MONETARY POLICY AND FINANCIAL

STABILITY IN THE MODERN ECONOMY

Adair Turner Chairman, INET

www.ineteconomics.org | 300 Park Avenue South | New York, NY 10010 | 22 Park Street | London W1k 2JB

Princeton

18th February 2016

Private domestic credit as a % of GDP: Advanced economies 1950 – 2011

1

Source: Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, C. Reinhart & K. Rogoff, 2013

“I am unable to take seriously people who complain about crisis but [do not ] talk about debts, whereby ‘debts’ I mean any obligation whose amount remains fixed or changes little when prices change”

2

Luigi Einaudi “Debiti”, 1934

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

3

Pre-crisis orthodoxy: monetary policy

4

Mervyn King Twenty Years of Inflation Targeting,

The Stamp Memorial Lecture, 2012)

We assumed that we could ignore much of the details of the financial system Olivier Blanchard

Chief Economist of the IMF, October 2012

The dominant new Keynesian model of monetary economics

lacks an account of financial intermediation, so that money,

credit and banks play no meaningful role

Textbook descriptions of banks and bank lending

5

Banks take

deposits of money

from savers and

lend it to

borrowers

Banks lend money to ‘entrepreneurs/ businesses’, thus allocating funds between alternative investment projects

Wicksell’s logic: I

Credit extended to entrepreneurs/businesses to fund capital investment

6

Marginal productivity of capital = Natural rate of interest

If Policy/Market rate < Natural rate Mal-investment and inflation

If Policy/Market rate = Natural rate Optimal investment and price stability

Wicksell’s logic: II

Natural rate is unobservable

7

But if Policy rate varied to ensure price stability

Then Policy/Market rate Natural rate ͠͠

Inflation targeting objective Credit creation and leverage optimal if price stability achieved

Three conceptually distinct functions of lending

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 8

Categories of bank lending: UK, 2009

9

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

Share of real estate lending in total bank lending

Source: The Great Mortgaging, Professor Alan Taylor, University of California, Davis

10

11

“With very few exceptions, the banks’ primary business

consisted of non- mortgage lending to companies in 1928

and 1970. 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.”

Oscar Jordá, Moritz Schularick and Alan Taylor,

“The Great Mortgaging”, 2014

Credit and asset price cycles: upswing

12

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

Credit and asset price cycles: downswing

13

Expectation of future asset price

falls

Less credit extended

High credit losses: low bank profits • Confidence dented • Reduced capital base

Falling asset prices

Restricted lender supply of credit

Cautious assessments of

credit risk

Reduced borrower

demand for credit

0%

100%

200%

300%

400%

500%

600%

700%

800%

1700

1750

1810

1850

1880

1910

1920

1950

1970

1990

2010

Net foreign assets

Other domestic capital

Housing

Agricultural land

Capital in Britain 1700 – 2010

14

% n

atio

nal i

ncom

e

Source: Capital in the Twenty First Century, T. Piketty (2013)

Desirable urban land: a market without equilibrium?

15

Indeterminate price – is there

an equilibrium?

Potentially infinite supply of credit

and private money

Highly income elastic demand

Capital gains motivation

Expectations prices expectations

Inelastic supply of

locationally specific land

16

The Orthodoxy As long as price stability is achieved, the level

and mix of private sector leverage can be ignored

Underlying assumption

Policy rate = natural rate optimal credit creation and allocation

Problems

With inefficient markets, self-fulfilling expectations and lending against irreproducible assets:

• Policy rate ≠ Market rate because of endogenous variation in spreads

• Expected private returns are heterogeneous by sector and unstable over time

?

Two questions:

17

Why does the growth in leverage matter?

How is it possible without stimulating inflation? ?

Sectoral financial surpluses/deficits as % of GDP: Japan 1990 – 2012

Source: IMF, Bank of Japan Flow of Funds Accounts

-15

-10

-5

0

5

10

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

PNFCs Government

%

18

Japanese government and corporate debt: 1990 – 2010

0

50

100

150

200

250

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Bank lending to non-financial corporates General Government debt

19

Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations

% G

DP

50

65

80

95

110

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Household Non-financial Corp Public

% G

DP

Source: Geneva Report No 16 Deleveraging, What Deleveraging? ICMB / CEPR September 2014

Developed economies – Debt to GDP

20

Global debt excluding financials

Source: Geneva Report No 16 Deleveraging, What Deleveraging? ICMB / CEPR September 2014

100

120

140

160

180

200

220

240

260

280

01 02 03 04 05 06 07 08 09 10 11 12 13

Developed Markets Emerging Markets

World

% o

f GD

P

21

Traditional policy levers blocked

First round stimulative effect

But concerns about long-term debt sustainability

22

Asset prices inequality

Stimulates financial speculation before real economy

Currency devaluation channel is zero sum game

Only works by re-stimulating growth of private credit

Funded fiscal deficits

Ultra loose monetary policy

• Interest rate at zero bound

• QE

Debt overhang : the unavoidable choice?

23

Sustained low growth and low inflation – debt burdens never

decline

Debt erosion via ultra low

interest rates

But leads to new debt creation

Debt write-off, default and

restructuring

But has disruptive / depressive

effect

?

Two questions:

24

Why does the growth in leverage matter?

