Adair Turner is Chairman of the Board of the Institute for New Economic Thinking, and came on as Chairman of Britain’s Financial Services Authority just as the world sank into financial crisis in 2008. He discusses his new book, Between Debt and the Devil: Money, Credit, and Fixing Global Finance and the critical questions — and radical solutions — that can help lift the economy for everyone. *This post originally appeared on the blog of the Institute for New Economic Thinking.
Lynn Parramore: Your book raises fascinating questions about the way we relate to money and how modern economies work. You talk a lot about finance— all the lending and swishing around of money and credit that allows a business to invest or lets me purchase a house, and so on. Why the focus on finance?
Adair Turner: A striking feature of the last 50 or 60 years in advanced economies, particularly in the U.S. and the U.K., is the dramatic increase in the relative role of finance. It’s gone in the U.S. from 2 ½ percent to about 8 percent of GDP. If finance was like restaurants or hotels or automobiles or clothes, we’d say, well, if it’s grown it must be because as people got richer, they wanted to buy more of these things, and it’s up to consumers. But nobody gets up in the morning and says, I think I’ll have a really good day today: I’ll go and buy some financial services. It’s not an end-consumption good. It’s not part of what makes us enjoy life. If what finance is doing is making the rest of the economy more efficient, then it’s beneficial. But there are some very big questions about whether we need all the finance we’ve got.
LP: When I walk down my city block, I pass three banks before I reach the end. I think, ok, those are the places I go to put my money and then the bank lends it out for investment. But there do seem to be more and more of them, which is kind of odd. You actually consider the question of whether banks should even exist. Tell me about that. Don’t we need them?
AT: Banks do provide payment services, which we need. Banks also provide loans, and we certainly need some loans in the economy. But there are two big issues for debate — and I deliberately pose them, even though I don’t end up saying we should abolish banks. First, yes, we need loans and private credit. But can you have too much? Increasingly, economists are realizing that you can. If private credit to GDP, private loans to GDP, is 50 percent rather than ten percent, that’s probably good for the economy. But if it’s 200 percent, then that’s probably bad. So in my book I ask, why is it possible to have too much? And why does this create instability in the economy?
The second question is, do you want banks to be the people who provide loans? If loans weren’t provided by banks, there would be a naturally arising limit to them because a set of individuals would decide whether to pick up their money and loan it to somebody else. The really intriguing thing about banks is that they don’t just take preexisting money and lend it on. They have a capacity to create credit, money, and purchasing power.
LP: Wait, doesn’t the government print the money in my pocket?
AT: Only a very small proportion of the money supply of an advanced economy is printed by the government. If you add up all the stuff called the “monetary base” — either the notes and coins which circulate or the holdings which the commercial banks have at the central bank, at the Federal Reserve — it’s a very small percentage, around two or three percent in the U.K. Most of the money supply is deposits at commercial banks or things which are very close to money, like deposits at money market mutual funds. That’s where most people hold the thing that is an immediately available store of value: what they think of as money. Most of that has been created by the banking system itself.
A bit of history on how banks arose: In the 13 th or 14 century, you might take your gold to a goldsmith for safekeeping. But then after a while, the goldsmith says, ok, if you give me the gold for safekeeping, I can give you a receipt. Then the receipt turns out to be something you could trade to other people. The goldsmith started saying, well, not everybody’s going to demand back the gold at the same time. So I can lend some out. Finally, they realized they didn’t need to lend out the gold, they could just lend out receipts to the gold. You just ended up with a very significant increase in credit or money or various forms of money-equivalent.
That process can be controlled by the government if it imposes liquidity requirements and reserve requirements on the banks. But it has to consciously impose them because left to itself, the banking system in total can — and will —create lots of credit and purchasing power. Then, if people lose confidence, it will destroy it as well. For instance, the story described in a great historical work which Milton Friedman did with Anna Schwartz, The Monetary History of the USA, is an extraordinary process of private banks creating spending power in the 1920s, followed by the complete collapse of that spending power between 1929 and 1933. Most of that spending power increase and decrease had nothing to do with the federal or state governments—it occurred within the banking system.
