MONETARY POLICY AND FINANCIAL STABILITY IN THE MODERN ECONOMY Adair Turner Chairman, INET Princeton 18 th February 2016 www.ineteconomics.org 300 Park Avenue South New York, NY 10010 22 Park Street London W1k 2JB
Private domestic credit as a % of GDP: Advanced economies 1950 2011 Source: Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, C. Reinhart & K. Rogoff, 2013 1
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 Luigi Einaudi Debiti, 1934 2
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 We assumed that we could ignore much of the details of the financial system Olivier Blanchard Chief Economist of the IMF, October 2012 Mervyn King Twenty Years of Inflation Targeting, The Stamp Memorial Lecture, 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 4
Textbook descriptions of banks and bank lending 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 5
Wicksell s logic: I Credit extended to entrepreneurs/businesses to fund capital investment 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 6
Wicksell s logic: II Natural rate is unobservable 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 7
Three conceptually distinct functions of lending Finance of new capital investment Non-real estate Commercial real estate Residential real estate Human capital Finance of increased consumption Enabling inter-temporal shift of consumption within life time income Finance of purchase of existing assets Real estate Collectibles Existing business assets e.g. Leveraged Buy Outs 8
Categories of bank lending: 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 9
Share of real estate lending in total bank lending Source: The Great Mortgaging, Professor Alan Taylor, University of California, Davis 10
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 11
Credit and asset price cycles: upswing 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 12
Credit and asset price cycles: downswing Less credit extended Restricted lender supply of credit Reduced borrower demand for credit Falling asset prices Expectation of future asset price falls Cautious assessments of credit risk High credit losses: low bank profits Confidence dented Reduced capital base 13
Capital in Britain 1700 2010 800% 700% 600% Net foreign assets Other domestic capital Housing Agricultural land 500% 400% 300% 200% 100% 0% 1700 1750 1810 1850 1880 1910 % national income 1920 1950 1970 1990 2010 Source: Capital in the Twenty First Century, T. Piketty (2013) 14
Desirable urban land: a market without equilibrium? Highly income elastic demand Capital gains motivation Indeterminate price is there an equilibrium? Inelastic supply of locationally specific land Expectations prices expectations Potentially infinite supply of credit and private money 15
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 creation and allocation optimal credit With inefficient markets, self-fulfilling expectations and lending against irreproducible assets: Problems Policy rate Market rate because of endogenous variation in spreads Expected private returns are heterogeneous by sector and unstable over time 16
Two questions:? Why does the growth in leverage matter?? How is it possible without stimulating inflation? 17
Sectoral financial surpluses/deficits as % of GDP: Japan 1990 2012 10 5 0 % -5-10 -15 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 PNFCs Government Source: IMF, Bank of Japan Flow of Funds Accounts 18
Japanese government and corporate debt: 1990 2010 250 200 Bank lending to non-financial corporates General Government debt % GDP 150 100 50 0 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 Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations 19
Developed economies Debt to GDP Household Non-financial Corp Public 110 95 80 65 50 2004 2005 2006 2007 2008 2009 2010 2011 2012 % GDP 2013 Source: Geneva Report No 16 Deleveraging, What Deleveraging? ICMB / CEPR September 2014 20
Global debt excluding financials 280 260 Emerging Markets Developed Markets World 240 220 % of GDP 200 180 160 140 120 100 01 02 03 04 05 06 07 08 09 10 11 12 13 Source: Geneva Report No 16 Deleveraging, What Deleveraging? ICMB / CEPR September 2014 21
Traditional policy levers blocked Funded fiscal deficits First round stimulative effect But concerns about long-term debt sustainability Ultra loose monetary policy Interest rate at zero bound QE 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 22
Debt overhang : the unavoidable choice? Sustained low growth and low inflation debt burdens never decline Debt erosion via ultra low interest rates Debt write-off, default and restructuring But leads to new debt creation But has disruptive / depressive effect 23
Two questions:? Why does the growth in leverage matter?? How is it possible without stimulating inflation? 24
Categories of credit creation and nominal demand Finance of investment Stimulates nominal demand Finance of consumption Stimulates nominal demand but required just to offset impact of inequality? Finance of existing asset purchase 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 25
Credit, Money and Prices: UK 2000-07 Mortgage credit 97% Household deposits in banks 79% Gross Housing wealth 105% Nominal GDP 44% 26
Bank lending to real estate sector and prices: Japan 1981 1999 YoY% 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% Commercial Land Price in the Six Major Cities (L) Bank Lending to the Real Estate Sector (R) 40% 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% 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) 27
Credit creation for GDP transactions and nominal GDP in Japan, 1983 1999 YoY % 12 10 8 6 4 2 0-2 Nominal GDP YoY % 12 10 8 6 4 2 0-2 -4 Cr (L) 83 85 87 89 91 93 95 97 99-4 Source: Princes of the Yen, Richard Werner, 2003 28
Quantity theory of disaggregated credit* NOT M = P. Y Velocity of circulation stable But: And: C R = P R C NR = P. Y where C R = credit to finance real estate purchase + P R = price of real estate C R = credit to finance GDP transactions P = prices of current goods and services So that: M = C R + C NR > P. Y Velocity of circulation falls * See Richard Werner, New Paradigm in Macroeconomics + Or more generally to finance existing assets Explaining instability and secular stagnation 29
Velocity of money circulation Velocity of Money (Nominal GDP/M2) Velocity of Money (Nominal GDP/M4) 3.0 2.5 2 1.8 1.6 2.0 1.4 1.2 1.5 1.0 1 0.8 0.6 0.5 0.4 0.2 0.0 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 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) Japan (M4) UK (M4) Source: BoE, BoJ, Datastream 30
Monetary aggregates matter The mix of debt by category matters 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 vs Finance for consumption vs Finance of purchase of existing scarce supply assets 31
Not one objective, one instrument Low and stable inflation insufficient Credit and asset price cycle and rising leverage can produce macroeconomic instability while never producing excess inflation Interest rate tool insufficient Interest rate elasticity of demand for credit varies by category Contrary to Wicksell, there is no one natural rate 32
Other policy objectives and tools Objectives Tools 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 33
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 Atif Mian and Amir Sufi House of Debt, 2014 34
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 Luigi Einaudi Debiti, 1934 35
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. Luigi Einaudi Debiti, 1934 36