Between Debt and the Devil: Money, Credit, and Fixing Global Finance

By Adair Turner

On Saturday September 20, 2008, I became chairman of the UK Financial Services Authority. We faced the biggest financial crisis in 80 years. Seven days before I started, I had had no idea we were on the verge of disaster. Nor did almost everyone in the central banks, regulators, or finance ministries, nor in financial markets or major economics departments.

Financial system fragility alone cannot explain why the post-crisis Great Recession was so deep and recovery has been so weak.

We need to ask why debt contracts exist, what benefits they bring, and what risks they inevitably create. We need to question whether banks should exist at all.

I now believe that banks should operate with leverage levels (the ratio of total assets to equity) more like five than the twenty-five or higher that we allowed before the crisis. And I argue that governments and central banks should sometimes stimulate economies by printing money to finance increased fiscal deficits.

I came to believe that the most fundamental problems of financial and economic instability are created not by activities that we would quite happily see disappear entirely, but by activities—such as lending money to someone to buy a house—which in moderate amounts are clearly valuable, but on an excessive scale can cause economic disaster. This book makes that argument.

The fact that we are now slowly recovering from a deep and long-lasting recession must not blind us to the reality that the 2007–2008 crash was an economic catastrophe. This catastrophe was entirely self-inflicted and avoidable.

The fundamental problem is that modern financial systems left to themselves inevitably create debt in excessive quantities, and in particular debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate.

Heating a house or fueling a car is socially valuable, but the carbon emissions produced have a harmful effect on the climate. Lending a family money to buy a house can be socially useful, but too much mortgage debt in total can make the economy unstable. So debt pollution, like environmental pollution, must be constrained by public policy.

One objective of this book is therefore to define the policies needed to prevent excessive debt creation leading to future financial crises.

The second is to propose how to escape from the debt overhang which past policy errors have bequeathed and which continues to depress economic growth across the developed world.

Finally I aim to identify why mainstream modern economics failed to see the crisis coming, and why it so confidently asserted that increasing financial activity had made the world a safer place.

At the core of financial instability in modern economies, this book argues, lies the interaction between the infinite capacity of banks to create new credit, money, and purchasing power, and the scarce supply of irreproducible urban land.

Is that true, and are future crises, as bad as 2007–2008, therefore inevitable? My answer is no, and I argue in this book that it should be possible and is essential to develop a less credit-intensive growth model. But I also argue that it will only be possible if we recognize and respond to three underlying drivers of increasing credit intensity.

The first is the increasing importance of real estate in modern economies. The second driver is increasing inequality. The third driver is global current-account imbalances unrelated to long-term investment flows and useful capital investment.

These three factors each result in a growth of debt that does not support productive capital investment and does not therefore generate new income streams with which debt can be repaid.

Financial and economic stability will only be attainable if we address these underlying factors.

Certainly we should use public policy sanctions penalize incompetent or reckless behavior. Certainly we should address the too-big-to-fail problem. But such policies will never be sufficient to achieve a more stable economy. Nor, either, will central bank policy still operating within the assumption that we can have one objective—low inflation, and one instrument—the interest rate.

We must also recognize that financial instability is inherent in any financial system that is allowed to create credit, money, and purchasing power, and we must decide how radically to address that fact.

Credit creation is too important to be left to the bankers: future policies need to reflect that fact.

While designing a better system for the future, we must also navigate as best possible out of the debt overhang left by past policy mistakes.

My proposals will horrify many economists and policymakers, and in particular central bankers.

In the pre-crisis years economic orthodoxy was characterized by an anathema against government money creation and a totally relaxed attitude to whatever level of private credit free markets generated. But the latter led to a disaster from which many ordinary citizens throughout the world are still suffering. To prevent future crises we need far tighter controls on private credit creation than we had before the crisis. *

Finance has a distinctive ability to grow beyond its socially useful size, making private profit from activities that add no true social value.

