Understanding more about our Financial System and its Instabilities

By John BristowComments Off on Understanding more about our Financial System and its Instabilities

Towards a Sustainable Financial System: a conference at the LSE in March 2014  

Opening address by Lord Adair Turner, currently a senior fellow, Institute of New Economic Thinking, in the Centre for Financial Studies in Frankfurt, and a member of the Financial Stability Board  working on reform architecture for the global financial system for the G20; and recently Chair of FSA in UK.

This can be seen on video (45 mins) on the LSE website

He raised 3 inter-related questions and discussed them in the address, summarising some of the errors in basic assumptions used to manage the finance system up to the 2008 crisis:

1. Given that 97% of our money is created by the private sector in the form of credit from private commercial banks, how much is needed and for what purpose is this created?

2. How does this affect the stability of the financial and economic systems?

3. What might be the role of regulation by the state and of control by the central bank?

Money is created in three ways:

(1) Fiat money: The state prints the optimal amount of money needed to stimulate nominal demand, creating a small unfunded fiscal deficit. This puts new money into the system and increases net private financial assets. Can a government create a fiscal deficit responsibly, to an optimal extent, in line with GDP? Can we trust politicians not to buy support and create inflation? Currently this is taboo.

(2) Banks in the private sector create money by loans in the form of numbers or  a figure in a deposit account of the borrower. This is then available immediately as money to purchase with, and then repaid later. This difference in time as the loan matures means that money and purchasing power is created in the economy by credit. Private net assets are not increased as for every bit of money there is a bit of debt. So it increases private debt. 97% of money is created this way now, in the market. Deposit money and actual money are confused in people’s mind.

(3) Funded fiscal deficit. This creates new private assets in the financial sector but not new money, as it has to be offset by a public liability to pay off the debt.

In the late 19th century there was a stable supply of money (nominal GDP) as it was based on gold or metallic money. This was accompanied by a slow decline (downward flexibility) in prices (e.g. through technology increasing productivity) and nominal wages, which in turn could create growth.

In a modern economy where money takes a deposit form, how can we know if just enough credit is created for the increase in nominal demand needed? How are we to achieve stability in the money supply and financial system today?

A sufficient growth in nominal demand (which in itself can be debated as it affects sustainability in all its senses, and reflects assumptions about the mix of economic systems we need for today) may be a 5% money increase: 2½% actual growth and 2½% reflecting increase in prices/inflation.

Will the amount of money created by private credit be optimal for the desired growth in GDP and nominal demand, say 5%?

Will a sufficient proportion of credit be allocated and used for productive or socially useful purposes?

Are the consequences of debt contracts taken fully into consideration?

Borrowers use two different ways of raising money or mobilizing capital in the form of a bond or debt (e.g. from a bank), or in an equity or share form (not through banks). Equity is not certain enough to mobilise sufficient capital. Debt is not contingent on the economy as a whole or the profitability of the borrower’s business. Debt contracts are needed.

Up till recently it was believed that private sector credit creation would be controlled by market disciplines.  Borrowers will borrow at a price or rate of interest that accords with their expected return from their investment, the so-called “natural rate of interest”, derived from assumptions about key economic factors such the natural rate of productivity growth and how much people want to spend and save. The pre-crisis theoretical orthodoxy on the monetary and macroeconomic side was: low and stable inflation was not just desirable but also sufficient as an objective, as then the financial system would be in balance because the money rate of interest would be in line with the natural rate of interest, and so the financial system would be creating the right amount of credit. So money creation by credit from private commercial banks had “no meaningful role” in influencing the amount of money in the economy (Mervin King 2012). On the financial theory side there was more concern that there would not be enough credit rather than too much, as debt contracts were seen to be essential and there was a belief that free markets by themselves would maintain an optimal balance.

But the crisis of 2008 showed that we created too much of the wrong kind of debt. Empirical arguments have since been developed that show the system can be too much credit as well as too little  (on a graph the relation of credit to GDP is an inverse or upside down U curve). We can lend money without a reasonable expectation of return, leading to overinvestment cycles. The securitization of subprime mortgages were a result of neglected risk.

In an upswing of the cycle, risks can be downplayed and banks can lend without due attention to risk leading to an over-creation of credit and debt contracts.

Debt contracts are not contingent on the state of a business or potential of an asset: so it is more possible to lend without a reasonable expectation of return.

