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  ©2015 CFA Institute ã cfa pubs .org First Quarter 2015  ã 19 Managing Credit Creation—Beyond Inflation Targeting Adair Turner Member House of Lords London Bank capital and derivatives regulation are not sufficient to avert another global financial crisis, primarily because of a buildup of excessive bank lending in real estate. Future policies must prevent the buildup of real economy debt and leverage to excessive levels. Monetary policy and macroprudential policy together must play a role in constraining and influencing both the quantity and the allocation of credit within the economy. I n the aftermath of the crisis, the advanced economies faced a debt overhang problem—excessive debt in the real economy—so severe that no combination of monetary and macropru- dential policies could provide more than an imperfect response. Such an imperfect response carries two impli- cations for policy. One implication is that escap- ing from the post-crisis recession may require— particularly in the eurozone—policies that go far  beyond and are quite different from the combina-tion of fiscal austerity and monetary stimulus that has formed the predominant post-crisis orthodoxy. Second, and the focus of this discussion, is that policies need to be developed that can prevent the buildup of real economy debt and leverage to excessive levels. The latter requires a wide- ranging rejection of pre-crisis orthodoxy regard- ing the objectives and the tools of central bank monetary policy.Pre-crisis orthodoxy states that low and stable inflation is not only a necessary objective but also sufficient to ensure macroeconomic and financial stability. It pays little attention to rising private sector leverage, and it rejects any idea that macroeconomic policy could or should distinguish between the eco- nomic function and benefit of alternative categories of credit provision. In contrast, I will argue that both the level of leverage and the mix among different categories of debt are fundamental determinants of not only narrowly defined financial stability but also over-all macroeconomic stability. Monetary policy and macroprudential policy together must play a role in constraining and influencing both the quantity and the allocation of credit within the economy. Contrary to pre-crisis orthodoxy, several cen-tral banks are now in the business of discriminat-ing among different categories of credit. The Bank of England’s Funding for Lending Scheme has incentives deliberately skewed to boost small and medium-sized enterprise (SME) lending but not mortgage lending. And the European Central Bank’s (ECB’s) new long-term refinancing operation, intro- duced in September 2014, is similarly skewed. Many central bankers seem to believe that such discrimination is a regrettable necessity under extreme circumstances and that lending will eventually return to a more neutral approach. My argument here is that no such return will or should occur because different categories of credit perform different functions within the economy, with very different implications for macroeco- nomic stability. Leverage and Pre-Crisis Orthodoxy: The Financial System as a Neutral “Veil” The most fundamental reason why the 2008 financial crisis has been followed by such a deep and long-lasting recession is the growth of real economy leverage in advanced economies over the previous half-century, with private sector credit as a percent-age of GDP growing from 50% in 1950 to 170% on the eve of the crisis. Of course, the crisis itself was triggered by multiple dangerous developments within the financial system—excessively leveraged banks, This presentation comes from the European Investment Conference held in London on 16–17 October 2014 in partnership with CFA Society United Kingdom.  CFA Institute Conference Proceedings Quarterly  20  ã First Quarter 2015  ©2015 CFA Institute ã cfa pubs .org dangerous maturity transformation, and defi- ciencies within the complex set of developments labeled “shadow banking.” But it is excessive leverage in the real economy of households and companies, and the resulting post-crisis debt overhang, that explains why six years of interest rates close to the zero bound have been able to produce only slow and weak recovery. Ahead of the crisis, this growth in leverage rang few alarm bells. Rather, it was treated as either positively benign or simply neutral. The benign assessment dominated among finance theorists and appeared to be supported by economic history and econometric results. Finance theory explains why the existence of debt contracts—which promise an apparently fixed return—facilitate a more effective intermediation of capital from savers to businesses/entrepreneurs than would be possible if only equity contracts existed. Empirical analysis suggested that “financial deepening”—including in the spe-cific form of increasing the ratio of private credit to GDP—was positively correlated with growth (Levine 2004). Any concerns, therefore, were focused on such countries as India, where private credit as a percentage of GDP seemed “too low.” Any idea that private credit could grow to levels that were “too high” was largely absent. Modern macroeconomic theory and central bank policy analysis have tended to treat the growth of leverage as simply neutral. In fact, to quite a sur- prising extent, economic theory largely ignored the details of the financial system. Major textbooks of new Keynesian monetary theory say little about the role of banks