C ENTRAL B ANKING AND M ONETARY P OLICY AFTER THE C RISIS Adair Turner Senior Fellow, Institute for New Economic Thinking OMFIF City Lecture 10 December Park Avenue South | New York, NY Park Street | London W1k 2JB

Recent central bank actions Federal Reserve 1 Targeted reserve requirement reductions for lending to agriculture and small business Bank of England Purchase of MBS FLS with “incentives for lending skewed towards SMEs” Targeted LTRO: for non-mortgage bank lending ECB PBOC Bank of Korea Stimulus package: finance for SMEs

Private domestic credit as a % of GDP: Advanced economies 1950 – Source: Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, C. Reinhart & K. Rogoff, 2013

Debt contracts: The finance theory perspective Non-state contingent contracts overcome “costly state verification” advantages over equity contracts in business finance Essential to mobilisation of capital Empirical evidence of benefits of financial deepening, i.e. bank credit ÷ GDP 3

Pre-crisis orthodoxy: monetary policy 4 Mervyn King Twenty Years of Inflation Targeting, The Stamp Memorial Lecture, 2012) We assumed that we could ignore much of the details of the financial system Olivier Blanchard Chief Economist of the IMF, October 2012 The dominant new Keynesian model of monetary economics lacks an account of financial intermediation, so that money, credit and banks play no meaningful role

Wicksell’s logic: I Credit extended to entrepreneurs/businesses to fund capital investment 5 Marginal productivity of capital = Natural rate of interest If Policy/Market rate < Natural rateMal-investment and inflation If Policy/Market rate = Natural rate Optimal investment and price stability

Wicksell’s logic: II Natural rate is unobservable 6 But if Policy rate varied to ensure price stability Then Policy/Market rate Natural rate ͠͠ Inflation targeting objective Credit creation and leverage optimal if price stability achieved

Three conceptually distinct functions of lending Finance of new capital investment Enabling inter-temporal shift of consumption within life time income Finance of purchase of existing assets Finance of increased consumption Non-real estate Commercial real estate Residential real estate Human capital Real estate Collectibles Existing business assets – e.g. Leveraged Buy Outs 7

Categories of bank lending: UK, Primarily productive investment Some productive investment and some leveraged asset play Mainly purchase of existing assets Pure life-cycle consumption smoothing Other corporate Commercial real estate Residential mortgage (including securitizations and loan transfers) Unsecured personal £bn But also achieves life-cycle consumption smoothing

Share of real estate lending in total bank lending 9 Ratio of real estate lending to total lending 10% 20% 30% 40% 50% 60% 70% Source: The Great Mortgaging, Jordá, Schularick and Taylor, 2014

10 “With very few exceptions, the banks’ primary business consisted of non- mortgage lending to companies in 1928 and By 2007 banks in most countries had turned primarily into real estate lenders. 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.” (Oscar Jordá, Moritz Schularick and Alan Taylor, The Great Mortgaging, 2014)

Credit and asset price cycles: upswing 11 Expectation of future asset price increases Increased credit extended Low credit losses: high bank profits Confidence reinforced Increased capital base Increased asset prices Increased lender supply of credit Favourable assessments of credit risk Increased borrower demand for credit

Credit and asset price cycles: downswing 12 Expectation of future asset price falls Less credit extended High credit losses: low bank profits Confidence dented Reduced capital base Falling asset prices Restricted lender supply of credit Cautious assessments of credit risk Reduced borrower demand for credit

Credit extension and house prices House prices 2000 – 2007 Household debt as a % of GDP 2000 – 2007 Source: BEA; ONS; ECB Q1 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q % GDP USUKSpainIreland Q1 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q Index: 2000 = 100 SpainUSUKIreland Source: Ministry of Housing (Spain), S&P (US), DCLG 13

14 Real estate a dominant risk in advanced economies – even without leverage Real economy debt overhang the crucial driver of post crisis recession – not just impaired financial system Excessive credit growth may never result in excessive inflation

Capital in Britain 1700 – % national income Source: Capital in the Twenty First Century, T. Piketty (2013)

