inelastic supply, has 4

5 powerful implications for financial and economic stability, which are not well captured by any concept of the relationship between the market and the natural rate of interest. For at the core of financial and macroeconomic instability in advanced economies lies an endogenous relationship between credit extension and asset prices, and above all real estate prices: In the upswing of the cycle (Exhibit 6) more credit extended against inelastic supply assets drives up the price, which then produces both increased credit demand and credit supply. On the borrower side the inner loop in Exhibit 6 observed asset price increases generate expectations of further increases, creating incentives to borrow more in order to enjoy capital gain or simply in order not to lose one s place on the housing ladder. While on the lender/supply side, rising asset prices mean lower loan losses, rising bank capital bases, increased capacity to lend, and increased confidence that further lending is likely to be profitable. In the downswing of the cycle, however, (Exhibit 7) the process swings into reverse, driving down both credit demand and credit supply in a self-reinforcing cycle. Because of these cycles, as Claudio Borio of the Bank for International Settlements has stressed, credit and real estate price cycles, are not just part of the story of financial instability and macroeconomic instability in advanced economies they are again and again almost the whole story. [Borio 2012] That was true in the Japanese banking crisis of the 1990s, the Scandinavian crisis of the early 1990s, and in our latest crisis of So clearly we must develop and deploy policy levers which will lean against those cycles and protect the financial system from their impact. That in itself justifies macro prudential tools of the sort that the UK Financial Policy Committee now has at its disposal. But our focus cannot be just on the resilience of the financial system itself, but on the macro economic impact of different categories of credit provision. We need indeed to recognise three key realities. First that there are underlying factors increasing the importance of real estate within advanced economies, which might increase instability even in the absence of credit finance. But credit supply further accentuates those risks Second that the most important cause of weak post crisis recovery is not an impaired banking system, but the real economy debt overhang and attempted private sector deleveraging. And third that excessive credit creation particularly when it takes particular forms - can produce severely harmful effects without ever producing excess inflation to which an inflation targeting central bank would feel compelled to respond 5

6 Real estate in advanced economies Thomas Piketty s book Capital in the 21 st century has rightly attracted great attention. [Piketty 2014] It focuses on the remarkable increase in the ratio of wealth to income (W/Y) which has occurred in advanced economies over the last 50 years. But what is startlingly clear from Piketty s own figures is that the predominant driver of that increase is the increasing value of real estate. Exhibit 8 shows the figures for the UK, with the W/Y ratio rising from around 2 in 1950 to over 5 in 2010, but with the vast bulk of that increase explained by the increasing value of residential homes. And again this phenomenon is not just British in most of the advanced economies which Piketty analyses, the lion s share of the increase in the W/Y ratio is explained by the rising value of houses relative to income. And the vast majority of that increase in turn, is explained not by new housing construction, but by the increase in the value of the urban land on which the houses sit. [Schularick 2014] So what is going on? I suggest three factors (Exhibit 9) The first is that as people get richer they tend to devote an increasing share of their income to the purchase of housing services. Other elements of consumption fall in importance either because of satiation (limits to how much food we wish to consume) or falling relative price (in particular for all products and services which are ICT intensive). But there is no necessary limit to how much of our income we will devote to competing with one another whether through the rental or ownership market for the right to live in the more attractive parts of town, or the ability to stay at the hotel close to the beach or close to the piste rather than far away from it. Expenditure on locationally desirable real estate is a high income elasticity consumption category : but if locationally desirable land is inherently inelastic in supply, the price relative to income will inevitably rise Second, however, if people observe that tendency and expect it to continue, it becomes rational to treat property as an investment asset class, valued because we expect capital gain or rental income, and not just because of the housing services we wish ourselves to consume. At the top end of the London market, multi-million