This document discusses the role of private debt and credit growth in economic stability. It argues that pre-crisis orthodoxy viewed low inflation as sufficient for stability, but private debt growth fueled asset price booms and recessions. Credit growth for real estate and existing assets does not directly stimulate GDP but can inflate prices. To promote stability, policy should constrain private leverage growth and the dominance of real estate lending through higher bank capital requirements and countercyclical policies.

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. 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. 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. 3
Shifting leverage:
Private and public debt-to-GDP

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. 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. 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. 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. 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. 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. 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. “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. 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. 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. Banks create credit, money and
purchasing power
Loan to
entrepreneur
100 Credit to
entrepreneurs
deposit account
100
Bank
14

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. 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. 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. Share of real estate lending in total bank
lending
Source: The Great Mortgaging, Professor Alan Taylor, University of California, Davis
18

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. ?
Two questions:
29
Why does this growth in leveraging matter?
How is it possible without stimulating inflation??

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. 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. 32
Shifting leverage:
Private and public debt-to-GDP

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. 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. 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. 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. 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. 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. 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