Desirable urban land: a market without equilibrium? 16 Indeterminate price – is there an equilibrium? Potentially infinite supply of credit and private money Highly income elastic demand Capital gains motivation Expectations prices expectations Inelastic supply of locationally specific land

Sectoral financial surpluses/deficits as % of GDP: Japan 1990 – 2012 Source: IMF, Bank of Japan Flow of Funds Accounts % 17

Japanese government and corporate debt: 1990 – 2010 Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations % GDP Bank lending to non-financial corporatesGeneral Government debt 18

19 Shifting leverage: Private and public debt-to-GDP

Global debt excluding financials Source: Geneva Report No 16 Deleveraging, What Deleveraging? ICMB / CEPR September Developed Markets Emerging Markets World % of GDP 20

Total German private sector leverage: % of GDP China: total social finance to GDP 21 % of GDP

Categories of credit creation and nominal demand 22 Stimulates nominal demand Finance of investment Finance of consumption Finance of existing asset purchase Stimulates nominal demand but required just to offset impact of inequality ? No direct stimulus to nominal demand Could just increase credit, money balances and asset pricing May stimulate demand via wealth effects and Tobin’s Q effects But not certainly proportional to credit created

UK Credit, money and demand 2000 – % change 105% 97% 79% 44%

Bank lending to real estate sector and prices: Japan 1981 – Source: Japan Real Estate Institute; Bank of Japan; Profit Research Center Ltd; calculations by Prof. Richard Werner, Southampton University (see Princes of the Yen, Richard Werner, 2003)

Credit creation for GDP transactions and nominal GDP in Japan, 1983 – Source: Princes of the Yen, Richard Werner, 2003

Explaining instability and secular stagnation | 26 Quantity theory of disaggregated credit * NOT But: So that: And: ∆ M = ∆ P. ∆ Y ∆ C R = ∆ P R ∆ C NR = ∆ P. ∆ Y ∆ M = ∆ C R + ∆ C NR > ∆ P. ∆ Y Velocity of circulation stable … whereC R = credit to finance real estate purchase + P R = price of real estate … C R = credit to finance GDP transactions P = prices of current goods and services Velocity of circulation falls * See Richard Werner, New Paradigm in Macroeconomics + Or more generally to finance existing assets

27 Velocity of money circulation Source: BoE, BoJ, Datastream Velocity of Money (Nominal GDP/M4) Velocity of Money (Nominal GDP/M2)

Monetary aggregates matter But not because excessive Money is a forward indicator of inflation But because excessive Credit is a forward indicator of crisis, debt overhang, post crisis depression and deflation 28

Not one objective, one instrument 29 Low and stable inflation insufficient Credit and asset price cycle and rising leverage can produce macroeconomic instability while never producing excess inflation Interest rate elasticity of demand for credit varies by category Contrary to Wicksell, there is no one natural rate Interest rate tool insufficient

30 Arbitrage helps policy Gets into all the cracks Advantage Heterogeneity and instability of expected returns and elasticity of response Disadvantage Interest rates as primary policy tool?

Other policy objectives and tools 31 Constrain both pace of growth of credit … and the level of private sector leverage Offset bias in system toward real state lending Constrain both pace of growth of credit … and the level of private sector leverage Offset bias in system toward real state lending Much higher bank capital requirements Much higher counter-cyclical capital requirements Increase capital risk weights for real estate lending above IRB levels Loan to income constraints on borrowers Banks with dedicated focus on non real estate Much higher bank capital requirements Much higher counter-cyclical capital requirements Increase capital risk weights for real estate lending above IRB levels Loan to income constraints on borrowers Banks with dedicated focus on non real estate Objectives Tools

Recent central bank actions Federal Reserve 32 Targeted reserve requirement reductions for lending to agriculture and small business Bank of England Purchase of MBS FLS with “incentives for lending skewed towards SMEs” Targeted LTRO: for non-mortgage bank lending ECB PBOC Bank of Korea Stimulus package: finance for SMEs