In the United Kingdom, finance has accounted for a growing share of national income.

But it is the financial crisis of 2007–2008 that makes it not merely interesting but vital to ask searching questions about the economic impact of this huge increase in financial intensity.

The crisis and its aftermath have been an economic catastrophe.

We cannot therefore avoid the questions: Which aspects of this growing financial intensity were beneficial and which harmful? Which led to the crisis, and how radically must we now reform to prevent a repeat?

Finance made much more money out of providing credit to the economy, and in particular credit to households.

Indeed, a central argument of this book is that the high level of private debt built up before the crisis is the most fundamental reason the 2007–2008 crisis wrought such economic harm.

The sheer complexity of the securitized credit and shadow banking system on the eve of the crisis is mind boggling.

Increased complexity made the financial system inherently less stable, and it facilitated excessive credit extension and leverage in the real economy. As a result it both made the crisis more likely and the consequences more severe.

Rising inequality has been a striking feature of most advanced economies over the past 30 years, and the financialization of the economy has played a major role in that increase.

The assumption that market completion and liquidity would inevitably generate favorable results rested on an overt and sophisticated, though mistaken, theory. The conclusions followed if the Efficient Market Hypothesis applied.

As Mervyn King, then governor of the Bank of England, put it in a lecture in autumn 2012, the dominant theoretical model of modern monetary economics “lacks an account of financial intermediation, so money, credit and banking play no meaningful role.”

Theoretical assertion and apparent empirical support therefore coalesced into a strong pre-crisis consensus: more finance was good for the economy, making the latter both more efficient and more stable. But the consensus turned out to be completely wrong.

Beyond some point, and in particular where debt is concerned, more finance can be harmful, and free market finance can fail to serve well society’s needs.

In fact financial markets, when left to free-market forces, can generate activity that is privately profitable but not socially useful. There can be too much finance, too much trading, and too much market completion. *

Two theoretical propositions in particular played a central role in the pre-crisis orthodoxy in both finance and macroeconomics—the Efficient Market Hypothesis (EMH) and the Rational Expectations Hypothesis (REH).

But real-world evidence and more realistic theory contradict both hypotheses. They show that human beings are not fully rational, and that even if they were, market imperfections could produce unstable financial markets that diverge far from rational equilibrium levels.

Both the EMH and REH are flawed, because they fail to recognize that the future is characterized by inherent irreducible uncertainty and not mathematically modelable risk.

Financial markets are bound to be susceptible to inefficiency and collective irrationality.

The crucial question is whether increasing financial intensity makes financial markets and the macroeconomy more unstable.

The most important reason the 2008 crisis was followed by such a deep recession and weak recovery was excessive private credit creation in the preceding decades.

Banking systems left to themselves are bound to create too much of the wrong sort of debt, instability, and crisis.

Fixing the banks will not be sufficient to fix the economy. More radical policies will be required.

Banks create credit, money, and thus purchasing power. They make loans to borrowers, crediting an asset on the banks’ balance sheet; at the same time they put money in the borrowers’ account, creating a bank liability.

The vast majority of what we count as “money” in modern economies is created in this fashion: in the United Kingdom 98% of money takes this form,and only 2% represents the notes and coins liabilities of the state.

How much credit banks create and to what purposes that credit is devoted are therefore issues of vital importance.

Shadow banking activities create credit and money equivalents outside the formal banking sector.

Central banks gravitated to the belief that, provided interest rates were maintained at levels that ensured low and stable inflation, the amount of credit that the banking system created would be of no concern. Low and stable inflation was sufficient to ensure financial and macroeconomic stability. But the crisis of 2007–2008 proved that assumption quite wrong. Excessive credit produced a crisis, even though inflation remained subdued.

Most credit in advanced economies is not used to finance new capital investment.

In most modern banking systems most credit does not finance new capital investment. Instead, it funds the purchase of assets that already exist and, above all, existing real estate.

Credit to finance investment in non–real estate assets accounts for no more than 14% of the UK total.

