Adair Turner solves debt crisis – Hindenburg flies again at Frankfurt!
This post will be my little summary and critique of Lord Adair Turner’s recent speech at the Centre for Financial Studies in Frankfurt. You can read the full text here.
It begins positively, with a frank admission that
“We are far from out of this crisis: it is far deeper and more difficult to escape than many of us initially thought”
Lord Turner then proceeds to outline his take on the causes of this ongoining crisis, first noting in passing that
“People tend to allocate blame for a crisis according to their ideological pre-disposition.”
An interesting admission – economics wouldn’t work this way were it a science – as it often claims to be. It has even financed a fake nobel prize in its efforts at association with empirical sciences.
Lord Turner argues the truth is a combination of these various “ideologies”:
“The crisis has resulted from the combination of over confident faith in free financial markets and structural flaws in the Eurozone construct. And underlying both has been a failure to recognise the central importance to economic and financial stability of debt and leverage levels in general and bank credit creation and leverage in particular.”
So far so good – he acknowledges that “over confident faith” in economic dogma (again, a motivation with no place in a supposed science) allowed banks to create too much money (“credit creation” means money creation – if it walks like a duck and quacks like a duck, let us call it a duck). One criticism though: whatever you think of “free markets” (and I’m no great fan) it’s uncharitable to refer to the financial system as one – the Bank of England estimates that the government guarantee of deposit insurance gives banks a subsidy of about £100bn annually.
Lord Turner then goes on to make three main points:
“First, that we cannot rely on free markets to ensure that private bank credit creation is optimal either in overall quantity or sectoral allocation and that our past regulation of bank capital and liquidity was not just a bit but hugely deficient … we need to monitor credit creation as a crucial macroeconomic variable … the more fruitful focus of analysis and of policy levers is on credit supply rather than money supply.”
Again, encouraging. One assumes that “money supply” refers to notes and coins, while “credit supply” refers to the money that commercial banks create out of thin air. Both are money though – both “walk” and “quack” like money. In which case, it seems that Lord Turner wishes to limit the amount of money private banks get to create out of thin air – currently there is no UK limit whatsoever. This is encouraging.
“Second, that at the core of the Eurozone’s problems was a failure to recognise that sovereign debt issued by a nation which no longer has its own currency is quite different from sovereign debt issued by a currency issuing power.” …
Third, the deleveraging challenge we now face, as a result of our past failure to control adequately either private debt or public debt creation, is so severe that it is likely to require a response which combines all of the possible mechanisms – debt servicing, debt write-down, and forms of controlled debt monetisation.”
Debt monetisation implies the government could issue bonds then purchase them via the Bank of England. A government doing this could seek to follow Prof. Steve Keen’s strategy for deficit reduction – print and inflate your way out of debt. It’s good to see that more creative solutions than austerity (which isn’t even a solution) are now being entertained.
Also like Prof. Keen, Lord Turner recognises that money and debt actually matter in economic models:
“the relative role within an economy of debt contracts and the aggregate scale of bank or shadow bank credit intermediation, are not, as some economic models have tended to assume, neutral factors in the economy, but crucially important”
Perhaps university economics can now move on from the idea that “including money in the models would only obscure the analysis” as Prof. Richard Werner informs us a popular undergraduate textbook has it! One criticism though: I think Lord Turner is being naughty here using the word “intermediation” to describe what banks do. Lest we forget it, banks are not intermediaries shuffling around existing money – they create the national money supply. It is this privilege, much glossed-over by professional economists, that prevents them functioning as “neutral factors in the economy”. Hence finance works nothing remotely like a free market.
Deregulated markets, in which banks are unconstrained in ability to create money, can lead to cycles of boom and bust, for reason that Hyman Minsky explored. Lord Turner goes through some of Minsky’s analysis:
“First, Minsky type credit and asset cycles, through which credit extension drives increasing asset prices – and in particular the price of residential and commercial real estate – which generates self-reinforcing changes in the expectations and apparent wealth of both lenders and borrowers, which generate further credit extension and further asset prices… Second, unstable and self-reinforcing perceptions of credit risk, with the market price for risk falling to an excessively low level in periods of boom and then adjusting rapidly when problems emerge.”
In other words, banks first create a lot of new money. They use this new money to gamble on asset prices rising perpetually. For a while this is a self-fulfilling prophecy and a few big players get extremely rich. But then risk perception catches up with reality, people discover they have been systemically over-valuing assets, the price of which plummets, leaving some players insolvent. Because the economy as a whole is insolvent – thanks to the perverse way “we” (i.e. banks) create money – these players are deemed “too big to fail” and get bailed out by governments, resulting in vastly more sovereign debt.