pound flats are bought primarily as investment assets rather than as places actually to live: there are few lights on late at night at One Knightsbridge. But the investment class phenomenon reaches far wider than that as illustrated by the dramatic growth of the UK s buy-to let sector. Third and finally, we have the amplifying effect of leverage, with credit finance used to support both competition for desirable real estate as a consumption good, and investment in real estate as an asset class. These three factors together interacting with inelastic supply are bound to make the value of real estate increasingly important in modern advanced economies and bound therefore to make fluctuations in real estate price an increasingly important source of potential instability. Leverage against real estate plays an important role in these interactions. But it is not the sole factor at work: and we would I suspect see an increasing relative importance of real estate, both as a desired consumption good and as an investment asset, even if credit against real estate had not become so dominant in the banking system as Jorda, Schularick and Taylor s figures demonstrate. 6

7 While managing the real estate credit cycle is therefore vitally important, other aspects of public policy such as those relating to urban design and the supply of new housing or to the tax treatment of property ownership also have a vital bearing on macroeconomic stability as well as being important in and of themselves. Debt overhang more dangerous than impaired banks I began by asserting that the most fundamental reason why the post crisis recession was so deep, and recovery so weak and slow, was the increase in private sector leverage shown in Exhibit 2. Let me know justify that assertion. Ahead of the crisis we should have been more aware of the dangers of excessive leverage, because we had a canary in the mine, an example of how harmful debt overhang can be. That canary was Japan. In the 1980s, Japan experienced an extreme version of the credit and real estate cycle shown on Exhibit 6. Credit extended to finance real estate grew at around 30 to 40% per annum: urban land prices increased four times in five years. In 1990 the boom ended, and confidence crash: commercial real estate prices fell 80% as the red down cycle (Exhibit 7) replaced the green up. What followed, in Richard Koo s terms, was a severe balance sheet recession. [Koo 2009] Companies which had previously borrowed money aggressively to invest in real estate now felt overleveraged, and cut investment in an attempt to reduce debt. The corporate net financial balance swung from deficit to surplus (Exhibit 10). The Bank of Japan cut interest rates close to 0, but even at close to zero, companies were uninterested in borrowing money because focused on balance sheet repair. Reduced investment depressed the economy and drove public finances into deficit, as taxes fell and social expenditures rose. Those fiscal deficits in turn played a useful stabilising role, offsetting the depressing effect of private sector deleveraging. Indeed Richard Koo argues persuasively that without them Japan would have suffered not just two decades of slow growth and mild deflation, but a really severe great depression. But the inevitable consequence of large public deficits was that public debt to GDP grew relentlessly reaching 230% of GDP today. Private sector deleveraging was offset by a public sector leverage increase. (Exhibit 11) Indeed what Japan illustrates is that once excessive leverage has first developed, it seems impossible to get rid of it, rather than simply shift it around from the private to the public sector. That was the pattern in Japan after 1990 and that too has been the pattern in many countries after the crisis of Thus for instance in the UK, Spain and the US (Exhibit 12) private sector households and corporate sectors have begun to deleverage, but for every percentage point of private deleveraging, public debt to GDP has increased by even more. At the level of the whole world indeed, as the recent Geneva Report by the International Centre for Banking and Monetary studies illustrates, we have seen no overall deleveraging, but a gradual increase in total leverage private and public combined (Exhibit 13) [ICMB 2014] The central economic problem of the post-crisis period is thus that we are struggling with a huge debt overhang. And the most important reason why demand has been depressed is not that the financial 7

