1. E SCAPING THE D EBT A DDICTION : Monetary and macro-prudential policy in the post-crisis world Adair Turner Senior Fellow, Institute of New Economic Thinking Center for Financial Studies Frankfurt, 10 February 2014 www.ineteconomics.orgwww.ineteconomics.org | www.facebook.com/ineteconomicswww.facebook.com/ineteconomics 300 Park Avenue South - 5 th Floor New York, NY 10010

2. Escaping Debt Addiction | 1 Banks create credit, money and purchasing power Loan to entrepreneur Bank 100 Credit to entrepreneurs deposit account 100

3. Escaping Debt Addiction | 2 Dynamics of real GDP and credit (Year on year % change) Source: Monthly Bulletin, European Central Bank, January 2014 Real GDP Real credit to households Real credit to NFCs United States United Kingdom

4. Escaping Debt Addiction | 3 Household deposits and loans: UK 1964 – 2009 Source: Bank of England, Tables A4.3, A4.1 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1964196719701973197619791982198519881991199419972000200320062009 % of GDP Securitisations and loan transfers Deposits Loans

5. Escaping Debt Addiction | 4 Private and public leverage cycles: US Source: McCulley and Pozsar 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 0 50 100 150 200 250 Financial Repression Housing bursts WWII ends Private debt as a % of NGDP Public and

6. Escaping Debt Addiction | 5 Private domestic credit as a % of GDP: 1950 – 2011 Advanced Emerging Source: Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten, C. Reinhart & K. Rogoff, 2013

7. Escaping Debt Addiction | 6 China: total social finance to GDP % of GDP

8. Escaping Debt Addiction | 7 Non-financial private sector* credit outstanding: % of GDP Source: BIS, Citi Research *Households + corporates

9. Escaping Debt Addiction | 8 4.9% 7.1% 6.5% 13.9% 0% 2% 4% 6% 8% 10% 12% 14% 16% Real GDP GrowthReal Domestic Private Credit Growth 1996-2003 2004-2011 Source: IMF, Haver Analytics, Citi Research Real annual credit and GDP growth in emerging markets: 1996-2011

10. Escaping Debt Addiction | 9 Total German private sector leverage: 1991 - 2010

11. Escaping Debt Addiction | 10 Private credit to GDP and growth Source: "Reassessing the impact of finance and growth“, S. Cecchetti and E. Kharroubi, BIS Working Paper No. 381

12. Escaping Debt Addiction | 11 Credit and asset price cycles 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

13. Escaping Debt Addiction | 12 The Dilemma Pre-crisis path of nominal GDP growth Pre-crisis path of credit growth ͠4% - 5% ͠10% - 15% If central banks had raised interest rates to slow credit growth …. this would presumably mean slower nominal GDP growth? We seem to need Ċ ˃ NGḊP to ensure adequate NGḊP … but this produces financial instability and post-crisis recession ͠2% real growth ͠2% inflation

14. Escaping Debt Addiction | 13 Categories of debt: UK, 2009 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

15. Escaping Debt Addiction | 14 Corporate loans by broad sector: 1987 – 2008 Source: ONS, Finstats Note: Part of the increase in real estate lending may be due to re-categorisation of corporate lending following sale and lease-back of properties and PFI (public finance initiative) lending, but we do not think these elements are large enough to change the overall picture. Break in series from Q1 2008 due to inclusion of building society data. Sterling borrowing only. 0% 5% 10% 15% 20% 25% 30% 35% Q1 1987 Q1 1989 Q1 1991 Q1 1993 Q1 1995 Q1 1997 Q1 1999 Q1 2001 Q1 2003 Q1 2005 Q1 2007 Q1 2009 % of GDP Non-commmercial real estate PNFC lendingCommercial real estate lending

16. Escaping Debt Addiction | 15 The dominance of real estate in bank lending + Commercial real estate at typically around 20% - 25% of total lending Source: Jordá, Schularick and Taylor, “Betting the Home”, forthcoming 2014 (*Bank and non- bank combined) *

17. Escaping Debt Addiction | 16 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

18. Escaping Debt Addiction | 17 National non-financial assets as a % of GDP Source: Blue Book 2013 Source: Vermoegensbilanzen 1991-2012 Destatis

19. Escaping Debt Addiction | 18 UK household net worth £trillion: 2012 4.5 1.5 1.3 4.3 3.2 0.1 7.6 Houses, other buildings and land Loans Deposits & currency Real estate + net monetary assets Other financial assets – claims against business debt and equity Other - mainly cars TOTAL Source: ONS National Banking Sheets