The UK mortgage credit and house price boom of 2000–2007 was primarily an existing assets boom, with only a relatively small rise in construction.

It is vital indeed to understand that an advanced economy in which there was no new investment in real estate at all would also almost certainly be one in which most new bank credit was extended to finance real estate.

Faced with severe debt overhang,the result has been seven years of recession and only weak recovery.

From the 1990s on, Japan provided a warning of the huge damage a debt overhang can cause. Two decades of slow growth and gradual price deflation followed.

Recessions are on average much deeper and longer lasting when preceded by large build-ups of mortgage debt.

Financial crises and bank insolvencies can cause great harm, but the debt overhang created by excessive private credit creation can be more harmful still.

Both Japan’s experience in the 1990s and Western experience after the 2007–2008 crisis show that restoring potential credit supply is insufficient to restore growth.

Credit supply at low price was ensured, but credit demand was lacking because of the debt overhang effect.

Public debate after the 2007–2008 crisis was skewed far too much toward the credit supply problem and that we were slow to realize the severity of the debt overhang challenge.

Fixing the banks is clearly doable. In contrast, a severe debt overhang appears to make all policy levers ineffective.

In most countries the reason public debt has increased rapidly since the crisis is simple: excessive private credit creation produced a crisis and post-crisis recession.

In the United Kingdom the total net costs of bailing out the banks - including equity injections, guarantees, and central bank liquidity support - have amounted to about 1.3% of GDP, but public debt as a share of GDP has soared from 44% in 2007 to 92% in 2013.

So leverage has not fallen but has simply shifted from the private to the public sector. In addition it has shifted between countries.

To understand excessive credit creation and debt overhang, we must therefore take a global perspective.

Once debt has first grown to excessive levels, all traditional policy levers appear blocked or have adverse side effects. Debt overhang seems to be a trap from which there is no clear escape.

Surely, it seems, we need an answer to the question: how will public debts ever be repaid?

Given the purposes for which bank credit is actually used in advanced economies, ultra-low interest rates are likely to stimulate speculation in existing assets more than they stimulate new business investment.

The severe difficulties that debt overhang creates, and the huge economic cost of the post-2008 recession and weak recovery, certainly make it vital to achieve future growth without excessive credit creation.

Shadow banking, financial innovation, and intense trading among financial institutions hardwired instability into the financial system, gave us the credit cycle on steroids, and made a severe debt overhang more likely.

The summary scorecard on three decades of financial innovations is therefore simple; whatever their theoretical advantages, their actual impact was a disaster. But one assertion made by the pre-crisis optimists was undoubtedly true: the new technology facilitated more credit creation.

Policies to mitigate the fundamental drivers of credit-intensive growth are essential: central banks and regulators alone cannot make the financial system and economies stable.

Even if we achieve maximum imaginable success in addressing the fundamental drivers of credit-intensive growth, we will still be left with credit and asset price cycles arising from the interface between the infinitely elastic supply of private credit and money, and the inelastic supply of existing irreproducible assets (in particular, real estate).

We cannot therefore avoid the question that Hyman Minsky posed—whether a monetary economy with debt contracts and capitalist financial institutions will ever be stable, and in particular whether stability is possible as long as there are fractional reserve banks.

Debt contracts and banks make financial instability inevitable. Left to itself, a free financial system will produce too much private credit.

But shouldn't we fix the problem by structural reforms rather than expecting central banks and regulators to manage an inherently unstable system?

Credit markets raise issues of vital general public interest: free market approaches to them are simply not valid.

In a world where free markets left to themselves will produce too much debt, and where tax regimes magnify that bias, implicit taxes on credit creation can be a good thing.

“if we are going to fix the financial system, we must address the key problem: the inflexibility of debt contracts.”

If financial innovation is to make a major contribution to a more stable economy, it must address the largest debt category—lending against real estate.