8 system has been impaired and unable to provide new credit supply, but that overleveraged households and companies do not wish to borrow. That argument has been illustrated by Atif Mian and Amir Sufi in their important new book House of Debt. [Mian and Sufi 2014] They illustrate how declines in consumption county by county across the US, are closely correlated with the level of household indebtedness. And business borrowing, they argue persuasively, has in turn been depressed, not primarily because of constraints on new bank credit supply resulting from an impaired financial system, but because of a lack of consumer demand. And while Eurozone policy has been predicated since 2012 on the belief that economic growth is held back by an impaired financial system unable to provide adequate new credit supply, the limited take-up of the ECB s new targeted LTRO scheme in September this year with banks utilising only 80 billion of the 400 billion made available clearly suggest that demand factors are more important. Indeed the ECB s own analysis referred to for instance in its May Monthly Bulletin has always recognised that demand factors are somewhat more important than supply. Recovery has been slow primarily because of the deflationary impact of attempted private sector leveraging by households and companies. Two implications for policy follow: The first is that we face extremely difficult policy choices as we attempt to escape from the post-crisis recession. Indeed it has sometimes seemed that all our policy levers are blocked, ineffective, or have adverse side-effects. Increased fiscal deficits would undoubtedly help to stimulate demand, but that option appears blocked by concerns about long-term public debt sustainability. Ultra-loose monetary policy can be used instead to achieve stimulus, but its effectiveness may wane over time, and as the IMF argues in its latest Global Financial Stability Report, it may be more effective in stimulating risky financial engineering than in stimulating new business investment and growth. [IMF 2014].We face indeed the paradox that ultra-loose monetary policy can only stimulate the economy by engineering a resurgence of the very private credit growth which helped generate the debt overhang problem in the first place. We thus seem out of ammunition, the policy magazine empty. In fact as I have argued elsewhere, in the face of deflationary risks the policy magazine can never be empty. There always remain policy options such as monetary finance of increased fiscal deficits which while radical, controversial, and undoubtedly entailing risks, should nevertheless be considered. [Turner February 2013] The second implication however, and my focus today, is simply that if excessive private debt results in crisis, post-crisis debt overhang and deflation, we need to design policies which can in future lean against excessive credit growth, and in particular against the growth of those forms of credit which cause most harm. 8

9 Excess credit growth without excess inflation Wicksell argued that if central banks set policy interest rates to achieve low and stable inflation, that would ensure a broadly optimal pace of credit creation. Conversely if policy and market rates were set below the natural rate, excessive credit creation and harmfully high inflation would result. But in the years of the Great Moderation, low and stable inflation was combined with credit growth far faster than nominal GDP growth, producing rising leverage, eventual crisis and post-crisis recession. Nominal GDP in advanced economies typically grew at around 5% per annum, appropriately in line with real growth potential and low inflation: but private credit grew at around 10 to 15% per annum. So how is it possible to have credit growth continually faster than nominal GDP growth without that producing accelerating nominal demand growth and inflation? 3 The answer lies in the different categories of credit already described. And the implication is that public policy must focus on constraining some specific categories of credit growth even though these will never produce excessive inflation. The impact of credit creation on nominal demand varies by category (Exhibit 14): If all credit was extended for the purpose described in textbooks to finance new capital investment it would have a first round effect which directly stimulated nominal demand. More capital investment in real estate construction, for instance, stimulates demand for construction workers. Whether, to what extent and when this will produce inflation, depend both on the amount of slack within the economy, and on the ease with which factors of production can move from consumption to investment focused sectors. But it is likely that rapid growth credit growth of this sort, continued over a long period, would tend to produce rapid nominal GDP growth and potentially inflation. If all credit was of this form, over investment bubbles financed by excessive credit would still be possible, but would likely result at some time in inflation to which inflation targeting central banks would feel compelled to respond The same would appear to be true when credit is extended to finance consumption: again here there is a first round effect which stimulates increased nominal demand someone borrows money and they are able to afford consumption which would not otherwise occur. But in an environment of increasing inequality, this stimulative impact may be required simply to offset a deficiency of nominal demand which would otherwise result. For if richer people have a higher marginal propensity to save than poorer, and if there is no automatic mechanism ensuring that the increased desired savings of the rich are matched by increased investment, rising inequality will produce deficient demand unless the savings of the rich are channelled to middle and lower income borrowers through the financial system. Rising consumer credit as a percent of GDP (and/or rising mortgage debt) can therefore be required to achieve merely adequate growth in nominal GDP: and leverage can increase to levels which endanger harmful debt overhang effects without that increase ever generating excess inflation. 3 See Turner 2014 for a more detailed discussion of this apparent conundrum. 9

