What Wicksell Hayek Fischer Knew and Mainstream Forgot Adair Turner Stockholm School of Economics September 12
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CREDIT, MONEYANDLEVERAGE:WHATWICKSELL, HAYEKANDFISHERKNEW ANDMODERNMACROECONOMICSFORGOT
AdairTurner
StockholmSchoolofEconomics Conferenceon:“TowardsaSustainableFinancialSystem" Conferenceon:“TowardsaSustainableFinancialSystem" Stockholm,12September2013
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IamsorrynottobewithyouattheconferenceinStockholminperson.Mysubject matt matter er is mone money y and and the the cred credit it cycl cycle. e. At the the time time of the the conf confer eren ence ce, , I will will be in Chin China, a, rese resear arch chin ing g issu issues es rela relati ting ng to the the cred credit it cycl cycle e – high highly ly appr approp opri riat ate e give given n disc discus ussi sion on on whet whethe her r Chin Chines ese e cred credit it deve develo lopm pmen ent t coul could d be a caus cause e of futu future re financialcrises. But But it woul would d also also be very very appr approp opri riat ate e to be with with you you in Stoc Stockh khol olm, m, beca becaus use e a renowned renowned Swedish Swedish economist, economist, Knut Wicksell, Wicksell, raised raised fundamenta fundamental l issues issues about the role role of cred credit it with within in an econ econom omy, y, whic which h are are high highly ly pert pertin inen ent t as we atte attemp mpt t to understandwhatwentwrongin2007to2008,andtheseverepost-crisisproblemsin whichwestillfindourselves. Wicksell’ Wicksell’skeyinsight skeyinsightsintotheinherentnatu sintotheinherentnatureofcreditcreat reofcreditcreationwereexplo ionwereexploredand redand th developedbysubsequentearlyandmid-20 centuryeconomists.Andthoseinsights havebecomemoreimportant havebecomemoreimportantas asaresultofdevelopme aresultofdevelopmentsinfinancia ntsinfinancialstructur lstructureand eand financ financial ial intens intensity ity in the centur century y since since Wickse Wicksell ll wrote. wrote. But to a signif significa icant nt extent extent Wicksell’sinitialinsights,andcertainlythefutureexplorationofthoseinsights,have been been ignore ignored d or consid considere ered d as unimpo unimporta rtant nt by much much of modern modern macro macro-ec -econo onomic mic theo theorry, and by the the prepre-cr cris isis is pol policy icy orth orthod odox oxy y of centr entral al banks anks and fina financ ncia ial l regulators. Inpart,therefore,mypurposetodayistoconsiderapieceofintellectualhistory:the strang strange e amnesi amnesia a of modern modern macroe macroecon conomi omics. cs. But also also to reach reachsom some e conclu conclusio sions ns aboutthepoliciesneededtoavoidarepeatofthe2008crisisandtosecuregreater financ financial ial stabil stability ity, , inthe advanc advanced edeco econom nomies ies but alsoin alsoin the develo developin ping g world. world. In particularIwillarguethat: 1|P 1|P a g e
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We need need to treat treat both both the credit credit cycle cycle and the aggreg aggregate ate level level of levera leverage ge acros crosss the the econ econom omy y and by secto ector r as cruci rucia al issu issues es of macr macroo-ec econ onom omiic importance And And that that we need need to cons constr trai ain n and and mana manage ge that that cred credit it cycl cycle e thro throug ugh h the the integratedapplicationofmonetaryandmacroprudentialtoolsinawaywhich goes goes beyond beyond curren current t propos proposals als for financ financial ial regula regulator tory y reform reform, , and beyond beyond the simple simple additi addition on of “finan “financia cial l stabil stability ity” ” as a new object objective ive alongs alongside ide but separatefrommonetary(i.e.,price)stability.
Mylecturebuildstothatconclusionthroughsixsections: 1. Wicksells’sfundamenta Wicksells’sfundamentalinsight:creditcrea linsight:creditcreatespurchasingpower tespurchasingpower 2. A fundam fundament ental aleco econom nomic iciss issue: ue: how to ensure ensure adequa adequate, te, but not excess excessive ive, , growthinaggregatenominaldemand 3. Impactsofcreditcreation Impactsofcreditcreationbeyondpricestability:H beyondpricestability:Hayek,MinskyandFis ayek,MinskyandFisher her 4. Changesovertime: Changesovertime:the theincr increasin easingimporta gimportanceofthe nceofthe financial financialsystem, system,andin andin particularofcreditcreation,tomacroeconomicdynamics 5. Thestrangeamnesiaofmodern(andnotsomodern)macroeconomics 6. Implications:developinganewapproach ***
1. WICKSELL,CREDITANDPURCHASINGPOWER
At the the core core of Wick Wickse sell ll’s ’s “Int “Inter eres est t and and Pric Prices es” ” (see (see Chap Chapte ter r Six: Six: The The Velo Veloci city ty of CirculationofMoney )isacarefulanalysisoftheroleofmoneyandpurchasingpower )isacarefulanalysisoftheroleofmoneyandpurchasingpower inaneconomywithawell-developedbankpaymentsystem.[Wicksell1898]Noting thatmosttransaction thatmosttransactions,evenalready s,evenalready byWicksell’stime,didnot byWicksell’stime,didnot involvethe involvethetran transfer sfer ofphysicalcoinsnorofpapernotes,Wicksellmakesthreeessentialpoints: •
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First,thateveninaworldwithoutcommercialbanksandbankdepositmoney, theextensionofcreditbetweenbusinessescouldexpandeffectivepurchasing power: power: a “simpl “simple e credit credit econom economy” y” thus thus create creates s purcha purchasin sing g power power beyond beyond a “purecasheconomy.” Second,thatifevidenceofcreditextended,suchaspromissorynotes,become transferable,thesetransferablecreditsbecameeffectivelyaformofmoney.
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We need need to treat treat both both the credit credit cycle cycle and the aggreg aggregate ate level level of levera leverage ge acros crosss the the econ econom omy y and by secto ector r as cruci rucia al issu issues es of macr macroo-ec econ onom omiic importance And And that that we need need to cons constr trai ain n and and mana manage ge that that cred credit it cycl cycle e thro throug ugh h the the integratedapplicationofmonetaryandmacroprudentialtoolsinawaywhich goes goes beyond beyond curren current t propos proposals als for financ financial ial regula regulator tory y reform reform, , and beyond beyond the simple simple additi addition on of “finan “financia cial l stabil stability ity” ” as a new object objective ive alongs alongside ide but separatefrommonetary(i.e.,price)stability.
Mylecturebuildstothatconclusionthroughsixsections: 1. Wicksells’sfundamenta Wicksells’sfundamentalinsight:creditcrea linsight:creditcreatespurchasingpower tespurchasingpower 2. A fundam fundament ental aleco econom nomic iciss issue: ue: how to ensure ensure adequa adequate, te, but not excess excessive ive, , growthinaggregatenominaldemand 3. Impactsofcreditcreation Impactsofcreditcreationbeyondpricestability:H beyondpricestability:Hayek,MinskyandFis ayek,MinskyandFisher her 4. Changesovertime: Changesovertime:the theincr increasin easingimporta gimportanceofthe nceofthe financial financialsystem, system,andin andin particularofcreditcreation,tomacroeconomicdynamics 5. Thestrangeamnesiaofmodern(andnotsomodern)macroeconomics 6. Implications:developinganewapproach ***
1. WICKSELL,CREDITANDPURCHASINGPOWER
At the the core core of Wick Wickse sell ll’s ’s “Int “Inter eres est t and and Pric Prices es” ” (see (see Chap Chapte ter r Six: Six: The The Velo Veloci city ty of CirculationofMoney )isacarefulanalysisoftheroleofmoneyandpurchasingpower )isacarefulanalysisoftheroleofmoneyandpurchasingpower inaneconomywithawell-developedbankpaymentsystem.[Wicksell1898]Noting thatmosttransaction thatmosttransactions,evenalready s,evenalready byWicksell’stime,didnot byWicksell’stime,didnot involvethe involvethetran transfer sfer ofphysicalcoinsnorofpapernotes,Wicksellmakesthreeessentialpoints: •
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First,thateveninaworldwithoutcommercialbanksandbankdepositmoney, theextensionofcreditbetweenbusinessescouldexpandeffectivepurchasing power: power: a “simpl “simple e credit credit econom economy” y” thus thus create creates s purcha purchasin sing g power power beyond beyond a “purecasheconomy.” Second,thatifevidenceofcreditextended,suchaspromissorynotes,become transferable,thesetransferablecreditsbecameeffectivelyaformofmoney.
