Between Debt and the Devil: Money, Credit, and Fixing Global Finance by Adair Turner, Princeton, £19.95
Adair Turner caused a stir in 2009 when he described much financial activity as “socially useless.” It was part of an interview with this magazine—which he fails to name in his book, instead referring to “a worthy but small circulation intellectual magazine.” Ouch!
Now Turner, Chairman of the Financial Services Authority from 2008 to 2013, has gone much further in this important and ambitious book. The shocking results of that 2008 failure meant that subsequently the authorities, quite rightly, did what they had to do to avoid complete meltdown in the markets. But this book is not a memoir of his role in steering us through the financial crisis. Instead he addresses deeper questions about what got us into such a mess in the first place, and demolishes much of the conventional wisdom about the functioning of financial markets and monetary policy.
Back in the 1980s, free-market economics became the dominant model. Many of its insights remain valid: the obituaries of Geoffrey Howe reminded us how in his first year as Chancellor he removed controls over pay, price and dividends, and then exchange controls. It is hard to see us going back to the world from which he liberated us.
He draws on the parallels between the west’s problems now and Japan’s debt overhang identified by Richard Koo. Martin Wolf has already done a lot to explain how dysfunctional the modern financial system has become. John Muellbauer has shown the extraordinary distortions in our housing market. He identifies Hyman Minsky as one of the few economic thinkers who identified the problem, but was ignored in his lifetime. Turner brings all this together in a coherent and compelling critique.
He attacks the efficient market hypothesis that all available information is reflected in current prices. Financial markets are susceptible to herd-like behaviour in which, like wildebeest moving across the savannah, it is safest to stick with the herd. And markets cannot provide any mechanism to enable one to attach numerical values to fundamental uncertainty about the future as against the measurable risks facing the player at the roulette table. Financial deepening was supposed to be good for overall economic performance but instead we have been exposed to an even more severe cycle of boom and bust.
"Virtuous bankers complying with the regulations could nevertheless lead to high levels of debt"
Nevertheless Turner largely avoids banker bashing. There were individual examples of greed and criminality, but he shows that the heart of the problem lies elsewhere. Virtuous bankers complying with not just the letter but the spirit of the regulations could nevertheless lead to an economy with unsustainably high debt levels. He quotes Friedrich Hayek: “How nonsensical it is to formulate the question of the causation of the cycle in terms of ‘guilt’ and to single out, for example, the banks as those ‘guilty’… Nobody has ever asked them to pursue a policy other than that which gives rise to cyclical fluctuations; and it is not within their power to do away with such fluctuations, seeing that the latter originate not from their policy but from the very nature of the national organisation of credit.”
He rehabilitates a richer economic tradition, which saw that banking is not another service in just another market. The power of banks to create credit and money makes them special. He places credit, not just money, at the centre of his model.
By the end of the 1980s, the Treasury had already lost confidence in the easy applicability of monetary rules because monetary growth was failing to predict inflation in the way that monetarism predicted and intermediate monetary rules were losing credibility. The independence of the Bank of England solved this problem by setting a target for inflation and essentially handing over to the Bank the intellectually tricky issues over conduct of monetary policy. Instead of rules you looked to an institution, which would deliver the policy and keep credibility.
This model worked for a while but Turner shows that intellectually the cupboard is bare. He challenges the idea that an independent central bank measuring nominal GDP and monetary growth and achieving low inflation can be confident it has delivered financial stability. He argues that modern economies have come to depend on increases in borrowing and credit ahead of the growth of nominal GDP; and it was the growth of credit which was the vulnerability behind the crash. This was driven by three factors. First, bank lending for real estate investment became a key feature of the financial system. In the UK, housing wealth increased from 120 per cent of national income in 1970 to 300 per cent by 2010—most of it due to increases in land value. This massively benefited the generation which held most of this wealth at the time. The second factor is growing inequality. As richer people tend to save more so rising inequality is deflationary—unless offset by poor people accessing credit. The third is global imbalances—even the Germans depend on credit growth in other countries which import their goods.
Thus modern growth came to depend on credit growth which stores up problems for the future. Total household debt in the UK grew from 15 per cent of GDP in 1964 to 95 per cent by 2007. Private credit borrowing grew at 10 per cent per annum in the decade leading to the crash. That is why one of the first elements of monetarist doctrine to fail was the stable demand for money—with all these forms of money being created velocity of circulation was falling.
The financial sector became an ever-bigger part of the economy. This made the system more unstable but these dangers were hidden in the boom years. The bonuses and profits of the financial sector provided the tax revenues, which meant the public finances appeared healthier than they were and the real estate boom made us all feel richer than we really were. But the public and household finances were vulnerable to a crash. The ballooning public debt and borrowing is not attributable directly to the bank bailout but the lost revenues of a deep recession and a slow recovery. And unlike previous recoveries this one has not delivered a bounce back to get us back to the previous trend of growth. Instead it looks as if we are not as rich as we though we were.
The official doctrine said the old model was stable and successful. But we needed credit growth of 10-15 per cent per year to get 2 per cent inflation and real growth in line with inflation. As Turner puts it: “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.” You could have excessive credit growth and a Japanese-style debt overhang without suffering excess inflation.