In the downswing of the cycle, there can be bankruptcy and default, as debt contracts do not respond to the state of economy in a smooth fashion.

While past equity investment carries on, if something wrong with the lending machine, the debt cannot be rolled over and there is a problem.

With debt overhang as people realize they are at risk or lose confidence, businesses become aware they are highly leveraged they de-leverage and reduce their investment. Households reduce consumption and spending.  Debt overhang leads to a slow recovery.

There are two problems with debt and so two forward indicators of such a crisis: (1) the pace of the growth of debt is high, and once there is a crisis (2) the higher the level of private debt relative to GDP (the right end of the inverse U curve) the bigger the problem.

The facts show that the system created too much debt before the crisis. Twenty years before the 2008 crisis pace of private credit growth was on average 10% – 15% per year higher than nominal GDP, growing at 5% (credit/GDP). In western developed economies the level of  private domestic credit as % of GDP rose from 50% in 1950s to 180% of GDP.

In the pre-crisis way of thinking, there was a policy conundrum: if central banks raised the interest rate when rate of increase in credit was higher than the rate of increase in GDP, there would be a risk that growth would be slowed and inflation drop below the desired target. But if they did not then they feared there would be instability. So there seemed no way of creating conditions for an  equilibrium in a monetary economy needed for economic stability and the desired rate of growth. The monetary system in its current form seemed to be inherently unstable.

To address this there is a need to attend to different categories of credit.

The original assumption about retail banking was that savings by the household sector would be lent to the business sector to finance investment. But the reality is that this has been only 15% of the credit. Instead credit has been used to finance the purchase of existing assets.

Financing consumption can be useful for smoothing across the life cycle when there is budgetary constraint. But lending money against existing assets (such as mortgages for purchasing real estate in the form of an existing building) has been a major cause of financial instability. It drives up the price of the asset – real estate – which validates in the minds of those lending and borrowing that there will be an increase in its net worth and so motivates them to continue to borrow and lend. This can feed through to new investment or to consumption through wealth, but this is not fully proportional to an increase in nominal demand. Every 15 yrs one banking system lends money for real estate without prudence.

In commercial or private real estate, changes in the money lending interest rate for the whole economy do not on their own have a sufficient effect on the credit to asset price boom while credit is easily available the asset prices (e.g. price of real estate) increase. Natural rate of interest is the interest rate in the mind of borrower, how far they expect an asset to increase in value or price, determines how much they borrow. But there is no one single natural rate for the whole of the economy.

The result is that there is more monetary wealth but no increase in nominal demand, which is the indicator that the central bank uses to raise interest rates. So it does not show up immediately. There is a problem then of debt overhang.

Three causes of rising intensity of credit in relation to growth:

1. Lending money against existing assets, especially real estate, creating a rise in real estate prices and an asset boom.

2. Pace of increase in inequality increases and there is more credit for consumption. Richer people have a larger propensity or desire to save but this money is not used for investment as it is lent to poorer people in the form of subprime mortgages to make up for deficiencies in income.

3. Global current account imbalances between surplus and deficit nations.

Countries where surpluses are not matched by equity or real property claims against the rest of the world, then they will be balanced by credit claims against the rest of the world.

We shift leverage between private and public sectors, or between countries, as this is the only way we know to address the excess leverage.

As too much private credit is created and it is not misallocated and not used effectively, Lord Turner suggests we need to go beyond bank regulation and look at the structure of the system and behaviour within it to get stability and equilibrium and address imbalances. Monetary and fiscal policies are needed to prevent too much debt and credit intensity that leads to unstable growth, and control is needed by the central bank.

Current account imbalances between surplus and deficit nations as it drives credit intensity and unstable growth

The central banks need to attend to and manage the level of debt as well as the rate of increase in it. The inverse U can be anticipated.  The limit could be 80% or 90%; it is not possible to be precise. But it is possible to see the shape of an inverse U curve.

The allocation of credit arising as a result of free market decisions can never be socially optimal. There is an externality of lending against real estate that goes up in price; this can never be captured by logical private assessment of risk rates. So higher risk ratings for real estate credit are needed.

There need to be constraints on lending both for the borrower as well as the lender.

There need to be more institutions that dedicate themselves to using savings for investment (as in Germany).

 

 

 

 

Economics, Money System
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