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Third,thatonceyouaddtheinstitutionsofwhathecalls“organizedcredit”, i.e.,commerci i.e.,commercialbanks albanks,youhaveasystemwhichcanclea ,youhaveasystemwhichcanclearlycrea rlycreatecreditand tecreditand matchingmoney,andasaresultcreatepurchasingpower. Thisinsightisfundamental.Banksdonot,astoomanytextbooksstillsuggest, takedepositsofexistingmoneyfromsaversandlenditouttoborrowers:they create create credit credit and money money ex nihilo nihilo – exte extend ndin ing g a loan loan to the the borr borrow ower er and and simu simult ltan aneo eous usly ly cred credit itin ing g the the borr borrow ower er’s ’s mone money y acco accoun unt. t. (Exhi (Exhibi bit t 1) That That crea create tes, s, for for the the bor borrower ower and and thus thus for for real eal econ econom omy y agents ents in tota total, l, a matchingliabilityandasset,producing,atleastinitially,noincreaseinrealnet wort worth. h. But But beca becaus use e the the teno tenor r of the the loan loan is long longer er than than the the teno tenor r of the the deposit–becausethereismaturitytransformation–aneffectiveincreasein 1 nominalspendingpowerhasbeencreated.
ThequestionwhichWicksellthereforeposesiswhethertherearethelimitstothis creationofaddition creationofadditionalspendi alspendingpower,orwhether ngpower,orwhethera a creditbasedsystemcancreate creditbasedsystemcancreate evermoremoneyandspendingpowerandasaresultproduceharmfulinflation.He cons consid ider ers s firs first t what what cons constr trai aint nts s will will aris arise e from from free freely ly chos chosen en bank bank mana manage geme ment nt decisions.Heassumesthatbankshold“reserves”ofeithernotesorcoinsorcentral bankmoney,to bankmoney,tocover coverboth bothunpre unpredicta dictablediffere bledifferencesbetwe ncesbetweenpayments enpaymentsin in andout withintheGirosystem,andanydangersofbankrunsarisingfromlackofconfidence. Theneedforsuchreserveswillactasaconstraintonnewcreditandmoneycreation. Buthemakesthreeimportantpointsaboutthestrictnessoftheseconstraints: •
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First,thattheneedforreservesacrossthewholesystemwilltendtoreduce the less that people use physical money (whether coin or paper) for paym paymen ents ts. . Ther Theref efor ore, e, if we reac reache hed d a worl world d in whic which h all all paym paymen ents ts were were alwaysmadebybankgiro,thebankingsystemasawholewouldnotappearto needanyreservesatall. Seco Second nd, , in a bril brilli lian ant t insi insigh ght t Wick Wickse sell ll cons consid ider ers s what what woul would d occu occur r if the the bank bankin ing g syst system em were were orga organi nise sed d as “one “one Bank Bank”. ”. The The answ answer er, , in a syst system em wher where e all all paym paymen ents ts were were giro giro paym paymen ents ts, , is that that ther there e woul would d be no free freely ly
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Paul Krugman Krugman has recently recently argued argued against against the idea that this creation creation of purchasing purchasing power makes makes banks banks
special,citingtheargumentwhichJamesTobinsetoutinhispaper special,citingtheargumentwhichJamesTobinsetoutinhispaper“Commercialbanksascrea “Commercialbanksascreatorsofmoney”. torsofmoney”. Tobinarguedthatthereremainsacrucialdistinctionbetweenfiatmoney(whichcannotbedestroyedexcept bygovernmentsrunningfiscalsurplusesandwithdrawingmoneyfromcirculation)anddepositmoney(which havingbeencreatedthroughcreditextensionwillonlyremaininthesystemifprivateagentsarewillingto holditratherthantopaydowndebt) holditratherthantopaydowndebt). . Tobinwasclearl Tobinwasclearlyrighttostres yrighttostressthatthere sthatthereareimporta areimportantdiffe ntdifferenc rences es betweenfiat(outside)anddeposit(inside)money. betweenfiat(outside) anddeposit(inside)money.ButinSection4(iii)(textandfootnot ButinSection4(iii)(textandfootnote17)Iarguethatthe e17)Iarguethatthe requirementfordepositstobevoluntarilyhelddoesnotunderminetheargument requirementfordeposits tobevoluntarilyhelddoesnotunderminetheargumentthatbanks’ability thatbanks’abilitytocreate tocreate credit/moneyandpurchasi credit/moneyandpurchasingpowerisf ngpowerisfundamentalto undamentaltomacro-econom macro-economicdynamic icdynamics. s.
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arisingincentivetoholdmoneyreservesatall,sinceallpaymentsoutofone customer’saccountinthe“oneBank”,wouldhavetoshowupasdepositsof anothercustomerinthesamebank. •
Third, he noted that if the international payment system still involves the movement of fiscal metallic money (e.g., gold) or other constraints on the growth of international credit, credit creation within an individual country mightbemoreconstrainedthanifweweredealingwithaclosedeconomy(or withoneglobaleconomy)inwhichallpaymentswereorcouldbebankcredit based. Conversely, if ever the international system developed to include extensiveuseofinternationalcredit,thoseconstrainswouldloosen.
Theseobservations,Iwillarguelater,arehighlypertinenttothehistoryofthelast hundred years of financial development, suggesting factors which have made the dynamics of credit creation progressively more important even than in Wicksell’s time. ButitisWicksell’sfundamentalinsightwhichismostimportant.Bankscreatecredit, money and purchasing power. That fact is fundamental to macro-economic dynamicsinanyeconomywithacomplexbanking (orshadow banking)system:and fundamentaltoboththe2007– 2008financialcrisisandthedepthofthepostcrisis recession. Wicksell,however,didnotdevelopalltheimplicationswhichfollowfromthisinsight. Hisanalysis,whileabrilliantstepforward,remainedlimitedintwoways: •
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First,heassumed,aswaslargelyempiricallytrueatthetime,thatmostorall bankcreditisextendedtobusinesstosupportinvestmentseitherinworking capitalorininvestmentprojects(i.e.topurchasenewrealphysicalcapital). Second, having identified that banks create purchasing power, Wicksel focused almost exclusively on the potential consequences of this for price stability,developinghisthesisthatcentralbankscanconstraincreditcreation andachievepricestabilitybyensuringthatthemoneyrateofinterestisinline with what Wicksell labels the “natural” rate of interest (essentially the marginalproductivityofcapitalearnedonnewinvestmentprojects).
Mostmodernmacroeconomicshassharedthisprimaryorexclusivefocusonprice stability;sotoodidpre-crisiscentralbankorthodoxy.Butintheinterveningyears, economists such as Hayek, Fisher, Minsky and to a degree Keynes, explored a far widersetofimplications. Thoseimplications are considered inSection 3. First, however,itisuseful to step back and consider the different ways in which aggregate nominal demand can be
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increased,andthepotentialadvantagesbutalsodisadvantagesofrelyingonprivate creditcreationtosecuresuchgrowth
2.MONEY, CREDIT,AGGREGATENOMINALDEMAND
Bank(andnon-bank)creditcreationcanbethoughtofasoneoftwopossiblemeans to avoid a harmful deficiency inaggregate nominal demand whichcouldariseina 2 puremetallicmoneysystem. Thereareadvantagestorelyingoncreditcreationto achievethiseffect,ratherthanonthealternative,whichisgovernmentfiatmoney creation.Butitisvitaltounderstandtheimplicationswhichfollowfromthischoice. Inapurepreciousmetalmoneysystem,withouteithersimpleororganizedcredit, theincreaseinthemoneysupplywouldbelimitedbytheflowofnewpreciousmetal availableforminting.Tworelatedeffectsmightasaresultconstrainrealgrowth: •
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First,ifthesupplyofnewpreciousmetalwerelimited,achievingrealoutput growthinlinewithpotentialmightrequiredownwardflexibilityofwagesand prices. But such downward flexibility might either be unattainable, or if 3 attainable,mightitselfhavedepressiveeffects. Second,insuchasystem,anincreaseinsavingscanliterallytaketheformof “hoarding” with spending power in some absolute sense removed from the economy. This would increase yet further the downward price flexibility 4 requiredbeforeequilibriumisrestored.