10 Most importantly, however, credit growth which finances the purchase of existing assets in particular real estate can exceed nominal GDP growth for many years, and can produce dangerous asset price bubbles and leverage levels, without ever producing an acceleration of nominal GDP. For here in distinction to Categories one and two there is no first round effect which stimulates nominal demand for the goods and services which enter GDP. The first round effect is instead simply an increase in credit extended to some households, an increase in bank liabilities held by others, and an increase in existing asset prices. Of course it is possible that nominal demand might subsequently be stimulated by wealth and Tobin s Q type effects; but there is no reason to believe that these effects will be fully proportional to the increase in credit and asset prices. Thus for instance in the UK between 2000 and 2007 (Exhibit 15), mortgage credit grew by 97%, household deposits by 79%, the value of all residential real estate by 105%, but nominal GDP grew by only 44%, an annual rate of 5.3%, broadly compatible with the Bank of England s 2% inflation target. Different forms of credit therefore have very different implications for nominal demand and thus potentially for inflation, and we cannot understand the overall impact without taking a disaggregated approach. Richard Werner s analysis of Japan in the 1980s and 90s disaggregates bank lending between that which funded real estate investments and all other, which he labels credit for GDP transactions. The former was broadly correlated to real estate prices (Exhibit 16) and the latter (which in the 1980s grew far more slowly) was broadly correlated with nominal GDP (Exhibit 17). But both contributed to the problem of debt overhang with which Japan was left after the real estate bubble burst. Credit and existing asset price cycles therefore matter in and of themselves, not because of their impact on nominal demand and output gaps. And banking balance sheet aggregates matter. Not because rapid money growth is a good forward indicator of future inflation But because credit and leverage growth particularly when it takes a Category 2 or 3 form can be forward indicators of crisis, post-crisis debt overhang, deleveraging and deflation The money delusion and the quantity theory of credit Before the crisis, however, central bank practice and modern monetary theory paid decreasing attention to balance sheet stocks, whether in aggregate or by category. Part of the reason for that decreased focus was that many policy makers and economists drew the wrong conclusion from the declining velocity of circulation of money. Facing the high inflation of the 1970s and early 80s, many central banks were influenced by monetarist arguments that aggregate money stocks were good forward indicators of inflation. The identity MV=PY implied a strong correlation between money stock (M), and nominal GDP (PY) if velocity (V) could be assumed relatively stable over time. And that assumption seemed to follow from the fact that the demand from money was governed by the function f (i,py), with increasing transaction money balances required if nominal GDP grew, and with the interest rate i determining the willingness of people or companies to hold non-interest-bearing money balances, rather than interest-bearing bonds. But this description of the demand from money makes little sense in a modern economy with a highly developed banking system. Most money is not held for transactions purposes but as a store of savings value an alternative to other financial instruments such as bonds or equities. Most money 10

