In his opening keynote address at the 2014 European Investment Conference, Lord Adair Turner, senior fellow at the Institute for New Economic Thinking, spoke to an audience of leading investment professionals about the shortcomings of “too big to fail” and inflation targeting. He proposed bold solutions to how governments, central banks, and regulators can work together to escape the excessive credit overhang in the real economy that has created a dangerous real estate boom and continues to depress global economic growth.
The economist began with an attack on the orthodoxies of pre-crisis central banking. “We need in future to develop policies which can prevent the buildup of real economy debt and leverage to excessive levels,” Turner said. “And that requires a wide-ranging rejection of pre-crisis orthodoxy as to the objectives and the tools of central bank monetary policy.”
Turner believes that the reason we are in such a deep post-crisis recession is not solely because of the impaired banking system and the supply of credit but the over-leverage of a real economy — in other words, a problem of credit demand. “It is not good enough to have a resilient financial system. We need to manage credit creation,” Turner said, arguing that central bankers need to go way beyond inflation targeting.
Turner contrasted this with a pre-crisis orthodoxy in which growth in leverage rang few alarm bells. Rather, leverage was treated as either positively benign or simply neutral. Prevailing central bank models had surprisingly little or no role for the financial system and financial intermediation, the process by which leverage is generated and loans distributed. “Now central banks are taking an interest in where credit is allocated in an economy,” said Turner, citing new policies at the Bank of England, the European central banks, and the Bank of Korea.
“The fundamental reason why the post-crisis recession after 2008 has been so deep and recovery so weak and slow,” Turner said, “is not that we have an impaired financial system, important though that is. It is the increase in real economy leverage, which occurred over an entire half-century before the crisis.” Private sector credit to GDP in the real economy increased from 50% in 1950 to 170% on the eve of the crisis.
Meanwhile, the central banks treated growth in debt as either positively benign or simply neutral. At the center of the central banks’ indifference to leverage was a set of theories. The financial system was treated as a neutral “veil” through which monetary policy passed to the real economy but whose size and detailed structure were largely unimportant. Turner dismisses these theories as based on “a largely fictional account.” Lending against real estate — something in inelastic supply — has powerful implications for financial and economic stability, which are not well captured by prevailing textbook orthodoxies, according to Turner.
Several related textbook definitions of credit need to be torn up, Turner argued. Mapping purposes of credit cannot currently be so precise because the ratio of actual real estate construction to purchase of real estate assets or equity withdrawal is not properly controlled. Turner cites the example of the United Kingdom, where lending to finance productive capital investment apart from real estate accounts for no more than around 15% of all UK bank lending, the remaining 85% being investment — a word Turner used carefully here — in existing property assets. That unbalanced pattern is mirrored across the advanced economies.
Turner isolates three factors that, together with the inelastic supply of real estate, are bound to make property increasingly important in modern advanced economies and a rising source of potential instability. First, as people get richer, they tend to devote an increasing share of their income to the purchase of housing services. Second, as investors observe this trend, they tend to regard housing as an investment asset class valued according to prospects of capital gain and income rather than for its utility alone. Finally, there is the amplifying effect of leverage.
Japan is the canary in the mine for Turner. Quoting economist Richard C. Koo, what Japan illustrates for Turner is that once excessive leverage has developed, it seems impossible to get rid of. Instead, it is shifted around from the private to the public sector. This was the pattern in Japan after 1990 and has been the pattern in many countries after the crisis of 2008, including the United Kingdom, Spain, and the United States. At the global level, as a recent Geneva Report by the International Center for Monetary and Banking Studies illustrates, we have seen no overall deleveraging since the crisis.
Having diagnosed an impressively concerning set of problems, Turner moved on to prescribe some solutions for the central banks. Traditional policy options, such as monetary finance of increased fiscal deficits, might be considered. But “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,” he said. Public policy must focus on constraining some specific categories of credit growth. “We need to move beyond inflation targeting, and central banks and macroprudential regulators need to influence and manage the quantity and allocation of credit in the economy,” Turner said.
Perhaps most controversially, Turner believes policy should not just seek to constrain the pace of credit growth but also limit the level of private sector borrowing freedoms, with authorities acting more aggressively to contain new credit. Alongside this, Turner seeks greater bank capital adequacy and higher counter cyclical capital buffers than currently agreed under Basel III. So, in Turner’s vision, the whole focus of macroprudential policy should be not just the resilience of the financial system itself but the management of credit creation to avoid excessive leverage.
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