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AsbothDavidGraeber[Debt:thefirst 5000 years]andFelixMartin [Money:TheUnauthorsiedBiography] havepointedout,itisnotthecasethatmetallicorothercommoditymoneysystemsdevelopedfirstinhuman history to be followed by credit. In many civilizations, systems of credit accounting and resulting debts predatedcirculating money. The role whichcredit (whetherin the simple or organised form) can play in supportingnominaldemandcannonethelessbeunderstoodbyfirstimaginingtheconstraintsthatwouldexist inapuremetallicmoneysystem. 3
Theextentofdepressiveeffectsarisingfromstickinessofpricesandwagesmayreflecttheextenttowhich
velocityof circulation ofthemetallic moneycould increase. One ofthe key ways inwhich the measured velocity(Y/M)canincreasehowever,isifprivateeconomicagentsthemselvescreatecredit(e.g.byextending trade credit), taking us into Wicksell’s “simple credit” case. Felix Martin’s “Money” describes a series of historicalexamplesofthespontaneouscreationofnon-bankcredittoovercomerestrictionsonthesupplyof moneyinitspurefiator“insidemoney”form:forinstancetheemergenceofprivatecreditrelationshipsand informalcreditclearingsystemsduringthe1970Irishbankworkersstrike. 4
Two sub- categoriesof“hoarding”behaviourcanbedistinguished. Thefirst andmostrelevanttomodern economichistory,involveseconomicagentsaccumulatingmetallicmoney(orpaperclaimsthereto)withthe aimofsavingeconomicresourcesforfutureuse.Thiscanhaveadepressiveeffectontheeconomythrough theremovalofaggregatenominaldemand:buteventuallyislikelytoproduceanoffsettingincreaseinfuture expenditure,as the wealth accumulated appreciates in real value as a consequence of induced downward price effects (Pigou’s wealth effect). The more extreme case, found in earlier societies, involved the permanentwithdrawalofmetallicmoneyfromcirculationforinclusioninburialhoardsandtempletreasuries.
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Concerns about the adequacy of nominal demand to support economic growth in th linewithrisingpotential,werethereforecentraltolate19 centurypolicydebates, particularly in the U.S. The monetisation of silver was proposed as a means to supplementapparentlyinadequatesuppliesofgold. Clearly if downward flexibility and wages and prices is compatible with full employmentandwithrealgrowthinlinewithpotential,noproblemarises.Butmost modern economics has tended to the assumption that atvery leastpricestability, and ideally a low but positive rate of inflation, is optimal. To achieve this, some growthinaggregatenominaldemandisrequired. Two meanscan beused todeliver a growth innominalpurchasing powerbeyond thatwhichwouldoccurgivenconstraintsimposedbyavailablesourcesofprecious metal. •
One involves the government/central bank issuing absolute fiat money (unbackedbypreciousmetals)tocoverfiscaldeficitsnotfundedbytheissue of interest bearing debt. And there are instances in economic history when suchmoneyfinanceoffiscaldeficitshasprovedcompatiblewithreasonable price stability, while supporting economic growth. The Pennsylvania 5 commonwealth used such a technique in the 1720s. The US federal government’s issues of pure fiat “greenbacks” during and afterthe civilwar supportedgrowthwithoutexcessiveinflation.AndJapanesefinanceminister TakahashiusedmoneyfinanceddeficitstopulltheJapaneseeconomyoutof recessionintheearly1930s,againwithoutproducingharmfullyhighinflation. But the option of government fiat money creation suffers from two disadvantages: - It politicises decisions about the allocation of additional purchasing power – with money potentially allocated to wasteful investment projects,ortotheconsumptionoffavouredpoliticalconstituencies. - And itmaybe difficult,oncethe option offiatmoneyfinanceisfirst recognized and allowed, to prevent its excessive use. The hyperinflations of Weimar Germany or modern day Zimbabwe 6 illustratethatdanger.
Onanumberofoccasionssuchpermanenthoardingdoesappeartohavehadmacroeconomiceffects(see Graeber,2012). 5
SeeAndrewJacksonandBenDyson“Modernisingmoney:whyourmonetarysystemisbrokenandhowitcan befixed”(2012),Appendix1,foradescriptionofthePennsylvaniaexample. 6
TheextenttowhichtheWeimarhyperinflationwasaconsequenceofexcessivegovernmentdebtfinancehas been contested by Michael Kumhof and Jaromir Benes in their recent paper “The Chicago Plan Revisited” (2012).TheyarguethattheprimarycauseofthehyperinflationwasinsteadthewillingnessoftheReichsbank
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Asaresult,societieshavetendedtoplacestronginstitutionalbarriersagainst overtmoney financing offiscal deficits. And the use ofthisoption has most commonly been associated not with overcoming problems of deficient demand,butasameanstofinancewartimeexpendituresinpoliticalcontexts whichmakeitdifficulttoraisesufficientresourcesviataxationortheissueof interestbearingdebt. •
The alternative route to adequate nominal demand growth is through the extension of bank (or other) credit and the creation of matching money or money equivalents. Suchasystem,asWicksell identified, createspurchasing power.Andinsuchasystemincreasedsavingswillnot,ifthesavingsarestill heldasfinancialsecuritiesorbankmoney,havethesamedepressiveeffectas the pure “hoarding” of metallic money. The development of commercial th bankingsystemsinthe19 centurymaythereforehaveplayedanimportant role inenabling a faster growth innominalGDP than wouldotherwise have beenpossible.AndthismayinturnhaveenabledfastergrowthinrealGDP,in linewithgrowingrealpotential.Somecontemporariescertainlythoughtso: -
Walter Bagehot, in the “Introductory” chapter to Lombard Street, argued that “much more cash exists out of banks in France and Germanyandinallthenon-bankingcountries,thancanbefoundin EnglandorScotland,wherebankinghasdeveloped…butthecashis not, so to speak ‘money market’ money: it is not obtainable.” [Bagehot, 1873] As a result, Bagehot suggested the French money could be “hoarded” and become effectively “useless”, while “the Englishmoneyis‘borrowable’money”.
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And Harold Moulton, the Chicago economist, argued in 1919 that th the U.S. could not have achieved its remarkable late 19 century growth without a growing commercial banking system able to support faster growth in spending power than would have been possible in an economy constrained by precious metal money sources[Moulton,1919]
Bank (andother)creditandmoneycreationcanthereforebeseenas analternative means to ensure adequate nominal demand growth. And compared with governmentfiatmoneycreation,itcanhavetwoimportantadvantages: toprovidelimitlessfinance(viabilldiscounting)toprivatesectorbanksandthustherealprivateeconomy(in anillustrationofthefactthatthepursuitwithoutlimitofthe“realbills”doctrinecaninfactbelimitlessly inflationary). Infacttheclassic butstillbestaccountof thehyperinflation, ConstantinoBresciani- Tourani’s “The Economics of Inflation” (1931) suggests a two phase process in which (i) monetary finance of fiscal deficitsandwardebtrepaymentswastheinitialmotiveforceofthetake-offofinflationtoveryhighlevels(ii) The inflationary impetus was then subsequently magnified by the Reichsbank support for private credit creationonwhichKumhofandBenesfocus.
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Itavoidsthedangerthatfiatmoneycreationcouldbepursuedtoexcess. Anditmayavoidthepoliticisedallocationofnewpurchasingpower,instead allocatingadditionalpurchasingpoweraccordingtomarketprinciples.Itmay therefore bea superiormeans for ensuringthatresources are placed inthe handsofentrepreneurs/businessescapableofusingthemtobesteffect.
But these potential advantages will not apply if bank credit creation can itself be excessive,orifbanksthemselvessometimesallocateadditionalpurchasingpowerin sub-optimalways. Andbankcreditcreation,unlikegovernmentfiatmoneycreation,entailsnotjustthe creationofnewmoneyandpurchasingpower,butalsothecreationofongoingdebt contracts,whichthemselvescanhavemacroeconomicconsequences. As a result, bank and other credit creation can, unless appropriately constrained, create the instability andmisallocationeffects describedby, among others, Hayek, MinskyandFisher.
3. IMPACTSBEYONDPRICESTABILITY: HAYEK, MINSKYAND FISHER
Bankscreatecredit,moneyandpurchasingpower:itthereforematterstowhomand for what purposes credit is extended. And credit extension, whether by banks or directly from savers to borrowers, creates ongoing debt contracts: it therefore mattershowlargethesedebtcontractsarerelativetoGDP. As a result, credit creation cycles have important effects which go beyond the potential impact on price stability on which Wicksell focused. These effects can 7 usefullybecategorisedunderthreeheadings : •
Hayekianrealinvestmenteffectsandcycles
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A further important implication of credit and debt-creation not considered here isits impact on wealth inequalities.Atleastthreespecificeffectscanbeidentified:(i)Thecreationofextremewealth:becausecredit andassociatedpurchasingpowerareallocatedtospecificagents,superioraccesstofavourablypricedcredit canbea crucialdriverofgreatwealthaccumulation:thekeyreasonwhy someRussianoligarchsbecameso rich wastheirsuperioraccess tocredit(sometimesfrom bankswhichthey owned orcontrolled) during the period of state asset privatisation. (ii) Rising inequality as a result of propertyprice appreciation: because creditextensioncandrivesustainedassetpriceappreciation(e.g.intheUKresidentialrealestate)favourable accesstocredithasinsomesocietiesbeencrucialtowealthaccumulationoverthelastseveraldecades:small differencesininitialendowments,whether intheformof moneyto financedepositsorof highincomeata crucialearlycareerstage, canas a result have very large effectson eventual wealth distribution. (iii) Debt accentuated poverty traps. Conversely, the use of credit by less creditworthy customers at high rates of interest,whethertobringforwardconsumptionorinanattempttoshareinthebenefitsofrisinghouseprices, canbeamajorself-reinforcingdriverofinequalityatthelowendofthedistribution.Thesub-primemortgage boomandsubsequentbustintheU.S.hasfurtherintensifiedU.S.wealthinequalities.