11 is interest-bearing, so that the opportunity cost of holding it is not given by the interest rate i, but by the differential between the interest rates paid on different variants of money and the return on alternative assets. Sometimes indeed, the interest rate paid on some categories of money (e.g. some retail deposits) can exceed the interest rate paid on free risk-free bonds, making the opportunity cost of holding money rather than government bonds negative. Interest-bearing money, moreover, can often be used for transactions purposes, either directly, or through instantaneous conversion to transactions money when needed. And what we label money (apart from notes and coins) is simply a rather arbitrary and changing subset of all bank liabilities. Given these complexities, it is hardly surprising that attempts to understand the changing demand from money have proved unsuccessful, and that money balances have proved to be of little predictive power. Money essentially results as the by-product of a credit creation process, rather than as something demanded in and of itself 4. As Benjamin Friedman has put it In retrospect the economics profession s focus on money meaning various subsets of instruments on the liability side of bank balance sheets in contrast to bank assets - turns out to have been a half century long diversion which did not serve our profession well. But that does not mean that bank balance sheet aggregates are unimportant, but rather that to understand their implications we must switch focus to the asset/credit side of the balance sheet. Instead of an aggregate quantity theory of money, given by the equation MV=PY, we should therefore think more in terms of a disaggregated quantity theory of credit (Exhibit 18) in which: increased credit extended against inelastic supply real estate will produce increases in the price of real estate, while increases in credit extended to finance current GDP transactions will tend to have some relationship to nominal GDP. And we should recognise that if credit against existing real estate (or other non-gdp related transaction) is growing faster than credit to finance GDP transactions, bank assets (and thus bank liabilities, and probably that subset which we label money) will grow more rapidly than nominal GDP, so that the velocity of money circulation will fall. 4 James Tobin argued in Commercial as Creators of Money [Tobin 1963] that the fact that a bank creates money when it extends credit does not mean the demand for money is irrelevant, since if households or corporates do not want to hold the new money created, they can pay down debt and money balances elsewhere in the system. The amount of money created has to be freely held by some combination of households and corporates. Therefore a set of prices must exist which leaves corporates and households in aggregate content to hold the stock of money created, rather than to switch (in aggregate) from money to other assets such as bonds or property, or to pay down debt. Asset portfolio allocations have to be in line with preferences given the prices prevailing. But this equilibrium set of prices can be achieved (and indeed is more likely to be achieved), not by any pay down of debt somewhere else in the system (and thus destruction of the newly created money) but by some combination of: 4 (i) an increase in interest rates on some categories of money balance (so that savings deposits pay close to or even above the bond rate); or (ii) the purchase of other categories of assets (e.g. property) which induces a change in the price of those assets so as to bring agents asset portfolios in line with preferences. Thus if money creation results in too much money for aggregate household portfolio preferences, balance can be restored by an increase in the value of other assets, such as property, rather than by a reduction of money balances (achieved by a pay down of debt). The extension of bank credit, therefore, drives a matching increase in money or some other category of banking (or shadow banking) system liability. And the aggregate value of these liabilities, or even of some subset which has strong money like characteristics, cannot be expected to bear any particular relationship to nominal GDP. 11

12 Thus while the fall in V observed in many countries in the 1980s and 1990s (Exhibit 19) was initially described as an enigma which needed to be explained, it was in no way enigmatic, but followed inevitably from increasing credit and leverage devoted to the purchase of existing assets. Faced with declining and unpredictable velocity, and thus a demand from money function which appeared unstable, central banks and monetary economists tended to the assumption that if money was not a good forward indicator of inflation, then aggregate balance sheets did not matter much at all. The focus on money rather than credit led us astray. Policy implications beyond inflation targeting What then are the implications for monetary and macro prudential policy? I will argue that we need to move beyond inflation targeting, and that central banks and macro prudential regulators need to influence and manage the quantity and allocation of credit in the economy. But I want first to stress two fundamental drivers of potential instability which we cannot expect to constrain by monetary and macro prudential levers alone, and thus two aspects of policy that do not fall to central banks or macro prudential regulators: First policies to address the rising importance of real estate within advanced economies, and the resulting potential instability. Policy levers here must include those which make the supply of locationally desirable real estate less inelastic, or which reduce tax advantages of property as an investment asset class. If we attempt to control the property cycle solely with monetary and macro prudential tools, we will almost certainly fail, and produce harmful distributional effects. 