LP: How does this relate to financial crises?
AT: Let’s look at the scale of the increase of lending that occurred. In 1950, across advanced economies, private credit was about 50 percent of GDP. It grew gradually up until the 1990s and then it grew even faster over the last 20 years up to 2007, when it reached 170 percent. The vast majority of all of that lending was actually not what the economic textbooks say banks do. They almost always say that banks lend money to entrepreneurs or businesses in order to fund capital investment. Well, that’s about 15 percent of what they do. Most is lending money against real estate. Some of that real estate is newly constructed, but most of the lending goes to people or to commercial real estate investors to buy real estate that already exists. There’s actually a socially useful function here – we need mortgages to lubricate the exchange of houses between individuals and between generations. But it’s a process that can incredibly easily get out of hand.
It can get out of hand, particularly when you’re talking about cities where it’s difficult to build new houses, like Manhattan, like San Francisco, like bits of L.A. or Miami — all the places with zoning constraints or where there’s a very strong tendency for people who can afford it to want to live in town and not right on the edge of town. In those areas, when you have a lot of credit extended, the price of houses goes up in the short term. Most of the housing value is not explained by the bricks and mortars, it’s explained by the land on which it sits. The reason why this is important is that you can get into these cycles, which we’ve seen again and again, where more credit gets extended to buy houses, so the price of houses or commercial real estate goes up, so borrowers think, oh, I’d better borrow some more money. The lender thinks, oh, it would be sensible to lend some more money. The process just goes on, up and up in a cycle until confidence breaks and then it comes down. When it comes down it drives the economy into a recession because you get a whole load of corporations or households which suddenly feel like they’ve got too much debt and they just hit the brakes on investment and consumption.
The debt just never goes away—it simply shifts around the economy from the private to the public sector. Soon it seems that all our classic policy levers are stuck. We think, well, the private sector is trying to cut debt, so why don’t we offset that with public deficits?
LP: Is that what happened in the U.S. in 2009?
AT: Yes, a whole load of U.S. households started cutting consumption and the economy went into a recession. Tax revenues went down, public expenditures went up, and unemployment went up. To begin with, you get a fiscal deficit and that seems fine, but the problem is, after a while the public debt goes up, and it’s as if for every unit that private debt goes down, public debt goes up two or three, and the total amount of debt goes up and up. After a while, people say, we can’t allow the public debt to go up anymore, we’ve got to try and get the fiscal deficit under control. Then you’ve got the public sector and the private sector trying to get their debt burdens under control, and that drives the economy into recession. To fix this we say, ah, let’s have ultra-loose monetary policy. We’ll have interest rates which are zero. We’ll have quantitative easing. But if people feel that they’re over-leveraged, you can cut the interest rate to zero and they still don’t want to borrow or invest or consume.
LP: And this is where we are now, right?
AT: This is where the devil comes in. A lot of people say that we’re stuck in this long-term, slow, inadequate growth across the world and we’re out of ammunition to fight against it. We can’t raise the fiscal deficits and we can’t cut interest rates even more than zero. I make the point that governments and central banks together never run out of ammunition because they always have a policy instrument available. Milton Friedman — not a mad, inflationist socialist! — said that if you ever get stuck in that position, what you do is “helicopter money.” (The original Friedman thought experiment involved the central bank distributing money by helicopter). You run fiscal deficits financed by printed money.
We’ve made this a taboo because we’re terrified by Weimar Germany and modern Zimbabwe, where people did it on such a large scale that it produced hyperinflation. So people say, you mustn’t even talk about money finance or helicopter money because it will produce hyperinflation. But they simultaneously say that we can do nothing whatsoever about deflation. Now, it can’t be true that it’s as binary as that. It can’t be true that money finance is an instrument which is either incapable of doing anything or the moment you switch it on takes you to hyperinflation. Clearly, from history, it is a tool which can be used provided you design it well, in moderation.