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Minskystylecreditandassetpricecycles DebtrigiditiesanddebtdeflationeffectsofthesortdescribedbyIrvingFisher andHenrySimons
Writing amid the wreckage of the Great Depression, indeed, Fisher and Simons concluded that these factors combined made bank credit creation so potentially dangerous, that it should be outlawed, with any appropriate nominal demand growthinsteadachievedbygovernmentfiatmoneycreation. (i)Realinvestmenteffectsandcycles:Hayek
Wicksell assumed that credit is largely extended to one particular category of borrower: to businesses/ “entrepreneurs” to fund investment. Schumpeter and Hayekmadethesameassumption.Fromthatassumption,twoconsequencesfollow: one potentially positive for economic growth; the other potentially negative for economicstability. Investment, if the economy is already operating full capacity, is at the expense of consumption,andamountsto whatHayekandotherslabelled“forcedsavings”:“an increase in capital creation at the cost of consumption, through the granting of additionalcredit,without voluntaryactiononthe partofthe individualswhoforego theirconsumption,andwithoutthemderivinganyimmediatebenefit” [Hayek1929]. Thisforcedorinducedsavingandinvestment,caninturndriveahigherrateofGDP growththanwouldotherwisebeachieved. Theempiricalsupportforthispropositionappearsclear,andrelevantnotonlytothe th th 19 orearly20 centuryeconomies,buttopostwarandmorerecentdevelopment 8 processes .AsJoeStudwelldescribesin“HowAsiaWorks” ,thesuccessfulpost-war developmentmodelsofJapanandKoreareliedon highlevelsofcapitalinvestment achieved through bank credit creation skewed towards business and in particular towards heavy industry. [Studwell, 2012] And in modern China, it is clear that bankingsystemcreditcreationandallocation,primarilyfromthestateownedbanks to state owned enterprises and to local governments to fund infrastructure investment has driven an extremely high investment rate, which has helped drive rapidgrowth.
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Theideathatbankingsystemsmayhaveplayedacrucialroleindrivingindustrialcatchupwasproposedby
Alexander Gerschenkron “Economic Backwardness in Historical Perspective” (1962) in respect to German th industrialisation in the late 19 century. Gerschenkron’s primary focus however was on the perceived advantagesofbanks(relativetoequitymarkets)inrespecttoscreening,monitoringandgovernance,rather thanonthecreationofcreditandpurchasingpowerperse.
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But the mention of Chinaalso immediatelysuggests a potential negative factor as well–thedangerthataskewtowardsinvestmentmightdriveoverinvestmentinlow return projects, and result in a macro-economic imbalance, a level of investment incompatiblewithrespectto futureconsumption,andthereforeonlymaintainedby acontinuallyincreasingflowofnewcredit. And while it can be argued that the danger of a Chinese over investment cycles derives in part from the political character of the credit allocation process, in particularbythe stateowned banks,the pre-crisisconstructionboomsexperienced byIrelandandSpainillustratesthatover-investmentcanalsooccurinsystemswhere creditallocationisdrivenbyprivatemarketconsiderations. AsHayeksetoutin “TheMonetaryTheoryoftheTradeCycle” ,bankcreditcreation andtheinvestmentcyclesthatitfundscanbeamajorcauseofeconomicvolatility. Hayek himself, ever wary of the belief that governments could offset the imperfections of market mechanisms without introducing still more serious imbalances, also argued that there was little we can do about such cycles: the negativeimpactofincreasedvolatilitywastoHayektheunavoidableconcomitantof the positiveimpact of a higher investment rate.“Solongaswemakeuseofbank creditasameansoffosteringeconomicdevelopment” , Hayek concluded“weshall havetoputupwiththeresultingtradecycles.Theyareinasense,thepricewepay for a speed of development exceeding that which people would voluntarily make possiblethroughtheirsavings,andwhichthereforehastobeextractedfromthem.” WhilepayingcreditbothtoWicksellandtohisownAustrianschoolmentorLudwig vonMisesforhavingcorrectlyidentifiedthecentralityofbankcreatedpurchasing power,Hayekthereforecriticisedbothfortheirsubsequentfocussolelyorprimarily on“thegeneralvalueofmoney”.“Allthesetheories,indeed,arebasedontheidea– quitegroundlessbuthithertovirtuallyunchallenged–thatifonlythevalueofmoney doesnotchange,itceasestoexertadirectandsignificantinfluenceontheeconomic system”. (ii)Existingassets,speculationandassetpricecycles:Minsky
Hayekcorrectlyidentifiedthatbankcreditcreationprocessescanskewtheeconomy towardsinvestment,orindeedtowardsspecificcategoriesofinvestment, withboth potentially beneficial and potentially harmful consequences. The danger of potentially harmful consequences becomes still more apparent when we consider thefullrangeofpurposestowhichcreditcreationcanbedevotedandthewayin which asset prices and apparent net worth can be endogenously driven by credit creationinself-reinforcingcycles. Like Wicksell and indeed Schumpeter, Hayek assumes that banks extend credit primarilytoentrepreneurs/businessestofundthepurchaseofcapitalassetsandnew business projects. So too indeed do most modern economics textbooks and 10|P a g e
academicarticles.Butinfactcreditextensioncantakeanumberofquitedifferent forms,withquitedifferentmacroandmicroimplications. Thus(Exhibit2): •
•
•
Much credit even if extended to businesses, funds not new investment projects,butalreadyexistingassets.Somecommercialrealestatelending,for instance,supportsnewphysicaldevelopment,butmuchalsorepresentsthe leveraged purchase of already existing buildings. Similarly, acquisition and leveragedbuyoutfinanceessentiallyfundstheleveragedpurchaseofexisting business assets (in part to enjoy the advantage of the tax deductibility of debt). Amajorityofbankcreditinmostsystemstoday,meanwhile,isnotextended tobusinessesatall,buttohouseholds,primarilyforhomemortgages.Some ofthiscreditfundsatleastindirectlytheconstructionofnewhouses,which are a form of “investment project”. But much of it, and in many financial systems the majority, funds the purchase of already existing houses, facilitatingintergenerationaltransfer.Itwouldbepossibleindeed,forthere to exist an economy with a stable population, in which there was no new housingconstructionatall,butwhichhadaverylargeandgrowingstockof residentialmortgagedebt. And a significant proportion of bank credit – unsecured personal finance – essentiallyfacilitateslifecycleconsumptionsmoothing,enablinglesspatient households to bring forward consumption ahead of income, or indeed enablingpoorerhouseholdstofundforaperiodoftimelevelsofconsumption 9 incompatiblewiththeirprospectivelifetimeincome.
Some of these non-investment categories of lending can serve socially useful purposes. But they are quite different purposes from the “lending for real investment projects” on which both the early literature and much modern economicstendstofocus. These non-investment categories moreover, are large and have grown far more rapidly over the last 50 years than lending for investment projects. A reasonable estimatemightsuggestthattodaynomorethan15%oflendingbytheUKbanking 9
Theuseofbankcredittopurchasehouses,andtofundimmediateconsumption,canofcoursebecombined, and can have important macroeconomic as well as distributional effects. In his recent book “Faultlines” RughuramRajanmakesapersuasivecasethatthesubprimemortgageboomintheU.S.haditsrootsinrising income inequalities, with low income household seeking to use debt financed purchase of homes to supplementinadequateincomewithassetpriceappreciation.Thelargescaleextensionofmortgagecreditto subprimeborrowersthusseemedforatimeanalternativetomorefundamentalpoliciestoaddressinequality.