There is no silver bullet: no single structural policy that will remove the risks created by debt contracts, private money creation, and price cycles in existing assets. We cannot therefore avoid a significant role for central banks and financial regulators in constraining and managing the quantity and the mix of debt.

The pre-crisis orthodoxy that we could set one objective (low and stable inflation) and deploy one policy tool (the interest rate) produced an economic disaster.

The fundamental reason recovery from the Great Recession has been slow and weak is the debt overhang.

Growing out of debt burdens will be far more difficult than in the post-war period. Indeed, in some countries the mathematics make it impossible.

Sometimes debts simply cannot be and will not be fully repaid. Other ways out of the debt overhang will have to be found. *

If debts cannot be eroded away by either real growth or inflation, they could be reduced by default and debt restructuring.

Rather than creditors receiving an undiminished nominal value degraded in real terms through inflation, the nominal value of debts could be reduced. *

The more realistic alternative involves negotiated debt write-downs and restructurings to reduce debts to sustainable levels, while avoiding the disruptive effect of bankruptcy and default. It can be applied to either private or public debts.

Excessive private credit creation produces crisis, debt overhang, and post-crisis deflation, and as a result, rising public debt burdens: leverage doesn't go away, it simply shifts from the private to the public sector. But once it has shifted to public debt, it may be easier to negotiate restructuring and write-down without harmful shocks to confidence.

The Bank of England owns government bonds worth 23% of GDP. Writing some of them off would not remove entirely the need for further improvement in public finances, but it would reduce the required pace and severity of fiscal consolidation. *

If we first admit that money finance is possible, how will we ensure we do not use it to excess?

The risks of money finance are thus not technical but political.

If governments are allowed to print money to finance deficits, they will be tempted to do so before elections, to spend it on favored political constituencies, and to run large fiscal deficits on a permanent basis rather than make tough choices about tax and public expenditure.

In the United Kingdom, for instance, there is no reason why the Bank of England Monetary Policy Committee, if equipped with the legal power, could not have approved in 2009 and 2010 a £35 billion helicopter money * operation to finance increased fiscal expenditure, instead of £375 billion of quantitative easing. And no reason it could not have refused to approve a larger helicopter money operation if it believed that would endanger inflation above the 2% target.

The potential to use monetary finance to escape from debt overhang and deflation should not therefore be excluded on the grounds that it will lead inevitably to excessive inflation and fiscal indiscipline.

Allowing monetary finance is dangerous, since governments may create fiat money in excessive quantities and misallocate the resulting spending power to inefficient ends. But the alternative route to adequate nominal demand—by means of private credit creation—is also dangerous, since free financial markets left to themselves are bound to create credit in excessive quantities and allocate it inefficiently, generating unstable booms and busts, debt overhangs, and post-crisis recessions.

Pre-crisis macroeconomic orthodoxy combined total anathema against fiat money finance with an almost totally relaxed attitude to private credit creation. Optimal future policy must reflect the reality that we face a choice of dangers and must combine far tighter controls on private credit creation with the disciplined use of fiat money finance when needed. Our refusal to use that option until now has depressed economic growth; led to unnecessarily severe fiscal austerity; and, by committing us to sustained very low interest rates, increased the rmacroeconomic rules will ensure social optimality is very elegant and appealing. But it was a fatal conceit that produced the disaster of 2007–2008, from whose consequences many ordinary citizens around the world are still suffering.

isks of future financial instability.

We need a new approach to economics and to public policy.

You cannot see a crisis coming if you have theories and models that assume that the crisis is impossible.

At the core of macroeconomic instability in modern economies lies the interaction between the limitless capacity of unconstrained private banking and shadow banking systems to create credit, money, and purchasing power, and the inelastic supply and rising demand for locationally specific urban land.

The idea that free financial markets plus simple macroeconomic rules will ensure social optimality is very elegant and appealing. But it was a fatal conceit that produced the disaster of 2007–2008, from whose consequences many ordinary citizens around the world are still suffering.