Lord Turner, the final keynote speaker of ECOBATE 2014, acknowledged Professor Richard Werner’s influence on his thinking:
'Richard's writings on monetary policy and the importance of a credit focus are absolutely important, and very important to the evolution of my thinking.'
He recalled a Financial Policy Committee meeting at the Bank of England in the autumn of 2011, where in a discussion about whether the policies under discussion would stimulate credit or restrict credit, he said 'we had to talk about what the credit is used for' but was told very firmly that: 'it was not the role of a central bank to ask questions about the market allocation of credit'. However, central banks across the world are now actually doing what he suggested then. For example the Bank of England's subsidised Funding for Lending scheme specifically wants: 'incentives for lending skewed towards SME's' (small and medium enterprises), rather than real estate lending and mortgages.
Lord Turner had a problem because his slide show went astray en route. But we were favoured instead with a bravura oratorical performance such as is rarely seen and heard in these days by the often inept use of PowerPoint. He strode the stage issuing a fascinating flow of ideas, using judicious arm waving to describe the slope of the missing graphs, as needed. One wished that speakers lost their slides more often - it might prompt better speeches and greater audience attention. But our speaker was on top of his subject, so that was obviously vital too.
He warned that there is a general understanding that this new tendency is only an extreme passing phase and that we ought to return to the pre-crisis orthodoxy of inflation targeting as the monetary aim, but he said: 'We cannot, we will not, we should not return to that' . Monetary policy in the future must distinguish between the different purposes to which credit is put.
A diversion into different economics theories followed:
a) Private borrowing in advanced economies has gone from 50% of GDP in the 1950s to 170% in 2007. Without reasonably safe debt for railway funding in the C19 we would not have had the mobilisation of capital that drove the industrial revolution. Thus some see high private sector leverage to be good for economic growth, e.g. India at 10%, needs more.
b) Others suppose that leverage and the details of the entire financial system are not important. Quoting Mervyn King:
'The dominant new Keynesian model of monetaray economics lacks an account of financial intermediation so that money, credit and banks play no meaningful role.'
Lord Turner taking us along with him in our bafflement: Surely if interest rates are the main economic tool doesn't that work through the financial system? It became clearer that the theory contains its own odd irrationality. He said that interest rate manoeuvering to achieve low and stable inflation 'somehow' operates through the financial system, which is understood by it exponents to be rather like a veil which itself is not impacted by the interest rate. The theory goes that whatever credit creation and lending happened for whatever interest rate and whatever the credit was allocated towards must be optimal. [All very Humpty Dumptyesque - Alice in Wonderland: 'A word means just what I intend it to mean...']
The whole basis of this comes from Knut Wicksell who promulgated a theory of a 'natural' interest rate which policy makers should aim to target so as to prevent inflation. Trouble is no one can observe what the natural rate is so central banks use the policy interest rate to try and achieve low inflation and assume that credit in the economy is optimal. This relies on two assumptions that are mistaken. Undergraduate text books often do not contain details of banking and finance but if they do they state that banks take deposits from savers and lend it to entrepreneurs. This is a mythological understanding of how banks and capital markets work. The truth which was fundamental to Hayek and to Schumpeter is the understanding that banks create credit money and purchasing power. They do not lend pre-existing deposits. If this is not understood we cannot understood the real economy.
Lending can be used for capital investment, for consumption and for buying assets. He said that over 70% of lending is towards pre-existing real estate and this finances a competition for a scarce, location-specific supply of urban land. The highly misleading text book role of banks: to intermediate household savings into productive business investment is a minor function today.
The emphasis on real estate lending creates a cyclical pattern which is self-feeding. Banks experience few losses as the boom starts and are able to lend more and the rising prices enable them to extend even more credit. Hopeful property owners, fearful of losing out add to the pressure. This is at the core of financial instability and the crises of the last 50 years. Whether in the UK, Japan, Sweden and Norway and elsewhere world wide, real estate credit is the root cause. Post-peak, borrowers become determined to pay down their over-leveraged debt and withhold investment from elsewhere and the deep recession we are now experiencing endures.
How do we get out of all this debt? It gets moved around the economy. For every % point of private debt reduction we get a raised % point in public debt because tax revenues are reduced due to recession and welfare has had to rise. All public policy levers are locked off. We worry about how to pay back the public deficit, we try and stimulate the economy by reducing interest rates without the desired response. So why have the low interest rates failed to bring inflation? The answer is the use to which the credit is put. He cited Richard Werner's book (New Paradigm in Macroeconomics) and his studies on the disaggregation theory of credit. The rise in credit for assets and particularly for real estate is a good indicator of future financial crisis but not of inflation in the real economy. In these circumstances the tool of inflation targeting using interest rates is not usable. To raise interest rates from 5% to 5.5% to dampen property price rises of 10% would be ineffective but to raise them to 10% would cause serious damage to the rest of the economy. He mentioned the failed experiment by the Swedish Riksbank (see this blog) as evidence of a central bank that tried this.
He wants central banks to set risk weighting far higher for mortgage lending than banks would set for themselves, to take account of the social risk; to use loan-to-value limits; and to introduce a new type of bank with restricted property lending powers but enabling productive lending. He ended on the emphasis that the differentiation of what credit is to be used for 'should be, will be and must be' a permanent part of the financial scene.
In the questions session following I put it that, frequently in this ECOBATE event the root cause of the crisis was mentioned to be property and real estate lending and speculation. Would the panel comment about the use of land value taxation to restrain the tendency to use credit in the property market and 'remove speculators' asbestos gloves' so that they wouldn't speculate so readily?
Lord Turner acknowledged, as Thomas Piketty has shown (Capital in the 21st Century) that wealth disparities are strongly correlated with increasing urban land values. He thinks tax favouritism such as exempting property gains from capital gains tax is a public policy making the situation worse. But that public policy could 'lean against' the situation by using Henry George's land value tax. He said we should be aware of possible effects from changes in public policy that cause instability in the economy and the need to offset those effects with other changes.
Sir John Gieve said that we should not think that hitting property for tax in place of VAT and income tax is possible, due to the public debt overhang which needs servicing. But yes, property taxation will increase along with other types. In an interesting follow-on point, Richard Werner said, regarding the high government debt and the high taxes needed for servicing it, that this arises from our debt-based monetary system. He is a well known advocate of a debt-free monetary system (YouTube) that would reduce much taxation.
POST CONFERENCE news item, Lord Turner 11 Nov 2014 in the Financial Times: Print Money to fund the deficit states:
'Government deficits should be financed with new money created by the central bank and added permanently to the money supply. ... There are no technical reasons to reject this option, only the fear that once we break the taboo, money financed deficits will be used on too large a scale'.
He sees such a policy is inevitable, thinking that current QE policies may be even more risky. He thinks the above would bring a return to normal interest rates which would counter highly leveraged financial engineering caused by low interest rates.
Reported by Charles Bazlinton from the ECOBATE 2014 in Winchester, UK on 8 October 2014. Charles is the author of The Free Lunch blog.