5 Second, policies to address the rising inequality which seems to make rising credit intensity doubly necessary both to maintain the standard of living of the poor, and to offset the rising savings of the rich. Here too we cannot solve the problem by monetary and macro prudential policy alone indeed simply constraining the credit growth which results from rising inequality might make secular stagnation inevitable. We must not therefore overburden central banks and macro prudential regulators with policy responsibilities they cannot alone deliver. But that recognised, the implications for monetary and macro prudential policy are still profound, and the pre-crisis orthodoxy of one objective (low and stable inflation) and one instrument (the policy interest rate), is clearly now inadequate (Exhibit 21) The objective cannot be just low and stable inflation because excessive credit growth can produce severely harmful effects without ever producing excess inflation. That is now largely accepted. But nor can we rely solely or even primarily on one instrument the policy interest rate That second assertion is subject to more debate. For there is a school of thought which while accepting the need to respond to credit upswings even when inflation is low and stable believes that 5 Thus, for instance, tight loan-to-value or loan-to-income limits on household mortgages will tend, if accompanied by still rapidly rising house prices, to have a disproportionate impact on people with limited initial wealth. 12

13 this should be done primarily by setting the policy interest rate higher than pure inflation targeting would then indicate. Two arguments are made for this approach (Exhibit 21): First, that when we move interest rates, market arbitrage ensures that we influence all interest rate based contracts throughout the financial system and economy. In Claudio Borio s words, the interest rate instrument reaches the parts of the system which other instruments cannot reach. Or, as Jeremy Stein puts it, interest rates get into all the cracks. [Stein 2013] By contrast, with quantitative macro prudential levers, regulatory arbitrage acts to undermine their effectiveness. Second that the effectiveness of macro prudential tools is unproven, their appropriate calibration unclear, and the risk of unintended consequences great. Both arguments have some power: and both therefore argue for a combined approach, using the policy interest rate alongside macro prudential tools. Specifically that implies that there may be occasions when interest rates should be set higher than a pure inflation targeting approach would suggest. But there is also a strong and conclusive argument why interest rate movements alone will never be sufficient to tame the power of the credit cycle. And that argument is yet again rooted in the very different categories of credit and the different economic functions which they perform. Different categories of credit are likely to display very different elasticities of response to changes in interest rate. If, for instance, house or commercial real estate prices are rising at 10 or 15% per annum, and if borrowers and lenders as a result expect further significant increase, then raising the policy interest rate from, say, 5% to 5.5 or 6% will likely have little impact on the real estate credit and asset price boom, but raising it from 5 to 10% will cause serious harm to business investment, growth and employment long before it slows down the boom. 6 What this illustrates indeed is the unreality of the assumption that there is one natural rate of interest defined by the marginal productivity of new capital investment which can describe borrower behaviour. Expected return is both volatile over time and potentially highly variable by sector. And particularly when return comes from the rising value of existing assets such as real estate, expectations are endogenously generated and self-reinforcing. In an advanced economy where existing real estate accounts for the majority of all assets, and real estate lending the majority of all credit supply, there is no one natural rate of interest rooted in the physical reality of investment returns, but several different and potentially unstable expected rates of return. We cannot therefore avoid the need for central banks and macro prudential regulators to play a role in managing and constraining the credit cycle, and to do so in a way which distinguishes between the different economic functions and different interest rate elasticity of different categories of credit provision. 6 The recent Swedish experience illustrates this point. Between 2010 and 2012 the Riksbank raised interest rates to slow down a Stockholm property boom; the boom continued but the Swedish economy fell into slow growth and deflation. 13