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systemisfundingthe“newinvestmentprojects”onwhichtheoreticaldescriptionsof bankingsystemsstilltendtoconcentrate.(Exhibit3) Non-investmentcategoriesoflendingcreatespecificanddifferentrisks.Inparticular lendingagainstalreadyexistingassetscreatespotentialdriversofinstabilitybeyond thoseidentifiedbyHayek. Hayek described cycles of investment and over investment in real new physical capital.But credit extension can driveeven stronger cycles inthe price of existing assets, and in particular of assets such as land where additional demand cannot induce an offsetting increase in supply. As Hyman Minsky described, the price of existing assets can be exogenously driven by cycles in the provision of credit, as resultofthebehavioursof,andincentivesfacing,bothborrowersandlenders.Inthe upswingofthecycle[Minsky,1986](Exhibit4): •
•
Borrowers make decisions based not on prospective future cash flows resultingfrominvestments,butontheexpectationoffuturepriceincreases. Whilelendersmakedecisionsinfluencedbyboth - Assessmentsofborrowercreditworthinesswhichareforatimeselffulfilling,withmorelendingdrivingassetpriceincreaseswhichappear tomakelendinglessrisky. - And by increases in bank, and otherintermediary, net worth – with lower loan losses both directly augmenting bank capital and thus lendingcapacity,andmakingiteasierforbankstoissuenewequity 10 capitalatahigherprice.
The possibility of such cycles undermines both Wicksell’s focus on price stability aloneandhis belief that anoptimal paceofcreditextension can beensuredif the moneyrateofinterestalignswiththenaturalrate.Thus: •
Creditandassetpricebubblescanoccurwhichhavenodirecteffecteitheron real investment quantities, or on the prices of current output goods and serviceswhichenterinflationmeasures.Butthesecyclescanhaveimportant macroeconomiceffectsthroughthevolatilitythattheycreateinthemeasured net worth of different real economic agents,taking into account both asset pricevariationsandthedebtburdensleftoverbytheupswingofthecredit cycle.Cyclesincreditextensionandinthepricesofexistingassetscanthus causehavocasmuchasrealinvestmentcycles.
10
AsSection4(ii)belowdiscusses,thesenetwortheffectswerefurtherintensifiedbythehardwiringofthe system ofsecuredfinancing, margincallsand mark tomarketaccountingwhichdeveloped inthe 20or 30 yearsrunninguptothe2008crisis.
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- Intheyearsrunninguptoandafterthe2007to2008crisis,Ireland andSpainsufferedclassicHayekianrealover-investmentcyclesinthe residential housing and commercial real estate sectors, with the construction sectors of the economy swelling beyond a sustainable size. - The UK did not experience a construction boom toanythinglikethe samedegree.ButitdidexperienceaMinsky-styleboominthecredit extendedagainstbothresidentialandcommercialrealestate,andin theirprices,withpredictablepost-crisisconsequences.
•
And any attempt to control the credit cycle through the use of the interest alone,mayproveseverelysuboptimal,giventheverydifferentinterestrate elasticityofdifferentcategoriesofcreditdemand.Ifcommercialrealestate investors or developers anticipate future rapid increases in property prices (extrapolatingpasttrendsdrivenbyeasycreditsupply)andmakeborrowing decisions on this basis (in what Minsky labelled the ‘Speculative’ or ‘Ponzi’ stagesofthecreditcycle)theywilllikelyprovefarlesselasticintheirresponse to increased interest rates than investors in real business projects not underpinned by rising property prices. Attempting to slow down a credit boomthroughinterestrates alonemaythuscausemajorharm tothenon – property parts of the economy long before it contains the property boom. Conversely, as Raghuram Rajan has recently argued, attempting to restimulate a post crisis economy with ultra-low interest rates, may result in “toomanybuildingsandnotenoughmachines.”[Rajan,2013]
(iii)Debtrigidities,anddebtdeflationeffects:FisherandSimons
Bank credit creation results in additional purchasing power. It can therefore be a usefulmeanstoensureadequategrowthinaggregatenominaldemand.Butbank creditcreationalsonecessarilyresultsinongoingdebtcontracts.Anddebtcontracts introduce rigidities and risks not created by equity contracts. A focus on these rigidities led leading economists of the 1930s – such as Irving Fisher and Henry Simons – to conclude that the overall level of leverage in an economy is a crucial macroeconomic variable, and that the crash of 1929, and the subsequent Great Depression,weredirectresultsofexcessiveleveragegrowthinthe1920s. Debt contracts are create different risks from equity contracts. The detailed 11 argumentsforthatpropositionhavebeenmadeextensivelyelsewhere .HereIwill outlinefouressentialpoints: 11
SeeAdairTurner“Monetaryandfinancialstability:lessonsfromthecrisisandfromsomeoldeconomic texts”(SouthAfricanReserveBankconference,November2012)
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•
•
•
•
First, the fact that debt contracts, with their apparently fixed and certain returns, induce a tendency for investors/ lenders to suffer from “local thinking”ormyopia,asaresultenteringintomanydebtcontractswhichas Gennoaili, Shleifer and Vishny have put it “owe their very existence to neglectedrisk.”[Gennoaili,ShleiferandVishny,2010] Second, the importance of the rigidities and potential disruption introduced bydefaultandbankruptcyprocesses,whichasBenBernankehaspointedout “inacompletemarketsworld[…]wouldneverbeobserved.” [Bernanke,2014] Third, the needfor shortandmediumtermdebt contracts tobe continually rolled over, making continuity of new credit flow a key macroeconomic variable,inawaythatthecontinuedflowofnewequitiesissuesisnot. Fourth,thefactthatagents’existinglevelsofleveragecanhaveimplications formarginaldecisionsoncreditdemand,consumptionorinvestment,inways not well captured by standard utility maximising assumptions. Agents who havesufferednetworthlosses,andwhonowperceivethemselvestobe“over leveraged”, may become focussed on the need to pay down existing debt, even if further borrowing to finance a marginal investment project might 12 deliverpositivemarginalbenefits.
These features of debt contracts can create economic stability whether credit is extended to entrepreneurs to finance investment projects or to speculators or consumers to purchase existing assets. And they can apply even when debt contracts arise directly between savers and borrowers, rather than resulting from bank credit and money creation. Henry Simons therefore argued that in an ideal economytherewouldbenoshorttermdebtcontractsatall–andbyshort-termhe meantlessthan50years.AndinFisher‘sfamousdescriptionoftheprocessofdebt deflation [Fisher, 1933], several of the steps arise simply from over indebtedness, whetherthedebtsarosefrombankcreditcreationorfromdirectlending.(Exhibit5) Butbankcreditandmoneycreationstillfurtherincreasestheserisks.Itfacilitates debt contract creation and thus makes it more likely that excessively high real economy leverage will be achieved: and it can increase the severity of the deleveraging downswing, as bank net worth constraints drive credit supply restrictions,fallingassetpricesandrealeconomyeffectsinaself-reinforcingcycle.
12
RichardKooarguespersuasively[Koo,2009]thatsuch“balancesheetrecession”effectswerecrucialtothe deflationarybiasoftheJapaneseeconomyafter1980screditandpropertypriceboomendedinthecrashof theearly1990s.Theimportanceofvariationsinborrowernetworth,exacerbatedbypreviouslyaccumulated debtburdens,inexplainingfluctuationsindemandforcreditisoneamongthemicrofoundationsofmacro effectsonwhich,asSection5(ii)describes,severalmoderneconomistshavefocusedattention.
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SimonsandFisherthereforeidentifiedbanks’abilitytocreatecreditandmoney ex nihiloasaparticularlyperniciousdriverofinstability. “Intheverynatureofthesystem” Simonsargued”bankswillfloodtheeconomywith money substitutes during booms and precipitate futile attempts at general liquidationthereafter.”[Simons,1936] Inresponsetothisdestructivedanger,theythereforeproposedthatbankcreditand moneycreationshouldbenotjustconstrainedbutabolished.