LP: So the devil is printing money?
AT: It’s called the devil because, interestingly, three years ago, Jens Weidmann, the president of the Bundesbank, gave a speech in which he came pretty close to suggesting that Mario Draghi was growing horns when first suggesting quantitative easing in Europe. Jens referred to a famous part in Goethe’s Faust, Part Two, in which Mephistopheles, the devil, tempts the emperor and says, you don’t need to be constrained in your expenditure by your tax revenues or how much people are willing to lend you, you can print money! Jens argued that this illustrates what a dangerous thing it is.
LP: So we have it in our cultural DNA to view the printing of money with alarm.
AT: We do. But there are many historical examples of printing money successfully. The Pennsylvania Colony, back in the 1720s and 30s, printed money, stimulated the economy, and did not produce hyperinflation. Other of the colonies printed money and produced extreme inflation. There’s a wonderful quote from Adam Smith where he says that the Pennsylvania expedient worked precisely because of the moderation, and for want of that moderation, the same expedient in the other colonies produced harm rather than benefit. It depends on how much you do.
The Union government, in the American Civil War, paid for quite a lot of the war by printing greenbacks. It did produce significant inflation, but it didn’t produce hyperinflation. On the Confederate side, it went completely over the top and produced thousands of percents of inflation, hyperinflation. Another case is when Takahashi, the Japanese finance minister, used money printing in the early 30s to pull the Japanese economy out of recession, and it worked. If you look at how America paid for the Second World War, probably 15 percent was effectively paid for by money printing. Money printing by the Federal Reserve directly funded the budget deficit. The government sold some bonds and then the Federal Reserve bought them, but it bought them permanently. That went on all the way from 1942 to 51. But it didn’t produce a hyperinflation. In 1951, it was brought to an end, but it was never reversed.
LP: Perhaps we need to develop, as the Rolling Stones put it, some "sympathy for the devil."
AT: Monetary finance is like a medicine, which, taken in small quantities, can be very valuable, and taken in large quantities, is toxic. We have to make a choice as to whether we trust ourselves enough to create a set of rules and institutional relationships that would give us the confidence that we could use money printing and money finance in a responsible fashion in a small amount, or whether we’re so terrified that we’ll misuse it that we lock it away in the medicine cabinet, even if, in certain circumstances, it would be helpful.
My belief is that we are in such a deep deflationary problem across the world that we have to consider radical options.
LP: Time to unlock the cabinet?
AT: Unlock the cabinet. Now, other people would say we have to consider other radical options. If Ken Rogoff was here, he would agree with me entirely that there’s far too much debt in the world for us just to grow out of it. He would not want to do money printing, but rather big debt write-offs. Or he would say we’ve got to drive the interest rate down to a negative level. But I think all the serious analysis increasingly realizes that we are a long way from being out of the effects of the crisis of 2008, and that all our classic policy levers just haven’t worked in the way that we thought they would.
If you go back to 2009, nobody foresaw that the central bank interest rates, having gone to zero, would be there six years later. For the last two years, we’ve been involved in a perpetual game where we’re always expecting the Federal Reserve to begin to increase interest rates and we’re continually disappointed. That’s because most people, the markets, the commentary, have failed to realize what a deep deflationary impact there is of the debt that we accumulated. The book is called Between Debt and the Devil because we have to think of two different ultimate ways in which economies grow the nominal value of demand. One of them is by governments directly or indirectly printing money and spending it. The other is by the banking system creating credit, money, and purchasing power.
The problem, before the crisis, was that we were completely relaxed about everything the private financial system did in terms of creating credit, money, and purchasing power. Now we’re far too terrified of the government printing some money and creating purchasing power. What we’ve got to understand is that both government creation of money and spending power and private creation of money and spending power can be dangerous and both can be useful. Optimal policy is about using both but constraining both, rather than iconizing one and demonizing the other.