Lord Turner then outlines three proposals to avoid a future Minsky Cycle:
“First, very significant increases in the static across the cycle prudential standards for bank capital and liquidity. …
Second, major reforms to our capital and liquidity regimes for trading activity, to prevent a repetition of the pre-crisis growth of intra-financial system risks. …
Third, the deployment of macro-prudential tools which can lean against the cycles of excessive exuberance followed by harmful deleveraging.”
This word “macro-prudential” appears numerous times in Lord Turner’s talk. It seems to be a catch-all term for slap-on-the-wrist measures to dissuade banks from “excessive exuberance”. If certain reports on the culture of finance are to be believed, perhaps a clampdown on cocaine trafficking would be one such “macro-prudential tool” dissuading “excessive exuberence”! What is “excessive” and who decides why is not made clear.
Lord Turner gives four ways out of the debt crisis (actually, he says there are “only four ways” – I disagree with this and will conclude by proposing a fifth way) :
1: real growth;
2: debt servicing;
3: debt restructuring/default; or.
4: some combination of inflation and/or financial repression which reduces the effective real burden of accumulated debt.
On the first way, more economic growth, Lord Turner comments that:
“The one we are all in favour of is real growth: that is the easy thing to say. And it is clearly therefore a priority for the new governments of Greece and Italy, and for other highly indebted Eurozone countries that they seek to identify and remove any structural barriers to medium-term real growth”
It shouldn’t be so easy to say! I for one am not in favour of it. Neither is former World Bank senior economist Prof. Herman Daly. Lord Turner looks silly by pretending such people don’t exist.
What about the second way, debt servicing a.k.a. “austerity”?
“The second route to deleveraging is debt servicing, paying down accumulated debts. And clearly that is an important part of the solution. … But if all countries and sectors try to do this simultaneously we will depress aggregate nominal demand, resulting in slow growth in nominal GDP. And whether low nominal GDP growth takes the form of lower real growth or low or negative inflation, that will make deleveraging via debt service more difficult and potentially impossible.”
I think this is under-selling the burden of debt servicing. More likely than mere slowed growth is the slashing and burning of public services, an economy that grinds to a shuddering halt and a civil society that falls apart. Also, Lord Turner does not ask where the money to reduce debt levels is going to come from, in an economy where more money only exists if more people go into debt.
He then argues that his third way can play its part, but that:
“too much reliance on default and restructuring can drive a deflationary spiral of the sort described by Irving Fisher.”
True enough – if you design an insolvent economy by allowing banks to simultaneously create voluminous assets and liabilities, via an accounting trick called double entry book keeping, you will get into trouble if many of those assets suddenly evaporate! Hence the concern over a Greek default. Having said this, if we are allowed to “think outside the box” and entertain monetary reform, other possibilities open up, one of which I describe at the end.
On a Greek default, Lord Turner comments that:
“… this too is an unavoidable part of the solution. This has now been recognised in the case of Greece, and as I argued above, mechanisms to allow controlled restructuring/debt reductions will have to be included in any future sustainable arrangements for subsidiary sovereign debt.”
So Greece will be allowed to default. Whether the conditionalities implicit in the phrase “controlled restructuring” will leave it as a sovereign nation or a financial technocracy is not spelled out. Greek citizens should expect the latter and continue their struggle for democratic alternatives.
Lord Turner then describes the fourth way, referred to earlier, debt monetisation :
“determined central banks can increase aggregate nominal demand, and create inflation or indeed hyper-inflation, if they buy government debt in sufficient quantity, and/or if they are willing to fund new public deficits with central bank money.”
But he has reservations about it:
“there are good reasons for being wary about throwing away the benefits which low and stable inflation have given us, and realistic about the ease with which debt burdens can be reduced via debt monetisation and higher inflation.”
If I might briefly bring actual human beings into this abstract, technocratic discussion; it’s worth noting that deliberately provoking high inflation would be massively screwing over both retired folk living off savings and students beginning university in 2012, who will have the interest on their loans tied to the rate of inflation.
Moving on to the Summary Conclusions of his speech, Lord Turner first states a “paradox”, then attempts its resolution:
“Larry Summers has stressed that the central paradox of a recession which follows a credit boom, is that while we got into the mess through too much borrowing, and too little saving, too high levels of leverage in public, corporate, household and financial sectors – if we all try to get out of it just by saving more, borrowing less and deleveraging, by paying off our debts, we will produce a still deeper recession which drives leverage, at least for a time, still higher.”