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(iv)100%reservebanksandfiatmoneyfinance
Theirproposal wassimple. Fractionalreservebanks shouldnotbeallowedto exist: all banks which provide payment system money should be required to hold 100% reservesat the central bank. Any loan fundingshould passdirectlyfromsaversto borrowers, without passing through a maturity transforming bank balance sheet. Themoneysupplywouldbeequaltothemonetarybase:andtheprocessofprivate creditandmoneycreation,describedbyWicksell,wouldceasetooperate. But if fractional reserve banks and private bank credit creation are outlawed, a potential source of growth in aggregate nominal demand disappears, leaving nominaldemandgrowthdependenteitheronthevagariesofpreciousmetalsupply, oronfiatmoneycreationbythegovernment.Thelogicalcorollaryofa100%reserve banking system is therefore the assumption that if nominal demand growth is desirable, governments/central banks should ensure it by running appropriately sized fiscal deficits financed not with interest bearing debt but with central bank money. Fisherclearlyacceptedandembracedthatlogicallink,arguingin1936forboth100% reservebankingandformoney financeddeficits [Fisher,1936]. Simons’preference was for an economy in which wages and prices were so flexible that real growth could be compatible with a quite fixed monetary base/money supply, and with unchangingnominaldemand.Butheacceptedthatuntilandunlesssuchflexibility was achieved, money financed fiscal deficits would be required [Simons 1936]. In 1948, Milton Friedman re-stated the case for both 100% reserve banking and for moneyfinancedfiscaldeficits[Friedman,1948]. None of which proves that abolishing fractional reserve banks and accepting the logicalcorollaryofmoneyfinanceddeficitswouldbesociallyoptimal.Theoffsetting argumentsagainstfiatmoneycreationandinfavourofcreatingdemandthrougha privatebankcreditsystem,outlinedinSection2above,mayalsobeimportant. ButwhattheinsightsofSimons,Fisher,MinskyandHayekdoclearlyillustrateisthat the ability of banks to create credit, money and ongoing debt contracts, has importantreal macro economy implications and creates importantinstability risks, 13 andcandosoevenifpurchasingpowercreationdoesnotthreatenpricestability.
4. CHANGESOVERTIME: THEINCREASING IMPORTANCEOFFINANCIAL FACTORS 13
Therealeconomyeffectsofpostcrisisrecessionmayofcoursebeaccompaniedbyathreattopricestability intheformofpriceinflationbelowtarget.
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TheimplicationofSections2and3isthatthedetailsoffinancialintermediationhave importantmacro-economicimplications,andinparticularthatthedynamicsofcredit and private money creation and aggregate levels of real economy leverage are crucialfactors. There are moreover strong arguments for believing that financial considerations havebecomesteadilymoreimportanttomacro-economicdynamicsoverthelast70 years, as a result of developments in advanced economy financial systems. Three setsofdevelopmentshavebeenimportant. •
•
•
Levelsofleveragehaveincreased,andthebalanceofdifferenttypesofcredit haschangedquitedramatically. Financialmarketdevelopmentshavetendedtoremoveanynaturallyarising constraintsonthestrengthofthecreditcycle,andinsomewayshaveturbo chargedit And, as financial intermediation has developed, the liabilities of both banks and other financial institutions have evolved in ways which make it decreasingly possible to understand what is going on by focusing solely or primarilyonthetransactionsdemandformoney.
(i) Increasingleverageandchangingmixofcreditcategories
TheimmediateaftermathoftheGreatDepressionandtheSecondWorldWarsawa dramatic reduction in aggregate private sector deleverage in the U.S. From the 1940s till the eve of 2008 crisis, however, aggregate private sector leverage relentlesslyincreased(Exhibit5).AsimilargrowthhasoccurredintheUKandmany otheradvancedeconomies. Equallyimportanthasbeenachangingbalancebetweenthedifferentcategoriesof credit extended. The assumption that either all lending(or all bank lending)takes the form of lending from the household sector to businesses to fund investment projectswasalwaysanoversimplification.Evenin1964lendingtohouseholdsbyUK Banksandbuildingsocietiesslightlyexceededlendingtocorporates(Exhibit6).Butit remainedtrueatthattimethatthehouseholdsectorwasalargenetdepositorinto the banking and building society sector and the corporate sector a significant net borrower.Betweenthenand2008majorchangesoccurred: •
•
Household sector debt soared from 14% to over 90% of GDP and the householdsector became a net borrower fromthe banking/building society sectorsystem.(Exhibit7) CorporatebankdebttoGDPalsogrewdramatically,from13%to35%GDP.In additiontherewasanimportantshiftinthesectoralbalancewithinthattotal, especiallyafterthe1980s.Lendingtocommercialrealestate(CRE)developers andinvestorsballoonedasapercentageofGDP,whilelendingtothenonCRE 17|P a g e
corporatesectorisnohigherasapercentofGDPthanin1964(Exhibit8):the manufacturing sector,indeed,hasinsomerecentyearsbeena netdepositor intotheUKbankingsystem. Anyassumptionthatbankintermediatedcreditcreationsystemisprimarilyinvolved with “funding investment projects” is therefore completely unrealistic. In most advancedeconomies,thoughtosomewhatdifferentdegrees,banklendingisstrong skewedtowardsthefundingofrealestatepurchasedbyhouseholds,corporatesor institutionalinvestors:inthemajorcountrywherethisislessthecaseintheformal bankingsector(theUS)thesecuritisation/shadowbankingsystemisstronglyskewed towardsresidentialmortgages.Thesecreditflowssometimesfundnewconstruction, butoftenalsofundthepurchaseofalreadyexistingassets. The potential for both Hayekian over investment cycles and Minsky type cycles in existing asset prices has therefore increased as overall leverage has grown. Price stability alone has become an increasingly ineffective measure of potentially importantmacroeconomiceffects. (ii) Facilitatingchangesincreditmarketstructureanddynamics
The increases in aggregate leveragedescribedabove have beenfacilitated by, and the potential adverse impact accentuated by, significant changes in the nature of bank(andshadowbank)creditcreationsystems.Thesehavetendedbothtoremove or reduce the power of naturally arising constraints on the credit cycle, and to hardwiresomecreditcycledynamics. Threesetsofchangeshavegreatlyreducedthepowerofthethreenaturallyarising constraintswhichWicksellidentifiedandwhichweredescribedinSection1.These are: •
•
Thedevelopmentofdepositinsuranceandtheincreasingassumptionofretail depositors that all banks are effectively risk free. This largely removes the danger of retail deposit runs, and certainly the danger of deposit money withdrawalintonotesandcoins(ratherthansimplythetransferofdeposits from one bank to another). It thus brings the system in total closer in behaviourtoWicksell’s“giropaymentsonly”model. The increased size and sophistication of interbank markets, which recycle liquidity within the overall banking and wider financial system. These have grown significantly in size relative to total bank balance sheets: whereas in 1960 the majority of banks’ balance sheets related chiefly to real economy depositorsandborrowers,nowmanybankbalancesheetsaredominatedby intra-financialsystemassetsandliabilities.(Exhibit9)Interbankmarketshave alsodevelopednewmechanismstoreducerisk,particularlythroughtheuse
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ofsecuredfinancingmechanisms,suchasrepocontracts.Thenetresultmight nothavesurprisedWicksell.
•
-
The more anoverall banking system creates efficient, low cost andapparentlylowriskwaystoredistributeliquidity,themore that the system in total will act as if it were Wicksell’s “one bank”.Indeedifallinterbankcreditextensionwereperceivedto beentirelyriskless,amulti-banksystemwouldeffectivelyactsas 14 “onebank”system.
-
And in a one bank system, the private incentives for banks to hold ultimate “reserves” of central bank money declines, with bankschoosingifpermittedtoholdtheirliquidityresourcesas “inside money” claims on other parts of the system, or in the formofliquiditylinesfromotherpartsofthesystem.Whenever central banks allowed it, holdings of monetary base reserves relentlesslydecreased.(Exhibit10)
Thefinalremoval–withthecollapseoftheBrettonWoodssystem–ofarole for non-credit based international payments (e.g. gold), and the extensive development of cross-border private credit, bringing the whole advanced worldeconomyclosertoWicksell’sunconstrainedclosedeconomymodel.
In addition, the development of securitisation, of secured funding and lending techniques,andofthemultistepchainsofcreditintermediationcoveredbytheterm ‘shadow banking’, facilitated additional credit creation and introduced systemic featureswhichtendedtohardwireandthereforeturbo-chargethedynamicsofthe creditcycle. •
•
Shadow banking enables the creation of both credit and near-money equivalents through multi-step chains of leveraged maturity transformation outsidetheformalbankingsystem[seeTurner2012aandFSB2012]. Andtheincreasinguse,bothwithintheshadowbankingsystemandinparts oftheformalbankingsystem,ofsecuredfinance,collateralisationtechniques, mark-to-market accounting and “value at risk” (VAR ) based risk management, has hardwired the links between changes in asset prices and changesinthenetworthofintermediariesandcontractcounterparties.Even
14
Beforethe2007to2008crisis,mostinterbanklendingwasindeedperceivedto beclosetoriskfree.This perceptionchangedsignificantlyinsummer2007,andthencollapsedbetweenSeptemberandOctober2008, causingaseizureoftheInterbankmarket.Effectivelywecanthinkofadvancedeconomybankingsystemsas switchingfromaWicksellian“onebank”toamultiplebankmodelbetween2007andautumn2008,withthe implicationsforcreditandpurchasingpowerimpliedbyWicksell’sanalysis.
