Combating the Debt Addiction

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A presentation held by the Swedish Minister for Finance Anders Borg at Global Utmaning's and the Swedish House of Finance's seminar "Combating the Debt Addiction" at the Stockholm School of Economics, Thursday May 22, 2014.

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Combating the Debt Addiction

  1. 1. Combating Debt Addiction Adair Turner Senior Fellow, INET The Swedish House of Finance Global Utmaning 22 May 2014 www.ineteconomics.org 300 Park Avenue South | New York, NY 10010 22 Park Street | London W1k 2JB
  2. 2. 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-term- economic-stability 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 1 Wealth, Debt, Inequality and Low Interest Rates: Four big trends and some implications. Lecture at Cass Business School, London 26 March 2014 http://ineteconomics.org/wealth-debt-inequality-and-low-interest-rates-four-big-trends-and-some- implications Reference:
  3. 3. Private domestic credit as a % of GDP: Advanced economies 1950 – 2011 2 Source: Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, C. Reinhart & K. Rogoff, 2013
  4. 4. 3 Shifting leverage: Private and public debt-to-GDP
  5. 5. 0 50 100 150 200 250 300 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 private debt as % of GDP public debt as % of GDP total debt as % of GDP Source: International Monetary Fund; Bank for International Settlements Private and public leverage: G7 + BRIC
  6. 6. China: total social finance to GDP 5 100 120 140 160 180 200 220 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
  7. 7. Dynamics of real GDP and credit (Year on year % change) Source: Monthly Bulletin, European Central Bank, January 2014 Real GDP Real credit to households Real credit to NFCs United States United Kingdom 6
  8. 8. The Dilemma 7 Pre-crisis path of nominal GDP growth Pre-crisis path of credit growth ͠ 4% - 5% ͠ 10% - 15% 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 ͠ 2% real growth ͠ 2% inflation
  9. 9. The Dilemma We seem to need credit growth faster than GDP growth to achieve an optimally growing economy, but that leads inevitably to crisis and post-crisis recession. 8
  10. 10. 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 9
  11. 11. Pre-crisis orthodoxy: monetary policy Low and stable inflation as sufficient for macroeconomic stability - Implicitly Wicksellian (natural rate = money rate of interest) 10 The dominant new Keynesian model of monetary economics lacks an account of financial intermediation, so that money, credit and banks play no meaningful role Mervyn King, ‘Twenty Years of Inflation Targeting’, The Stamp Memorial Lecture, 2012) * * *
  12. 12. “A growing body of empirical analyses […] demonstrate a strong positive link between the functioning of the financial system and long-run economic growth […] better developed financing systems ease external financing constraints facing firms” Ross Levine: Finance and Growth: Theory and Evidence. Handbook of Economic Growth, 2005 Positive correlation between growth and: • Liabilities of financial system ÷ GDP • Bank credit to private enterprise ÷ GDP • Turnover of equity markets ÷ market capitalisation 11 Pre-crisis orthodoxy
  13. 13. The problems with debt  Cycles of over-supply and over-demand  ‘Local thinking’ Upswing Downswing  Bankruptcy and default  Rollover need and impaired lending capacity  Debt overhang 12
  14. 14. Textbook descriptions of banks and bank lending 13 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
  15. 15. Banks create credit, money and purchasing power Loan to entrepreneur 100 Credit to entrepreneurs deposit account 100 Bank 14
  16. 16. 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 15
  17. 17. Categories of bank lending: UK, 2009 16 227 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
  18. 18. The dominance of real estate in bank lending 17 Total bank credit to domestic private sector % of GDP Mortgage credit % of GDP Mortgage credit as % of total 129% 74% 57% 206% 131% 64% 155% 78% 50% 175% 101% 57% 122% 78% 64% 130% 91% 70% + Commercial real estate at typically around 20% - 25% of total lending Source: Jordá, Schularick and Taylor, “Betting the Home”, forthcoming 2014 (*Bank and non-bank combined) *USA AUS ESP NLD SWE DNK
  19. 19. Share of real estate lending in total bank lending Source: The Great Mortgaging, Professor Alan Taylor, University of California, Davis 18
  20. 20. 19 “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)
  21. 21. Credit and asset price cycles: upswing 20 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
  22. 22. Credit and asset price cycles: downswing 21 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
  23. 23. Credit extension and house prices House prices 2000 – 2007 Household debt as a % of GDP 2000 – 2007 Source: BEA; ONS; ECB 0 20 40 60 80 100 120 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007%GDP US UK Spain Ireland 0 50 100 150 200 250 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Index:2000=100 Spain US UK Ireland Source: Ministry of Housing (Spain), S&P (US), DCLG 22
  24. 24. 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 23 %nationalincome Source: Capital in the Twenty First Century, T. Piketty (2013)
  25. 25. Desirable urban land: a market without equilibrium? 24 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
  26. 26. Average income increases US (1980=100) 0 50 100 150 200 250 300 350 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 bottom 20% top 5% top 1% S Source: US Census Bureau; World Top Incomes Database 25
  27. 27. Inequality, demand and credit 26 Rich have higher marginal propensity to save than poor Rising inequality Deflationary impetus – growth of NGDP falls Rich lend to poor Deflationary impetus offset: • NGDP growth maintained • Growth in credit intensity Savings not matched by investment +
  28. 28. Dynamics of real GDP and credit (Year on year % change) Source: Monthly Bulletin, European Central Bank, January 2014 Real GDP Real credit to households Real credit to NFCs United States United Kingdom 27
  29. 29. Interactions between credit categories and effects Increased apparent wealth Reduced saving: increased consumption Increased price of existing real estate Increasing credit supply / demand Equity withdrawal mortgage supply & demand Boom in new real estate construction Increased prices for new real estate Borrower and lender net worth, confidence and expectational effects
  30. 30. ? Two questions: 29 Why does this growth in leveraging matter? How is it possible without stimulating inflation??
  31. 31. 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 % 30
  32. 32. Japanese government and corporate debt: 1990 – 2010 Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations %GDP 0 50 100 150 200 250 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 20010 Bank lending to non-financial corporates General Government debt
  33. 33. 32 Shifting leverage: Private and public debt-to-GDP
  34. 34. Categories of credit creation and nominal demand 33 Stimulates nominal demandFinance of investment Finance of consumption Finance of existing asset purchase Stimulates nominal demand offsetting 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
  35. 35. Bank lending to real estate sector and prices: Japan 1981 – 1999 34 -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)
  36. 36. Credit creation for GDP transactions and nominal GDP in Japan, 1983 – 1999 35 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 %
  37. 37. Explaining instability and secular stagnation |36 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
  38. 38. 37 Velocity of money circulation Source: BoE, BoJ, Datastream 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Q41980 Q21982 Q41983 Q21985 Q41986 Q21988 Q41989 Q21991 Q41992 Q21994 Q41995 Q21997 Q41998 Q22000 Q42001 Q22003 Q42004 Q22006 Q42007 Q22009 Q42010 UK (M2) Japan (M2) Velocity of Money (Nominal GDP/M4) 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 Q41980 Q21982 Q41983 Q21985 Q41986 Q21988 Q41989 Q21991 Q41992 Q21994 Q41995 Q21997 Q41998 Q22000 Q42001 Q22003 Q42004 Q22006 Q42007 Q22009 Q42010 Japan (M4) UK (M4) Velocity of Money (Nominal GDP/M2)
  39. 39. Not one objective, one instrument 38 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
  40. 40. Other policy objectives and tools 39 • 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

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