The above “paradox” is resolved by answering the question “Where Does Money Come From?” Lord Turner lets himself down by regarding it as paradoxical. “How do we square the circle?” he asks. By recognizing that the shapes have been described incorrectly. There is no such thing as “too much borrowing, and too little saving” because there is no such thing as savers and borrowers! Banks did not lend too much money – they created too much money, out of thin air, using an accounting trick called double entry book-keeping. And if these “loans” are now repaid, money others need to repay their debts will be destroyed, provoking a recession. It’s all very simple and not at all paradoxical, if and when you don’t willfully ignore key facts like how money is created and supplied to the economy.
Having given his analysis of the problem, Lord Turner finally lays out his solution – proposed reforms to prevent financial crises recurring. After several positive comments and talk of “radicalism”, he ends his speech with a disappointing remedy:
“Private leverage and bank maturity transformation has to be constrained by capital and liquidity standards far higher than those which had developed pre-crisis. We must not divert from the Basel III reforms. And we need powerful macro-prudential levers to contain credit and asset price cycles.”
The mysterious “macro-prudential levers” make a final appearance. But I want to focus on his assertion that the amount of money banks create will in fact be constrained by higher “capital and liquidity standards”. What this means is that banks will be required to have a certain level of cash and central bank reserves on their books after intra-day clearing (read Chapter 3 of Where Does Money Come From? for more details, or watch this) in order to make further “loans”.
Economics undergraduates – as Lord Turner once was at Cambridge – are taught about the “money multiplier” or “pyramid” model of bank lending. This model says that the total amount of “credit money” created by banks is fixed by the total amount of “base money” – the technical name for this description is an exogenous money supply. Assuming this theory is correct, Lord Turner’s proposal would work to limit the total of “credit money” banks get to create.
Unfortunately the theory is wrong! Why is nicely explained in chapter 5 of Where Does Money Come From? :
“In reality, rather than the Bank of England determining how much credit banks can issue, one could argue that it is the banks that determine how much central bank reserves and cash the Bank of England must lend to them. The tail wags the dog. This follows from the banks acceptance of its position as a lender of last resort… When a commercial bank requests additional central bank reserves or cash, the Bank of England is not in position to refuse. If it did, the payment system described above would rapidly collapse.”
In reality then, the money supply is endogenous, as is revealed by studying the actual data – something proper sciences do in order to develop models that conform to data, rather than relying on “ideological pre-disposition”. In fact, Steve Keen claims that upon studying financial data, one finds that increases in central banks reserves (“the dog”) happen after increases in “credit money” (“the tail”) – not before, as Lord Turner’s assumed model would predict. Higher capital and liquidity standards will not put an upper limit on the money supply.
Lord Turner’s “regulations” leave the inherent instability of the financial system, the unconstrained creation of money by banks, intact. “Macro prudential levers”, whatever they may be, simply will not cut it. It’s analogous to declaring after the Hindenburg disaster that we will continue filling airships with hydrogen, but be very prudent in not allowing any matches aboard! Lord Turner’s proposals leave a fundamentally explosive financial system in place, encouraging us all to climb aboard with assurances that this time, nothing can go wrong. Positive Money proposes filling our airships with helium.
To summarise my commentary: Lord Turner’s four proposals for reducing our debt burden are painful for society: all result in somebody getting screwed over for other peoples’ mistakes. #1 screws over the planet. #2 screws over civil society. #3 screws over those left holding the defaulted assets. #4 screws over the old (retirees with savings) and the young (students with loans). And, in contrast to Positive Money’s proposals to directly prevent private banks creating money, his proposal to “regulate” the creation of money via capital and liquidity standards won’t avoid future financial explosions.
But is there a fifth way of reducing debt, without screwing anyone over? Defaulting on “odious” debts is socially desirable but causes headaches for accountants. Take Greece – if Greece defaults, billions of dollars worth of Greek bonds would evaporate and anyone left holding these bonds on their books would be in trouble.
Can we allow desired defaults, but avoid this problem? Excessive sovereign debts have built up, due to bailing out private banks. Our “financial alchemy” creates and destroys money and debt in tandem, ex nihilo. Negative private equity (more private debt than money) could only ever be transmuted into negative sovereign equity. We are now crippling civil society by forcing nations to honour these excessive debts.
How could we engineer a debt jubilee, a wiping clean of the slate? Michael Rowbotham argues in Goodbye America! that we could simply allow defaults but pretend the assets still exist, by allowing banks to keep them on their books. Creative accountancy got us into this mess, so perhaps it should get us out!
Lord Turner recognises there are huge systemic problems, which is good. But he identifies false solutions. He should now jettison analysis based on the failed theories he learnt as an economics undergraduate and begin considering more creative proposals. Our Hindenburg of a financial system must not be allowed to fly again.