14 Specific policies distinguishing credit categories So what specific objectives and policies does that imply? I suggest three objectives, the first increasingly accepted, the latter two still not fully agreed (Exhibit 22) First, central banks and macroprudential regulators need to lean against credit and asset price cycles and in particular constrain the self-reinforcing upswing of the cycle illustrated in Exhibit 6. That objective is already defined in the Basel III capital adequacy regime, which establishes a counter cyclical capital buffer, and the guideline that it should be applied if the pace of credit growth exceeds past trend. Second, however, our aim should reach beyond constraining the pace credit growth, to include also limits on the level of private sector leverage. For while rapid credit growth above trend may be a good predictor of financial crisis, once the crisis occurs it is the debt overhang effect which drives post-crisis deflation, and the severity of that effect must depend on the absolute level of debt relative to income. This focus on the level rather than pace is not yet agreed. Indeed the Basel III guideline implicitly assumes that the level of leverage is of no importance, since it assumes that credit growth in line with past trend is acceptable even if trend growth exceeds nominal GDP growth, making further increases in leverage inevitable. In future, central banks and regulators should pay attention to the absolute level of leverage and act more aggressively to contain new credit creation, the higher the level of leverage already achieved. Third, we should act to lean against the naturally arising bias system towards excessive real estate lending. Lending against real estate is the predominant cause of financial instability, and the leverage created by it is the predominant cause of post-crisis stagnation. But seen from the purely private perspective of bank lenders, it will often appear and indeed often will be low risk. The central problem indeed is that real estate lending can generate an adverse social externality which it will never be within the interest of private banks to take wholly into account. It is possible for instance to imagine circumstances in which: Banks lend aggressively against existing real estate, generating increased prices and increased household leverage. After a crack in confidence, house prices fall, and households try to delever, cutting consumption in the fashion described by Atif Mian and Amir Sufi. But with the losses incurred by banks being sufficiently low that, across the whole cycle and offset by good year profits, aggressive real estate lending is still rationally attractive. The deflationary impact of attempted leveraging can result from the action of borrowers who do actually pay off their debts in full: and balance sheet recession could occur even without loan losses which threatened bank solvency and financial crisis. Lending which is good lending from a private perspective, can contribute to a collectively harmful result. Rational well-run banks will therefore lend more against real estate than is socially optimal: public policy needs to lean against that bias. As for tools, these should include two measures focussed on lending in general 14

15 Much higher bank capital requirements, which will both reduce the risk of financial crisis, and place some limits on the total level of leverage in the real economy. And much higher counter cyclical capital buffers than currently agreed under Basel III But they should in addition include actions which directly address the bias of system towards real estate lending. These should include: Setting capital risk weights for real estate lending significantly above those which private assessments of credit risk will ever suggest are appropriate. Under the advanced internal rating system, introduced by Basel II, banks make their own assessments of credit risk; and these assessments often suggest weights for residential real estate lending of 10% or less, against the 100% typical for lending to SMEs. And seen from a purely private perspective real estate lending can indeed seem less than a tenth as risky as lending to SMEs. But these assessments fail to take account of the social externality effect. Regulators should set minimum floors for real estate weights far above those which private risk assessments will make suggest appropriate. Borrower as well as lender constraints, such as maximum loan to value and loan to income limits. These measures will all in different ways constrain lending, overall or by particular category, below that which would otherwise occur. And we have to be clear that that is the specific objective. The focus of macro prudential policy should be not just the resilience of the financial system itself, but the management of credit creation to avoid excessive leverage. And constraints on excessive credit creation in particular against real estate should not therefore be viewed as the unfortunate or unintended consequence of macro prudential