Lord Adair Turner gave the November SBE Masterclass on the subject of monetary policy after the crisis, outlining the content of his new book - “Between Debt and the Devil”. Lord Turner began by talking about the failure of forecasters to see the crisis coming, arguing that western economies remain in a deflationary trap. In the 60 years to 2007 debt ratios in advanced economies ballooned, yet this rung few alarm bells - it was seen as either ‘positively benign’ by the academic finance theorists or ‘neutral’ by monetarists.
Economic models had failed because they ignored the financial sector - money, credit and bank balance sheets. Monetary policy involved targeting low and stable inflation by using the single policy instrument of interest rates - reserve requirements were seen as old hat. But this generated the Great Moderation which ended in a major financial and economic bust.
The problem of seeing the banking sector only as a veil through which official interest rates feed through is that it ignores the facts that a) banks create credit and b) the vast majority of bank lending funds housing and consumption, as opposed to investment. The intermediation of household savings with productive investment is thus only a small portion of banks’ business. The more mortgage credit that is extended, the greater the upside for prices of inelastic housing and expectations of house price growth, in turn feeding stronger bank balance sheets - and so the cycle continues.
In many countries the value of urban real estate can account for most, if not all, of the rise in household wealth over recent years - not because of housing investment, but rather the rise in the value of the land on which those houses sit. The desire to spend money on housing is highly income elastic - people devote a rising portion of their income to live in a desirable location as incomes rise, and thus modern economies are naturally prone to becoming more housing centric, it is argued. The combination of housing being treated as an investment asset combined with inelastic supply creates the fuel for rising house prices.
When credit rises to high levels, a crisis of confidence leads to debt lingering in the economy as it did in Japan over the past two decades. Real estate prices started to fall in Japan in the early 1990s, following which corporates delevered by cutting investment - even with zero policy rates. This caused a continuation of recession and consequently rising public deficits. This public sector support offset the weakening in private sector demand, but as corporate debt came down public debt stocks rose sharply - the debt was shifting from the private to public sector, a pattern which has repeated itself across western economies over the past decade.
We are thus caught in a debt trap, Lord Turner argues, whereby the usual levers to support growth don’t work. Following the rise in public debt subsequent austerity programmes at the same time corporates are deleveraging would cause renewed recessions were it not for ultra loose monetary policy - the transmission mechanism of which is imperfect and is subject to diminishing marginal returns. For example - would another 10bp or 20bp of rate cuts really do much to help the economy? This looks like pushing on a string. What about rising bond prices that result from quantitative easing? This can cause rising inequality. What about the currency channel? While it may help individual countries it is hardly a solution to a global debt overhang. Thus it might seem that we are out of monetary and fiscal ammunition.
Why has credit growth not created excessive inflation but rather the risk of deflation? Lord Turner argues it is due to inequality - richer people have a lower propensity to consume, their savings being onlent to lower-income households to offset weaker income growth among those cohorts. Large rises in bank balance sheets can thus occur without increasing nominal aggregate demand. It is therefore important to look at credit in a disaggregated sense.
Lord Turner concludes his talk by asking two questions. First, how do we stop getting into such financial crises? As it is a combination of inequality, real estate demand, and global current account imbalances that cause such borrowing booms in the first place, it is these issues that need to be addressed. You can’t just rely on regulation according to Lord Turner. Some people argue we should abolish credit-creating fractional reserve banks. Indeed Lord Turner believes we have allowed the ‘fraction’ to be too low - in other words banks should be better capitalised (more like 5-1), with even higher capital requirements suggested for lending to real estate. Otherwise it will never be rational for private banks to limit lending for house purchase.
Second, how do we get out of the current post-crisis mess once we’re in it? Turner argues that central banks are actually not out of ammunition - if aggregate demand remains lacking, central banks and governments can always create demand by dropping helicopter money to fund the public deficit. Of course this is considered taboo in policymaking circles. Overt monetary financing (the permanent creation of central bank reserves) is technically possible but there are risks - authorities must be trusted with such a policy that it will be used appropriately. That authority should be an inflation targeting central bank.