How is it possible without stimulating inflation? ?

Categories of credit creation and nominal demand

25

Stimulates nominal demand Finance of investment

Finance of consumption

Finance of existing asset purchase

Stimulates nominal demand but required just to offset impact of inequality ?

• No direct stimulus to nominal demand • Could just increase credit, money balances

and asset pricing • May stimulate demand via wealth effects

and Tobin’s Q effects • But not certainly proportional to credit

created

Credit, Money and Prices: UK 2000-07

26

44%

105%

79%

97%

Nominal GDP

Gross Housing wealth

Household deposits in banks

Mortgage credit

Bank lending to real estate sector and prices: Japan 1981 – 1999

27

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%Commercial Land Price in

the Six Major Cities (L)

Bank Lending to the Real Estate Sector (R)

YoY%

Source: Japan Real Estate Institute; Bank of Japan; Profit Research Center Ltd; calculations by Prof. Richard Werner, Southampton University (see Princes of the Yen, Richard Werner, 2003)

Credit creation for GDP transactions and nominal GDP in Japan, 1983 – 1999

28

Source: Princes of the Yen, Richard Werner, 2003

-4

-2

0

2

4

6

8

10

12

-4

-2

0

2

4

6

8

10

12

83 85 87 89 91 93 95 97 99

YoY %

Cr (L)

Nominal GDP

YoY %

Explaining instability and secular stagnation | 29

Quantity theory of disaggregated credit*

NOT

But:

So that:

And:

∆M = ∆P. ∆Y

∆CR = ∆PR

∆CNR = ∆P. ∆Y

∆M = ∆CR + ∆CNR > ∆P. ∆Y

Velocity of circulation stable

… where CR = credit to finance real estate purchase+

PR = price of real estate

… CR = credit to finance GDP transactions

P = prices of current goods and services

Velocity of circulation falls

* See Richard Werner, New Paradigm in Macroeconomics

+ Or more generally to finance existing assets

30

Velocity of money circulation

Source: BoE, BoJ, Datastream

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Q4

1980

Q2

1982

Q4

1983

Q2

1985

Q4

1986

Q2

1988

Q4

1989

Q2

1991

Q4

1992

Q2

1994

Q4

1995

Q2

1997

Q4

1998

Q2

2000

Q4

2001

Q2

2003

Q4

2004

Q2

2006

Q4

2007

Q2

2009

Q4

2010

UK (M2) Japan (M2)

Velocity of Money (Nominal GDP/M4)

00.20.40.60.8

11.21.41.61.8

2

Q4

1980

Q2

1982

Q4

1983

Q2

1985

Q4

1986

Q2

1988

Q4

1989

Q2

1991

Q4

1992

Q2

1994

Q4

1995

Q2

1997

Q4

1998

Q2

2000

Q4

2001

Q2

2003

Q4

2004

Q2

2006

Q4

2007

Q2

2009

Q4

2010

Japan (M4) UK (M4)

Velocity of Money (Nominal GDP/M2)

Monetary aggregates matter

31

• But not because excessive money growth is a robust forward indicator of inflation

• But because excessive credit growth and level are forward indicators of crises, debt overhang, post crisis depression and deflation

Finance for investment

• Real estate

• Other

Finance for consumption

Finance of purchase of existing scarce supply assets

The mix of debt by category matters

vs

vs

Not one objective, one instrument

32

Low and stable inflation insufficient

Credit and asset price cycle and rising leverage can produce macroeconomic instability while never producing excess inflation

• Interest rate elasticity of demand for credit varies by category

• Contrary to Wicksell, there is no one natural rate

Interest rate tool insufficient

Other policy objectives and tools

33

• Constrain both pace of growth and level of private sector leverage

• Offset bias in system toward real state lending

• Much higher bank capital requirements

• Much higher counter-cyclical capital requirements

• Increase capital risk weights for real estate lending above IRB levels

• Loan to income constraints on borrowers

• Banks with dedicated focus on non real estate

Objectives Tools

“If we’re going to fix the financial system – if we are to avoid the painful boom and bust episodes that are becoming all too frequent – we must address the key problem: the inflexibility of debt contracts. The contract must be made contingent on economic outcomes… It must resemble equity more than debt”

34

Atif Mian and Amir Sufi “House of Debt”, 2014

“What if the contract for loans, personal and material capital did not exist; if it were impossible to invest capital at a fixed rate of interest, and everyone instead collected variable dividends depending on the net income of the firm; if it were impossible to hire labour at a fixed salary or wage, but all intellectual and manual workers were paid instead with a share of the firm’s output? In this case, why should there be crisis? All would share in the result of production and, whether prices were high or low, each would receive his slice of the cake”

35

Luigi Einaudi “Debiti”, 1934

“It would be absolutely impossible for the economic mechanism to function if everything were as mobile as depicted above. Profit-sharing for workers, capitalist and worker shareholding, cooperative systems are properly called ‘ideal’ schemes for a small minority of savers and workers who possess the rare qualities needed to run risks. But they are called ‘nonsense’ for the great majority of savers, who do not know how to select even a halfway decent investment, and [for most] workers. The economic categories of the interest rate, wages, rent and taxes therefore are not inventions of economists but necessities rooted in human nature.”

36

Luigi Einaudi “Debiti”, 1934