and financial intermediation. Central  bank models used to inform policymaking—the so-called dynamic stochastic general equilibrium models—had little or no role for the financial sys- tem itself. As Olivier Blanchard, chief economist at the International Monetary Fund (IMF), said, “We assumed that we could ignore much of the details of the financial system.”The financial system was thus treated as a neu- tral “veil” through which monetary policy passed to the real economy but whose size and detailed structure were largely unimportant. As long as cen- tral banks achieved low and stable inflation through interest rate policy, the level and mix of credit created seemed of no macroeconomic importance. Modern monetary theory is strangely silent about credit and leverage. But it still rests, at least implicitly, on a theory about the relation-ship between credit creation and inflation that goes back to the Swedish economist Knut Wicksell (1936). Wicksell noted the ability of private banks to create credit, money, and purchasing power and worried that if they extended too much credit to  businesses/entrepreneurs, harmful inflation would result. 1  He argued that the harmful inflation would occur if market rates of interest were set to less than the “natural rate” of interest (i.e., the return that  businesses/entrepreneurs can earn on new capital investment). But as long as the central bank ensured that market interest rates were broadly in line with the natural rate, the pace of credit creation would  be optimal.In fact, as Wicksell also argued, the natural rate cannot be directly observed, so central banks cannot follow a rule under which they set policy rates in line with it. But what they can do is set policy rates to deliver low and stable inflation, knowing that such stability will be achieved only if the policy rate and the natural rate are aligned. Thus, low and stable inflation seems to ensure optimal credit creation, and central banks do not need to pay direct attention to the amount or the mix of credit being created nor to the details of the financial system itself. Alternative Uses of Credit: Capital Investment, Consumption, and Existing Assets Finance theory assumes that rising leverage is posi-tively beneficial; modern monetary theory assumes that it is neutral in terms of its macroeconomic effects but optimal because finance theory says so. But both of these conclusions rest on a dangerously mistaken assumption. Almost any standard economic textbook, if it describes the banking system at all, will typically explain how banks take deposits from savers (such as households) and lend the money to entrepre- neurs/businesses, allocating capital between alter- native investment projects. As descriptions of what  banks—or indeed many debt capital markets—do in modern advanced economies, this account is largely fictional. There are three conceptually distinct func- tions of lending.First, credit can be used to finance new capital investment, whether in plant and machinery, real estate, or human capital. In relation to that element of credit, it might be somewhat true that excessive credit creation will tend to result in inflation, and that controlling inflation will, therefore, constrain excessive credit supply. 2  Second, credit can be used to finance increased consumption by enabling 1 See Turner (2013a) for a more detailed discussion of Wicksell’s analysis. 2 The belief that credit-fueled overinvestment cycles must pro- duce excess inflation was contested by F.A. Hayek in his  Monetary Theory and the Trade Cycle  (1933). See Turner (2013a) for a discus-sion of the link between real estate construction cycles and price cycles in existing real estate.  Managing Credit Creation—Beyond Inflation Targeting ©2015 CFA Institute ã cfa pubs .org First Quarter 2015  ã 21 households to consume now and pay back later. That may sometimes, as economic theory suggests,  be welfare enhancing by allowing a more efficient inter-temporal allocation of consumption within lifetime permanent income constraints. But it has nothing to do with the allocation of capital. And the quantity of such credit extended is in no way governed by a relationship between the market and the “natural” rate of interest. Third, it can be—and to a very large extent is—used to finance the pur- chase of assets that already exist. Those assets could include, for instance, existing companies, with buy- outs often accompanied by significant increases in leverage but no increase in investment. But the most important existing asset is real estate. The major- ity of bank lending in advanced economies is used to finance a competition between households and  between companies for the ownership of existing real estate and effectively for the irreproducible urban land on which it sits.In the United Kingdom in 2009, total bank lend- ing was divided between consumer credit (£227  billion), residential mortgages (£1,235 billion), com- mercial real estate (£243 billion), and other corporate lending (£232 billion). Mapping these figures against the three functions of credit cannot be too precise for several reasons. Lending against real estate (whether residential or commercial) can finance either actual real estate construction (the first function) or the pur-chase of real estate that already exists (third function). And a residential mortgage can be used either to fund the purchase of real estate assets (third function) or to fund increased consumption through equity with- drawal (second function). Although