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inthetraditionalbankingmodel,changesinintermediarynetworkplayarole intheself-reinforcingcreditandassetpricecycledescribedinExhibit4Butin a world of collateralised contracts and mark-to market accounting, with margincallsdrivenbymovementsinassetpricesandbyVARbasedestimates of potential price volatility, that cycle is hard wired and as a result turbo charged (Exhibit 11) Liquidity, asset prices , and intermediaries’/ counterparties’ net worth, become linked in the potentially self-reinforcing cyclesdescribedby,forinstance,HyunShinandMarcusBrunnermeier[Shin 2010;BrunnermeierandPedersen2009]. (iii)Bank(andnear-bank)liabilities:notjusttransactionsmoney
Banks create credit and thus purchasing power. That has major macroeconomic consequences. But that impact is not well captured by the focus on transactions money, onmoney asa medium ofexchange,whichhasdominatedin mostmacroeconomictreatmentsofbankcreditandmoney. Inthepredominantmodel,householdsandcorporateshavea“demandformoney” whichiscapturedbythefunction f (i,Y ). Moneyis needed tosupporttransactions, 15 whichmaybesomewhatproportionaltonominalincomeY .Butthedemandfor moneybalancesisalsoinfluencedbytheinterestrateonbonds i ,whichdetermines the opportunity cost of holding non-interest bearing money. This thinking about a “demand for money” was a key element within the ISLM framework of the neoclassicalsynthesis,withaliquiditytraparisingiftheinterestrateisalreadysolow that agents are indifferent between holding money or bonds, and open market operations thus ineffective. It also underpins the monetarist focus on the importanceofthemoneysupply(theMinMV=PY ),sinceitmightseemreasonable toassumethatoverthelongterminterestratecycleeffectsareneutralandthusthe influenceofY dominates,makingV reasonablyconstant. Butwhilethe“demandformoney”hasplayedakeyroleinmacroeconomics,itisnot clearthatitwaseverareallyusefulwayofthinkingaboutthedynamicsofcreditand moneycreation,andthereisastrongcasethatanyvalueitdidhavehasdeclined over time, in part because of the increases in leverage and the changing mix of categoriesofcreditdiscussedinSection4(i)above.
15
ThefocusonY intheequationMV=PY ratherthanontheaggregatevalueoftransactions T ,requiresthe assumption thatT isbroadlyproportionalto Y .Itisnotableindeed,thatleadingearlyeconomistssuchas WicksellfocusedonT itself.Overthelong-term,eventheT/Y relationshipcanchangesignificantlyinthelight ofchangesinforinstancethedegreeofverticalintegration:themorethateconomicfunctionsareperformed withinlargefirms(withinternalaccountingbetweendifferentstepsinthevaluechain)ratherthanbetween firms,thelowertheratioT/Y .Overtheshort-termhowevertheratiomaybereasonablystable.
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Four aspects of reality make a focus on the demand for transactions money of limitedanddecliningvalue: •
•
•
•
Moneyisheldfordifferentreasons.AsKeynesnotedinhis TreatiseonMoney (BookOne:ThePureTheory )moneyisheldforseveraldifferentpurposes,only someofwhicharerelatedtoitsroleasamediumofexchange.[Keynes,1930] Businessesandinstitutionsholdsomemoneytomaketransactionswhichare partofthevaluechainswhichdelivernominalGDP;buttheyalsoholditfor speculativeandfinancialtransactions(purchasesandsalesofalreadyexisting assets) whichdonot enternominalGDP calculations. Households also hold some money balances to make current transactions, but in addition savings balances,whosevaluerelativetomoneyGDPisnotdrivenbythetransactions intensityofGDP. The complexities created by these different uses of money cannot be overcome,andfocusonthetransactionsdemandformoneyrestored,simply by focusing on any given subset of bank liabilities, such as non- interest bearingcheckabledeposits. Inthebusinesssector,theneedfortransactions balancesisinpartdeterminedbyeaseofaccesstocreditfacilitiessuchasunusedoverdraftfacilities.Inthehouseholdsector,creditfacilities(e.g.credit cards)alsoplayakeytransactionsrole.Andtherelationshipbetweensavings moneyandtransactionsmoneyis fuzzyandhasbecome moresoovertime. Savings deposits can become available transaction money not only as they reach maturity but also in many cases immediately if a small redemption penaltyispaid.Savingsdepositsindeedcanalsobeheldinaninterestbearing but instant access form. The need for pure transactions moneyis therefore influenced by the amount of savings money which households in any case holdandthewayinwhichtheyholdit. Theideathattheinterestrateonbonds,i ,determinestheopportunitycostof holdingmoneyhasbecomedecreasinglytrue.Mostmoney,andevensome instantaccessmoney,isinterestbearing,andthathasbecomeincreasinglyso overtime.Atsomepointsintheeconomiccycleindeed,forinstanceduring 2010to2011intheUK,itwaspossibleforahouseholdtoearnmoreona savings deposit which was reasonably liquid and had certain capital value, than on a publicly traded bond subject to capital value pricing risk. Equilibrium in the relative demand for bonds and different categories of moneyisdeterminedbydifferencesbetweenmoneyandbondinterestrates whichcanbeeitherpositiveornegative,andnotbytheinterestrateonbonds alone. Finally, it is possible for a shadow banking system to create close money equivalents outside the formal banking system, with these near money equivalents serving to support either current transactions or financial 21|P a g e
investments/savings purposes. U.S. money market funds are close money equivalents, held in large quantity by households, but also by corporates/institutions: but so too, for large institutions, can be holdings of shorttermsecuredcontractclaims,suchasthosedeliveredbytherepoand othershorttermsecuredlendingmarkets. Asa result,anyattempttomeasurethedefinitive quantityoftransactionbalances, separate from other bank (or shadow bank) liabilities has become increasingly 16 impossible . But more fundamentally, it is not clear that thinking in terms of a “demand for money” best helps us understand the dynamics of credit and money creation. Instead it would seem more useful to think in terms of the following process: •
•
•
•
•
Banks(andshadowbanks)createcredit,influencedbycentralbankinterest rateandotherpolicyleversbutalsobytheself-reinforcingdynamicsofcredit creationandassetpriceeffects. Money necessarily arises as a by-product. The creation of a bank asset necessarilycreatesaliability. Atthelevelof the wholebanking system,thismoneycanonlybedestroyed whenandifloansarepaidback.Butthereisnocertaintythatitwillbepaid backed by any of the subsequent recipients of money: it may either be continually recycled in current spending by each recipient, or held as increasedsavingsbalances. Theamountofmoneycreatedhastobefreelyheldbysomecombinationof householdsandcorporates.Thereforeasetofpricesmustexistwhichleaves corporatesandhouseholdsinaggregatecontenttoholdthestockofmoney created,ratherthantoswitch(inaggregate)frommoneytootherassetssuch as bonds or property. Asset portfolio allocations have to be in line with preferencesgiventhepricesprevailing. Butthisequilibriumsetofpricescanbeachieved(andindeedismorelikelyto beachieved),notbyanypaydownofdebtsomewhereelseinthesystem(and 17 thusdestructionofthenewlycreatedmoney)butbysomecombinationof:
16
As GurleyandShawprescientlynotedin1955,“asfinancialevolutionproceeds,onesalvagesconventional quantity theory by so extending the concept of M and V that they bear little resemblance to ‘means of payment’and‘turnoverofthemeansofpayments’”[GurleyandShaw,1955]
17
Thuswhile,asperfootnote1,JamesTobinarguedcorrectlythatitispossibleforbankcreatedmoneytobe destroyedbydebtpaydownifdepositorsdonotwantinaggregatetoholdthenewmoneycreated,thefact
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-
Anincreaseininterestratesonsomecategoriesofmoneybalance(so thatsavingsdepositspayclosetoorevenabovethebondrate)
-
The purchase of other categories of assets (e.g. property) which induces a change in the price of those assets so as to bring agents’ assetportfoliosinlinewithpreferences.Thusifmoneycreationresults in “too much” money for aggregate household portfolio preferences, balance can be restored by an increase in the value of other assets, such as property, rather than by a reduction of money balances (achievedbyapaydownofdebt).
