Creating Money: for what purpose?

Creating Money: for what purpose? Towards a Sustainable Financial System London School of Economics 21 March 2014 Adair Turner Senior Fellow, INET www.ineteconomics.org www.facebook.com/ineteconomics

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 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-termeconomic-stability) 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 Bank Loan to entrepreneur 100 100 Credit to entrepreneurs deposit account 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 Pure metallic money Money supply constrained by precious metal resources Real growth may require downward flexibility of wages and prices Pure hoarding possible Alternatives / complement Pure fiat money creation: unfunded fiscal deficits Private bank (or other) credit extension Funded fiscal deficits 5

Alternative ways to stimulate nominal demand Pure fiat money: unfunded fiscal deficits New money Increase in private NFA Private credit and money creation New money And future private debt No increase in private NFA But maturity transformation Funded fiscal deficits No New money But increase in private NFA And future public debt liability 6

Advantages Disadvantages Fiat money creation Always possible Public authorities can choose optimal quantity Allocation is political decision Tendency to excessive use Private credit creation Allocation determined by market disciplines Is the amount created optimal? Implications of resulting debt contracts? 7

Banks create credit, money and purchasing power Bank Loan to entrepreneur 100 100 Credit to entrepreneurs deposit account Wicksell s thesis: Bank purchasing power creation optimal if: Money Rate of Interest = Natural Rate of Interest (MPC) 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

Potential Benefit Credit driven forced saving More rapid rate of growth Japan/Korea financial repression models of development Potential Disadvantage Over-investment cycles Macro-economic imbalance Growth sustained by yet more credit 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 Low and stable inflation objective Financial system a veil money, credit and banking play no meaningful role Implicitly Wicksellian Finance theory 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 Upswing Cycles of over-supply and over-demand Local thinking 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) Real GDP Real credit to households Real credit to NFCs United States United Kingdom Source: Monthly Bulletin, European Central Bank, January 2014 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

% of GDP China: total social finance to GDP 220 200 180 160 140 120 100 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 18

The Dilemma Pre-crisis path of nominal GDP growth Pre-crisis path of credit growth 4% - 5% 10% - 15% 2% real growth 2% inflation 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 19

Theory: Money creation and debt Empirics: Rising leverage and the policy conundrum Categories of credit Implications 20

Three conceptually distinct functions of lending Finance of increased consumption Enabling inter-temporal shift of consumption within life time income Finance of new capital investment Non-real estate Commercial real estate Residential real estate Human capital Finance of purchase of existing assets Real estate Collectibles Existing business assets e.g. Leveraged Buy Outs 21

Categories of debt: UK, 2009 bn Other corporate Commercial real estate 232 243 Primarily productive investment Some productive investment and some leveraged asset play Residential mortgage (including securitizations and loan transfers) 1235 Mainly purchase of existing assets But also achieves life-cycle consumption smoothing Unsecured personal 227 Pure life-cycle consumption smoothing 22

Credit and asset price cycles Increased credit extended Increased lender supply of credit Increased borrower demand for credit Increased asset prices Expectation of future asset price increases Favourable assessments of credit risk Low credit losses: high bank profits Confidence reinforced Increased capital base 23

Index: 2000 = 100 % GDP Credit extension and house prices House prices 2000 2007 Household debt as a % of GDP 2000 2007 250 120 200 100 150 80 60 100 40 50 20 0 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Spain US UK Ireland 0 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 US UK Spain Ireland Source: Ministry of Housing (Spain), S&P (US), DCLG Source: BEA; ONS; ECB 24

Inequality, demand and credit Rich have higher marginal propensity to save than poor + Savings not matched by investment Rich lend to poor Central bank facilitates Rising inequality Deflationary impetus growth of NGDP falls Deflationary impetus offset: NGDP growth maintained Growth in credit intensity 25

Global current account balances as a % of world GDP 1 0.5 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008-0.5-1 -1.5-2 United States Germany+Japan Developed Rest OPEC Developing Rest China Source: IMF BOPS 26

The problems with debt Upswing Cycles of over-supply and over-demand Local thinking Downswing Bankruptcy and default Rollover need and impaired lending capacity Debt overhang 27

% GDP Japanese government and corporate debt: 1990 2010 250 200 150 100 50 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 20010 0 Bank lending to non-financial corporates General Government debt Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations 28

Shifting leverage: Private and public debt-to-gdp 29

Advantages Disadvantages Fiat money creation Private credit creation Always possible Public authorities can choose optimal quantity Allocation determined by market disciplines Optimal amount ensured by policy interest rate? Allocation is political decision Tendency to excessive use Market misallocation possible Overinvestment cycles Existing asset price cycles No, because of heterogeneity of interest rate elasticity Ongoing debt contracts rollover and overhang effects 30

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 Increase capital risk weights for Constrain real level estate as well finance as rate above of IRB growth estimates of leverage Social optimal weights Address externality and bias privately optimal LTV and LTI limits in real estate lending Borrower constraint since lender constraints imperfect Banks with dedicated focus on non-real estate business finance Constrain level as well as rate of growth of leverage To avoid crowding out 33