the mapping can only be imperfect, it is clear that the majority of lending in the United Kingdom before the crisis fell into the third cat- egory, with a large element in the second category as well. The United Kingdom had a large mortgage and house price boom, but it did not have a major construction boom. A large slice of commercial real estate lending also supports investment in existing property assets, not new construction. As for lend- ing to finance investment apart from real estate, it is clear that it accounts for no more than about 15% of all UK bank lending. That pattern is not unique to the United Kingdom but is found across the advanced econo- mies. Jordá, Schularick, and Taylor (2014) analyzed the percentage of total bank lending devoted to real estate in 17 advanced economies from 1870 to 2013. Their results illustrate the relentless rise in the importance of real estate since 1950, with increased real estate lending being by far the predominant driver of the increase in leverage, as shown in Figure 1 . They concluded that “with very few exceptions, the banks’ primary business consisted of non-mortgage lending to companies in 1928 and 1970. In 2007, banks in most coun- tries had turned primarily into real estate lenders” (p.10). And furthermore, “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” (p.2). So, the textbooks are wrong; at the very least they should be changed to reflect reality. Lending against real estate, which has a somewhat inelastic Figure 1. Ratio of Real Estate Lending to Total Bank Lending in 17 Countries, 1880–2013 Ratio (%)7060504030201001880 10 50 901900 30 7090 20 6040 80 2000 10 Note:  Share of real estate lending to total lending is averaged for the 17 countries. Source:  Based on data from Jordá, Schularick, and Taylor (2014).  CFA Institute Conference Proceedings Quarterly  22  ã First Quarter 2015  ©2015 CFA Institute ã cfa pubs .org supply, has powerful implications for financial and economic stability that are not well captured by any concept of the relationship between the market and the “natural” rate of interest. At the core of financial and macroeconomic insta- bility in advanced economies lies an endogenous rela- tionship between credit extension and asset prices, and above all, real estate prices. In the upswing of the cycle, more credit extended against assets with an inelastic supply drives up the price, which then produces both increased credit demand and credit supply. On the borrower side, observed asset price increases generate expectations of further increases, which create incentives to borrow more to enjoy capi-tal gain or simply not to “lose one’s place on the hous- ing ladder.” Although on the lender/supply side, rising asset prices mean lower loan losses, increased  bank capital bases, increased capacity to lend, and increased confidence that further lending is likely to be profitable. In the downswing of the cycle, the process swings into reverse, driving down both credit demand and credit supply in a self-reinforcing cycle. Because of these cycles, as Claudio Borio at the Bank for International Settlements (BIS) has stressed, credit and real estate price cycles are not just part of the story of financial and macroeconomic instability in advanced economies, they are almost the whole story (Borio 2012). That was true in Japan’s banking crisis in the 1990s, the Scandinavian crisis in the early 1990s, and the latest crisis in 2008. Policy levers must be developed and deployed that will push back against those cycles and protect the financial system from their impact. That goal justifies the macroprudential tools similar to those that the UK Financial Policy Committee now has at its disposal.The focus cannot be just on the resilience of the financial system itself; it must also be on the mac- roeconomic impact of different categories of credit provision. Three key realities need to be understood: ã There are underlying factors increasing the importance of real estate in advanced econo-mies, which might increase instability even in the absence of credit finance. But credit supply further accentuates those risks. ã The most important cause of weak post-crisis recovery is not an impaired banking system but the real economy debt overhang and attempted private sector deleveraging. ã Excessive credit creation—particularly when it takes particular forms—can produce severely harmful effects without ever producing excess inflation that an inflation-targeting central bank would feel compelled to respond to. Real Estate in Advanced Economies Thomas Piketty’s book Capital in the Twenty-First Century  has for good reason attracted great atten- tion. It focuses on the remarkable increase in the ratio of wealth to income that has occurred in advanced economies over the past 50 years. But what is startlingly clear from Piketty’s own figures is that the predominant driver of that increase is the increasing value of real estate. Figure 2  shows capital in the United Kingdom rising from around 200% of national income in 1950 to more than 500% in 2010, and the bulk of that increase is explained by the increasing value of residential homes. Again, this phenomenon is not limited to Figure 2. Capital in the United Kingdom, 1700–2010 Net Foreign AssetsOther Domestic CapitalHousingAgricultural LandPercentage of National Income (%)8006007005004003002001000170020101810505080207090191050 Note:  The x -axis is not to scale. Source:  Based on data from Piketty (2014).
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