But what is to be done? The real test will come at the next crisis. This is why policymakers are worrying. It could be a crash in China, or Grexit back on the agenda, or cyber-attacks seriously disabling the financial system or just the vagaries of the economic cycle. The eurozone looks vulnerable. Despite having once been an advocate of joining the euro, Turner now shows how it is in far worse trouble than we are. At least we have the capacity to issue debt as sovereign control over our currency. But the member states of the eurozone are effectively issuing sub-sovereign debt without the power to create fiat money and so with a risk of default which the UK does not have—and this affects their national banking system, as this debt is held by those countries’ banks.
What is available to tackle the next crisis? Entering a slow-down with interest rates close to zero and public debt close to 80 per cent is not a great start. And we must be getting to the limits of the system’s capacity to absorb quantitative easing (QE). That is why George Osborne and the Treasury argue that we need to reduce public debt now.
Turner argues for a far more radical approach. First he would stop excessive debt creation. He flirts with the idea of 100 per cent reserve banks as proposed in the US post-1930. But he does not go that far—instead he wants to tax credit intermediation. He argues that debt contracts appear to offer more certainty than they do and favours instead equity-type contracts in which a wider range of returns is signalled. He believes the authorities should influence allocation of credit between different uses. And, most radically, he is willing to embrace the idea of the government directly providing citizens with money to spend without the usual “sterilising,” which is intended to avoid monetary financing of public spending. This is what the President of the Bundesbank has explicitly compared to a pact with the devil. And we can understand why: it is a policy we associate with the hyperinflation of Weimar Germany and the rise of Hitler.
Turner responds by coming over all reasonable and moderate. He argues that the disciplines of the independent central bank can be used to limit these cash injections. Is £35bn of direct stimulus worse than £350bn of indirect stimulus through QE? The obscure structure of the Bank’s accounting might even be harnessed to monetise some of the QE, which has already happened. We do need ways of stimulating nominal demand that do not result in rising public debt. But there is a risk that inflation will result and we will be back to another old problem which we think we have resolved.
Back in the 1970s, the monetarist model was the exciting insurgent. It earned its longevity by shifting from intermediate monetary rules to independent central banks with an inflation target and a lot of discretion about how they met it. But even that model now looks inadequate. Fresh thinking is desperately needed and this book lays down a challenge which subsequent accounts of monetary policy will have to address.
Adair Turner caused a stir in 2009 when he described much financial activity as “socially useless.” It was part of an interview with this magazine—which he fails to name in his book, instead referring to “a worthy but small circulation intellectual magazine.” Ouch!
Now Turner, Chairman of the Financial Services Authority from 2008 to 2013, has gone much further in this important and ambitious book. The shocking results of that 2008 failure meant that subsequently the authorities, quite rightly, did what they had to do to avoid complete meltdown in the markets. But this book is not a memoir of his role in steering us through the financial crisis. Instead he addresses deeper questions about what got us into such a mess in the first place, and demolishes much of the conventional wisdom about the functioning of financial markets and monetary policy.
Back in the 1980s, free-market economics became the dominant model. Many of its insights remain valid: the obituaries of Geoffrey Howe reminded us how in his first year as Chancellor he removed controls over pay, price and dividends, and then exchange controls. It is hard to see us going back to the world from which he liberated us.
"Virtuous bankers complying with the regulations could nevertheless lead to high levels of debt"Nevertheless, theories can ossify into a doctrine that loses contact with reality. The crash of 2008 showed how this had happened to financial economics. Financial markets were supposed to be as close to the pure free market as you could get. Since the crash that model has been challenged by distinguished economists and commentators, and now Turner delivers the coup de grace. He comprehensively attacks all the key doctrines on which the conventional models of financial markets and monetary policy rested.
He draws on the parallels between the west’s problems now and Japan’s debt overhang identified by Richard Koo. Martin Wolf has already done a lot to explain how dysfunctional the modern financial system has become. John Muellbauer has shown the extraordinary distortions in our housing market. He identifies Hyman Minsky as one of the few economic thinkers who identified the problem, but was ignored in his lifetime. Turner brings all this together in a coherent and compelling critique.
He attacks the efficient market hypothesis that all available information is reflected in current prices. Financial markets are susceptible to herd-like behaviour in which, like wildebeest moving across the savannah, it is safest to stick with the herd. And markets cannot provide any mechanism to enable one to attach numerical values to fundamental uncertainty about the future as against the measurable risks facing the player at the roulette table. Financial deepening was supposed to be good for overall economic performance but instead we have been exposed to an even more severe cycle of boom and bust.
"Virtuous bankers complying with the regulations could nevertheless lead to high levels of debt"
Nevertheless Turner largely avoids banker bashing. There were individual examples of greed and criminality, but he shows that the heart of the problem lies elsewhere. Virtuous bankers complying with not just the letter but the spirit of the regulations could nevertheless lead to an economy with unsustainably high debt levels. He quotes Friedrich Hayek: “How nonsensical it is to formulate the question of the causation of the cycle in terms of ‘guilt’ and to single out, for example, the banks as those ‘guilty’… Nobody has ever asked them to pursue a policy other than that which gives rise to cyclical fluctuations; and it is not within their power to do away with such fluctuations, seeing that the latter originate not from their policy but from the very nature of the national organisation of credit.”