20. Escaping Debt Addiction | 19 Variation in land value per hectare: UK 1983 – 2010 UK Source: Blue Book 2013 10 9 8 7 6 5 4 3 2 1 £ million

21. Escaping Debt Addiction | 20 Credit extension and house prices House prices 2000 – 2007 Household debt as a % of GDP 2000 – 2007 Source: BEA; ONS; ECB 0 20 40 60 80 100 120 Q1 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007 % GDP USUKSpainIreland 0 50 100 150 200 250 Q1 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007 Index: 2000 = 100 SpainUSUKIreland Source: Ministry of Housing (Spain), S&P (US), DCLG

22. Escaping Debt Addiction | 21 Interactions between credit categories and effects Increased apparent wealth Reduced saving: increased consumption Increased price of existing real estate Increasing credit supply / demand Equity withdrawal mortgage supply & demand Boom in new real estate construction Increased prices for new real estate Borrower and lender net worth, confidence and expectational effects

23. Escaping Debt Addiction | 22 Inequality, demand and credit Rich have higher marginal propensity to have than poor Rising inequality Deflationary impetus – growth on NGDP falls Deflationary impetus offset: NGDP growth maintained Growth in credit intensity Rich lend to poor Central banks facilitates Savings not matched by ______ investment +

24. Escaping Debt Addiction | 23 Changes in housing wealth: UK 2003 – 2013 Households with no mortgage debt Buy-to-let landlords Households with mortgages £bn 556 434 -59 Source: Savills, Private landlords gain the most from rising property market, Financial Times, 18 January 2014

25. Escaping Debt Addiction | 24 Global current account balances as a % of world GDP

26. Escaping Debt Addiction | 25 Eurozone current account deficits: 2000 – 2008 % of GDP 2000 – 2008 Source: International Monetary Fund, World Economic Outlook Database, October 2012 Greece Ireland Portugal Spain % of GDP

27. Escaping Debt Addiction | 26 Decomposition of cumulative capital inflows: Spain (% of 2007 GDP) TARGET 2 Liabilities to ESCB

28. Escaping Debt Addiction | 27 Sectoral financial surpluses/deficits as % of GDP: Japan 1990 – 2012 Source: IMF, Bank of Japan Flow of Funds Accounts %

29. Escaping Debt Addiction | 28 Japanese government and corporate debt: 1990 – 2010 Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations % GDP 0 50 100 150 200 250 199019921994199619982000200220042006200820010 Bank lending to non-financial corporatesGeneral Government debt

30. Escaping Debt Addiction | 29 Shifting leverage: private and public debt-to-GDP Spain %GDP

31. Escaping Debt Addiction | 30 Policies required to achieve more stable growth Reduction in inequality or at least reduced pace of increase in inequality Reduction in global current imbalances between surplus and deficit nations  Remove biases to credit creation in deficit countries  Remove biases to excessive savings in surplus countries Integrated set of monetary, macro-prudential and fiscal policies to lean against ‘too much of the wrong sort of debt’.

32. Escaping Debt Addiction | 31 Monetary, macro-prudential and fiscal policies to combat excessive debt creation Level as well as rate of growth of leverage a key indicator But no precise threshold for ‘too high’ leverage can be defined Tax on credit intermediation – or at least removal of tax biases in favour of debt Recognises the adverse externality of debt creation Major political difficulties given winners and losers Dangers of arbitrage via shadow banking Preemptive interest rate rises to lean against credit/asset price cycles But insufficient due to heterogeneous interest rate elasticity of credit demand Much higher bank capital ratiosWould require parallel action to prevent shadow bank based arbitrage Encourage equity and hybrid contractsUnlikely to occur spontaneously without government support Manage the mix of credit by category

33. Escaping Debt Addiction | 32 Managing the mix of credit by category: possible policies Increase capital risk weights for real estate finance above those indicated by private assessment of risk Addresses the externality of lending against real estate Loan-to-value or loan-to-income limits on real estate lending Borrower constraint since lender constraints imperfect Underwriting mortgage standards to prevent reliance on price rise assumptions Introduced by UK FCA Constraints on high interest consumer lending Danger of illegal alternatives Constraints on marketing preferable to prohibition Banks with dedicated focus on non-real estate business finance To avoid crowding out of investment or trade finance

34. Escaping Debt Addiction | 33 Real yields to maturity on UK indexed linked gilts Source: Bank of England Statistics, Zero coupon real yields 10-year Yield 20-year Yield

35. Escaping Debt Addiction | 34 Velocity of money circulation Source: BoE, BoJ, Datastream Velocity of Money (Nominal GDP/M4) Velocity of Money (Nominal GDP/M2)