policy, but the quite overt aim. Finally, should we not consider the argument for licensing a particular category of banks which have a dedicated focus on lending money to businesses to fund business growth, and which are explicitly excluded from other categories of lending? After all that is what our economic textbooks suggest all banks already do. A major shift but already occurring Such policies would represent a very major shift from pre-crisis orthodoxy. And they rest on a theoretical base which is not yet fully accepted: The idea that central banks and regulators should favour some categories of lending over others is still treated with suspicion. And the idea that macro prudential policy should be focused on the macroeconomic consequences of the credit cycle rather than solely on the resilience of the financial system itself was explicitly rejected in the design of the formal remit of the UK FPC. But under pressure of circumstances, the shift is already occurring (Exhibit 23) 15

16 The Bank of England s Funding for Lending Scheme is now designed quite explicitly to incentivise banks and building societies to boost their lending to the UK real economy with incentives to boost lending skewed towards SMEs And when the FPC took action at the June 2014 meeting to constrain further growth of high LTI mortgage lending, the potential for household indebtedness to lead to a large adverse impact on aggregate demand was an important reason for that action. [Bank of England 2014] The Bank of England is thus already discriminating between alternative uses of credit, and using macro prudential tools for macroeconomic purposes rather than solely to ensure financial system resilience. We should not see such actions as simply regrettable necessities under today s extreme circumstances. Rather they are early steps towards a new approach which will see managing the quantity and broad allocation of credit creation as a vital policy objective. 16

17 References Bank of England: Quarterly Bulletin Q3, September 2014 Borio, Claudio: The Financial Cycle and Macroeconomics: What Have We Learnt?, BIS Working Paper No. 395, December 2012 ( Friedman, M. Benjamin: Monetary Policy, Fiscal Policy, and the Efficiency of Our Financial System: Lessons from the Financial Crisis, International Journal of Central Banking, Vol 8, ( ), January 2012 Hayek, Friedrich A.: Monetary Theory and the Trade Cycle. First published in 1929; reprinted in Prices and Production and Other Works; Ludwig von Miles Institute, ICMB/CEPR: Deleveraging, What Deleveraging? The 16th Geneva Report on the World Economy. Report authors: Luigi Buttiglione, Philip Lane, Lucrezia Reichlin, Vincent Reinhart. September 2014 International Monetary Fund: Global Financial Stability Report. Monetary and Capital Markets Department on Market Developments and Issues, IMF, October 2014 Jordá, Oscar, Moritz Schularick and Alan Taylor: The Great Mortgaging: Housing Finance, Crises, and Business Cycles, NBER Working Paper No , September King, Mervyn: Twenty Years of Inflation Targeting, Remarks at the London School of Economics, Stamp Memorial Lecture, 2012 ( Koo, Richard: The Holy Grail of Macroeconomics: Lessons from Japan s Great Recession, Wiley, Levine, Ross: Finance and Growth: Theory and Evidence, NBER Working Paper No , September 2004 ( Mian, Atiff and Amir Sufi: House of Debt: How They (and You) Caused the Great Recession and How We Can Prevent it from Happening Again. Chicago University Press, forthcoming Piketty, Thomas: Capital in the Twenty First Century, Harvard University Press, April 2014 Schularick, Moritz, K. Knoll and T. Steger: No Price Like Home: Global House Prices, , Centre for Economic Policy Research, Discussion Paper 10166, September Stein, Jeremy: The Fire-Sales Problem and Securities Financing Transactions, Remarks at the Federal Reserve Bank of New York Workshop on Fire Sales as a Driver of Systemic Risk in Triparty Repo and other Secured Funding Markets, New York, 4 th October Tobin, James: Commercial Banks as Creators of Money, Cowles Foundation Discussion Paper No. 159,

18 Townsend, Robert: Optimal contracts and competitive markets with costly state verification, Journal of Economic theory, 21(2), , Turner, Adair: Escaping the Debt Addiction: Monetary and Macro-Prudential Policy in the Post-crisis World. Lecture at the Center for Financial Studies, Frankfurt, February Turner, Adair: Credit, Money and Leverage: What Wicksell, Hayek and Fisher Knew and Modern Macroeconomics Forgot. Conference on Towards a Sustainable Financial System", Stockholm School of Economics, September Turner, Adair: Debt, Money and Mephistopheles: How Do We Get out of This Mess? Lecture at Cass Business School, London, February Werner, Richard: New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance, Palgrave MacMillan, Wicksell, Knut: Interest and Prices; Macmillan, First published as Geldzins and Guiterpreise (1898) Woodford, Michael: Interest and prices: Foundations of a theory of monetary policy, Princeton University Press,