Global Finance, Debt and Sustainability

Adair TurnerChairmanInstitute for New Economic Thinking

Council on Economic Policies | International Monetary Fund Zurich, 3 October 2016

300 Park Avenue South - 5th Floor, New York, NY 10010 USA | 22 Park Street, W1J 2JB London, UK

Private domestic credit as a % of GDP: Advanced economies 1950 – 2011

1

Source: Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, C. Reinhart & K. Rogoff, 2013

“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

2

Textbook descriptions of banks and bank lending

3

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

Share of real estate lending in total bank lending

Source: The Great Mortgaging, Professor Alan Taylor, University of California, Davis

4

5

“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

Credit and asset price cycles: upswing

6

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

Japanese government and corporate debt:1990 – 2010

0

50

100

150

200

250

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

Bank lending to non-financial corporates General Government debt

7

Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations

% G

DP

Global debt excluding financials

Source: Geneva Report No 16 Deleveraging, What Deleveraging? ICMB / CEPR September 2014 for years 2001 to 2013

8

% of GDP

100

120

140

160

180

200

220

240260

280

01 02 03 04 05 06 07 08 09 10 11 12 13

Developed MarketsEmerging Markets

World

2013 2015

Source: BIS for years 2013 and 2015

Traditional policy levers blocked

First round stimulative effect

But concerns about long-term debt sustainability

9

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

Funded fiscal deficitsFunded fiscal deficits

Ultra loose monetary policy

• Interest rate at zero bound

• QE

Ultra loose monetary policy

• Interest rate at zero bound

• QE

Debt overhang : the unavoidable choice?

10

Sustained low growth and low inflation – debt burdens never

decline

Debt erosion via ultra low

interest rates

But leads to new debt creation

Debt write-off, default and

restructuring

But has disruptive / depressive

effect

The Dilemma

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

11

Three fundamental drivers of credit intensive growth

Inequality

Real estate

Global current account imbalances

12

0%

100%

200%

300%

400%

500%

600%

700%

800%

1700

1750

1810

1850

1880

1910

1920

1950

1970

1990

2010

Net foreign assetsOther domestic capitalHousingAgricultural land

Capital in Britain 1700 – 2010

13

% n

atio

nal i

ncom

e

Source: Capital in the Twenty First Century, T. Piketty (2013)

Monetary aggregates matter

14

• 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

• 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

Finance for consumption

Finance of purchase of existing scarce supply assets

Finance for investment• Real estate• Other

Finance for consumption

Finance of purchase of existing scarce supply assets

The mix of debt by category matters

vs

vs

Estimated change in per capita GDP growth when credit intermediation increases by 10% of GDP

15

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3

30 40 50 60 70 80 90 100 110 120 130 140

Perc

enta

ge p

oint

s

Intermediated credit, % of GDP

Source: OECD Policy Paper No. 14, June 2015

Emerging advanced

economies

16

Reconciling Levine vs OECD

Financial Intensity

Growth, productivity,

social welfare Advanced economies last 40/50 years

17

- and creates debt overhang which traps us in slow growth

Most debt is not needed to drive growth

But what if maximum growth is not a desirable objective?

18

Happiness and income per capita in the USA

Source: Bruno Frey & Alois Stutzer, Happiness and Economics, Princeton University Press, 2002

19

Income and Human Contentment: Possible stylised pattern over time

Inco

me

/ Con

tent

men

t

Pre-industrial societies The Great Transformation

Economic and technological progress

Income

Human wellbeingcontentment / happiness

China

Africa

Developed economies

20

Different marginal utility of different “goods”Ut

ility

/ Ha

ppin

ess

Utili

ty /

Happ

ines

s

Utili

ty /

Happ

ines

s

Income Income Income

Good health?Branded fashion

goods?Congestion and

environmental damage?

Growth in already rich countries: a possible position

21

• Growth in average per capita GDP has diminished potential to deliver human welfare

• Human ingenuity plus economic freedom will produce rise in productivity and thus growth

• Different forms of growth have different potential to increase human welfare

Maximising growth should not be the

objective

But economic freedom is valuable

in itself and will produce growth

Public policy needs to ensure that - the harmful impacts

of growth are minimised- The positive impacts

maximised

Growth and debt

Debt is an apparently low risk claim on future money income

Both the private credit creation system and the public political process can create “too much debt” relative to future prospective money income

This can leave economics stuck in a debt overhang trap

This problem is more likely to be severe if future money growth prospects

Are reduced for bad reasons

Should be reduced for good reasons

22

If maximum growth is not the objective, we should be

even more wary of

accumulating excessive

debt

Policy implications: Preventing harmful debt build-up

23

Fixing FundamentalsFixing Fundamentals

Inequality Real estate Global imbalances

Radically changed regulationRadically changed regulation

Far more bank capital Stronger counter-cyclical levers LTV and LTI limits Risk weights to reflect social risk not private

Discouraging harmful debt Encouraging more useful /more sustainable growth

Policy implications: escaping the debt overhang

Ultra-loose monetary policy can only ultimately work by reigniting private credit growth

Fiscal policy could stimulate the economy and could be skewed to more sustainable ends

… but appears blocked by public debt sustainability concerns

Money finance of fiscal deficits is the always available option

24

The case for monetisation

25

The price level should be controlled by “expanding and

contracting issues of actual money…[and]… monetary rules

should be implemented and in turn should largely determine fiscal

policy.” Henry Simons (1936)

“Government expenditures would be financed exclusively by tax revenues or the

creation of money.… the chief function of the monetary authority [should be] the creation of

money to meet government deficits and the retirement of money when the

government has a surplus.” Milton Friedman (1948)

“A tax cut for households and businesses that is explicitly coupled with incremental BoJ purchases of

government debt, so that the tax cut is in effect financed by money creation.. [with it clear that].. much or all of the increase in the money stock is viewed

as permanent”.Ben Bernanke (2003)

26

Two essential sources of nominal demand growth

27

Private credit and money creation

Sovereign fiat money creation – now or expected in the future

28

States fail because of short-term politics

Bank credit markets inherently inefficient and unstable

Dangerous

Forbidden

Free market ensures optimal result

Modern orthodoxy

Chicago Plan

Fiat money

creation

Private credit and

money creation

So dangerous that banks should be abolished

• Essential to deliver some nominal demand growth

• Can be contained by rules

Political processes can be rational

Markets efficient and rational