He rehabilitates a richer economic tradition, which saw that banking is not another service in just another market. The power of banks to create credit and money makes them special. He places credit, not just money, at the centre of his model.
By the end of the 1980s, the Treasury had already lost confidence in the easy applicability of monetary rules because monetary growth was failing to predict inflation in the way that monetarism predicted and intermediate monetary rules were losing credibility. The independence of the Bank of England solved this problem by setting a target for inflation and essentially handing over to the Bank the intellectually tricky issues over conduct of monetary policy. Instead of rules you looked to an institution, which would deliver the policy and keep credibility.
This model worked for a while but Turner shows that intellectually the cupboard is bare. He challenges the idea that an independent central bank measuring nominal GDP and monetary growth and achieving low inflation can be confident it has delivered financial stability. He argues that modern economies have come to depend on increases in borrowing and credit ahead of the growth of nominal GDP; and it was the growth of credit which was the vulnerability behind the crash. This was driven by three factors. First, bank lending for real estate investment became a key feature of the financial system. In the UK, housing wealth increased from 120 per cent of national income in 1970 to 300 per cent by 2010—most of it due to increases in land value. This massively benefited the generation which held most of this wealth at the time. The second factor is growing inequality. As richer people tend to save more so rising inequality is deflationary—unless offset by poor people accessing credit. The third is global imbalances—even the Germans depend on credit growth in other countries which import their goods.
Thus modern growth came to depend on credit growth which stores up problems for the future. Total household debt in the UK grew from 15 per cent of GDP in 1964 to 95 per cent by 2007. Private credit borrowing grew at 10 per cent per annum in the decade leading to the crash. That is why one of the first elements of monetarist doctrine to fail was the stable demand for money—with all these forms of money being created velocity of circulation was falling.
The financial sector became an ever-bigger part of the economy. This made the system more unstable but these dangers were hidden in the boom years. The bonuses and profits of the financial sector provided the tax revenues, which meant the public finances appeared healthier than they were and the real estate boom made us all feel richer than we really were. But the public and household finances were vulnerable to a crash. The ballooning public debt and borrowing is not attributable directly to the bank bailout but the lost revenues of a deep recession and a slow recovery. And unlike previous recoveries this one has not delivered a bounce back to get us back to the previous trend of growth. Instead it looks as if we are not as rich as we though we were.
The official doctrine said the old model was stable and successful. But we needed credit growth of 10-15 per cent per year to get 2 per cent inflation and real growth in line with inflation. As Turner puts it: “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.” You could have excessive credit growth and a Japanese-style debt overhang without suffering excess inflation.
But what is to be done? The real test will come at the next crisis. This is why policymakers are worrying. It could be a crash in China, or Grexit back on the agenda, or cyber-attacks seriously disabling the financial system or just the vagaries of the economic cycle. The eurozone looks vulnerable. Despite having once been an advocate of joining the euro, Turner now shows how it is in far worse trouble than we are. At least we have the capacity to issue debt as sovereign control over our currency. But the member states of the eurozone are effectively issuing sub-sovereign debt without the power to create fiat money and so with a risk of default which the UK does not have—and this affects their national banking system, as this debt is held by those countries’ banks.
What is available to tackle the next crisis? Entering a slow-down with interest rates close to zero and public debt close to 80 per cent is not a great start. And we must be getting to the limits of the system’s capacity to absorb quantitative easing (QE). That is why George Osborne and the Treasury argue that we need to reduce public debt now.
Turner argues for a far more radical approach. First he would stop excessive debt creation. He flirts with the idea of 100 per cent reserve banks as proposed in the US post-1930. But he does not go that far—instead he wants to tax credit intermediation. He argues that debt contracts appear to offer more certainty than they do and favours instead equity-type contracts in which a wider range of returns is signalled. He believes the authorities should influence allocation of credit between different uses. And, most radically, he is willing to embrace the idea of the government directly providing citizens with money to spend without the usual “sterilising,” which is intended to avoid monetary financing of public spending. This is what the President of the Bundesbank has explicitly compared to a pact with the devil. And we can understand why: it is a policy we associate with the hyperinflation of Weimar Germany and the rise of Hitler.
Turner responds by coming over all reasonable and moderate. He argues that the disciplines of the independent central bank can be used to limit these cash injections. Is £35bn of direct stimulus worse than £350bn of indirect stimulus through QE? The obscure structure of the Bank’s accounting might even be harnessed to monetise some of the QE, which has already happened. We do need ways of stimulating nominal demand that do not result in rising public debt. But there is a risk that inflation will result and we will be back to another old problem which we think we have resolved.
Back in the 1970s, the monetarist model was the exciting insurgent. It earned its longevity by shifting from intermediate monetary rules to independent central banks with an inflation target and a lot of discretion about how they met it. But even that model now looks inadequate. Fresh thinking is desperately needed and this book lays down a challenge which subsequent accounts of monetary policy will have to address.