The extension of bank credit, therefore, drives a matching increase in money or some other category of banking (or shadow banking) system liability – real sector assets tomatch the real sector liability created. And the aggregate valueof these liabilities, or even of some subset which has strong “money like” characteristics, cannotbeexpectedtobearanyparticularrelationshiptonominalGDP. As a result, in a historical period in which economies have experienced the rapid growthinleverageandthechangingmixofcategoriesofcreditillustratedinExhibits 8and9,adeclineinthemeasuredvelocityofmoney,wasnotonlyunsurprisingbut inevitable. In the UK, some households borrowed to buy houses and others accumulated large savings deposit balances (some of which indeed directly arose from the saleof houses whosevalue rose significantly relativeto GDP);as a result the measured velocity of circulation declined. (Exhibit 12) And asRichard Werner has illustrated, the decline in the measured velocity of circulation in Japan, frequentlydescribedasan“enigma”,wassimplytheinevitableconsequenceofthe changingbalancebetweenthedifferentpurposesforwhichcreditisextendedand moneyisheld.[Werner,2005] Thereisthereforeastrongcasethat,asBenjaminFriedmanhasputit“inretrospect theeconomicsprofession’sfocusonmoney–meaningvarioussubsetsofinstruments ontheliabilitysideofbankbalancesheetsincontrasttobankassets-turnsoutto havebeenahalfcenturylongdiversionwhichdidnotserveourprofessionwell” [B. Friedman 2012] Instead, as Stiglitz and Greenwald put it “The focus on monetary policy should shift from the role of money in transactions to the role of monetary policyinaffectingthesupplyofcredit” .[GreenwaldandStiglitz2003]Indeed,asIwill argue in Section 6, there needs to be an integrated consideration of how both monetarypolicyandmacroprudentialtoolsjointlyaffectthecreditcycleandtheongoingstockofdebt.
that there areotherpossible (andin many circumstances morelikely)adjustmentmechanismsmakesbank moneycreationapotentiallycrucialmotiveforceofmacro-economicdevelopments.
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Butsuchafocusoncreditandonongoingdebtcontractscarriestheimplicationthat the quantitative stock of bank and other financial assets (and their matching liabilities)aremattersofmacro-economicimportance,thoughforreasonsotherthan anypotentialimpactonpricestability.Oneharmfulconsequenceoftheeconomics profession’sfocusonthedemandformoneyindeed,wasthatwhentherelationship between moneysupply and the pricelevel appearedto breakdown, central banks tended to lose interest in stock quantities. If velocity was so unstable over the mediumtermthatmoneysupplytrendscarriedonlyveryweakimplicationsforprice stability(asbecameincreasinglyapparentinthe1980s)thenthemoneysupplywas perceivedtobeunimportant.Thetruelessonshouldhavebeenthatbankandother financial assets, and in particular the aggregate level of debt, are important for reasons quite independent of their immediate or medium term impact on price stability. Credit creation and debt build up can have important long-term consequenceswhichwilleithernevershowupinpricestabilityeffects,oronlyafter a long delay, at which point the dominant impact may well be deflationary rather thaninflationary. InthesensethereforetheBundesbankwasrightinitslong-heldviewthatshortand medium term price stability prospects were an insufficient definition of monetary and financial stability, and that attention should also be paid to a quantitative “pillar”.Butitwouldhavebeenbettertodefinethepillarintermsofaggregatenew creditandtheresultingdebtstock,notintermsofmoney. Letmesumupmystorysofar. Itgoesasfollows: •
•
•
•
•
Wicksell and subsequent economists rightly identified that bank credit creationwasspecialbecauseitcreatedmoneyandpurchasingpower Subsequent economists such as Hayek and Fisher rightly argued that credit cyclesareofcrucialeconomicimportanceforreasonsunrelatedtoassetprice stability. The potential importance of the credit cycle increases yet further when we considerthemultiplealternativeusesofcredit,andthepossibilityofMinskystylecreditandexistingassetpricecyclesaswellasHayekianoverinvestment cycles. Credithasplayedarelentlesslyincreasingroleintheeconomy,facilitatedby depositinsurance,thedevelopmentofinterbanktradingandliquiditytransfer mechanisms,byglobalization,andbysecuritisationandshadowbanking. Afocussolelyonthetransactionsdemandformoneywasalwaysdangerously simplistic,andbecameincreasinglyirrelevantovertime.
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Credit is important. It is fundamental to purchasing power creation and nominal demand: and it became even more important over the 65 years since the Second WorldWar,andparticularlyfromaboutthe1960sand1970sonwards. One might therefore expect that macroeconomics would have focused on it ever more attention. In fact the trend, though with some exceptions, has been in preciselytheoppositedirection.
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5.THESTRANGEAMNESIAOF MODERN,ANDNOTSO MODERN, MACROECONOMICS
Olivier Blanchard noted in October 2012 that much of modern macroeconomics “assumedthatwecouldignoremuchofthedetailsoftheFinancialSystem ”.Mervyn King noted that the dominant new Keynesian model of new monetary economics “lacksonaccountoffinancialintermediation,somoney,creditandbankingplayno meaningfulrole” [King,2012]. Ideas matter: intellectual frameworks matter; and the absence of the financial systemfrommodernmacroeconomicsplayedaroleintheoriginsofthe2007-2008 crisis. One cannotsee acrisiscomingif one hasassumeditspossibility away. The strange amnesia of modern economics therefore requires an explanation if economicsistoprovidebetterinsightinfuture. (i)FromWickselltothelate1980s
MarkGertlerprovidedin1988anexcellentsummaryofthe evolutionuptillthenof economicthoughtonissuesoffinancialstructure.[Gertler,1988]Initsfinalstages, the story is one in which a desire for elegant frameworks, for simple policy guidelines, and for mathematical rigour overrode a commitment to deal with real worldcomplexity.Theresultwaseitheranassumptionthatthefinancialsystemisa pureneutralveil;orafocusononeissueonly:onmoneyasamediumofexchange. AsGertler stresses,thetendency toignorethefinancialsystem,andinparticularto abstractfromthedetailsofbankcreditandpurchasingpowercreation,isnotsimply aproductoftheNewClassicalorNewKeynesianapproacheswhichhavedominated thelastthreeorfourdecadesofeconomics.ItwasalsoastrongtendencyinpostwarKeynesianismandMonetarism. Keyneshimself,asalreadydiscussed,setoutin“TheTreatiseonMoney” aninsightful discussion of the different functions of money, escaping from a sole focus on transactions demand. His “General Theory” includes brilliantly intuitive narrative descriptionsofthepotentialinstabilityoffinancialmarkets.[Keynes1936]Thereis also a discussion of the importance of the “state of credit” and of the “state of confidence”ofborrowersandlenders.ButasGertlerdescribes,themacro-economic literature which followed “The General Theory” , largely ignored these issues. The neoclassicalsynthesisoftheISLMframeworkconsidersthedemandfortransactions money and the interest rate differential between money and bonds, but not the credit creation process, nor the influence of balance sheet stocks of debt. Policy orientedKeynesiansmeanwhilefocussedonrealflowsofConsumption,Investment, and Government expenditure, on multipliers and fiscal policy, rather than on the financialsystem.AndwhileFriedmanandSchwartz’s “MonetaryHistoryoftheU.S.” [FriedmanandSchwartz,1963]reassertedtheimportanceofmonetaryvariables,its 26|P a g e
focuswasalmostentirelyontheapparentrelationshipbetweentransactionsmoney andoutput,withlittleattentiontothedeterminantsofbankcreditcreationandstill lesstotheimplicationsofthebalancesheetstockofdebtresulting. GertlerthendescribestheeffortsofeconomistssuchasJohnGurley,EdwardShaw and James Tobin to resurrect a focus on the details of financial intermediation. GurleyandShaw’s“FinancialAspectsof EconomicDevelopment” [GurleyandShaw, 1955] argued strongly that a focus on money as a transaction medium was both increasingly impossible (because of the multiple uses of money and the multiple ways in which money equivalents could be created) and inadequate, because of otherimportantconsequencesoffinancialintermediation.Theyarguedthatbalance sheets matter, and that “financial capacity” – a measure of borrowers’ ability to absorb debt and thus to avoid reductions in either current or future spending commitments–couldbeakeydeterminantofaggregatedemand.Andtheywarned that with a “sophisticated financial structure providing financial assets, other than moneyandbonds,inincreasingproportiontoboth,controlofthemoneyaloneisa decreasinglyefficientmeansofregulatingflowsofloanablefundsandspendingon goodsandservices”. GurleyandShaw’sinsightswerefurtherdevelopedinthe1960articlewhichgaveus thedistinctionbetween“outside”and“inside”money.[GurleyandShaw,1960]And inthe1960sand1970seconomistssuchasJamesTobinandHymanMinskymade important contributions, stressing the centrality of financial intermediation, of unstablefinancialdynamics,andofbalancesheetquantities.CharlesKindlebergerin 1978,meanwhile,providedan authoritativehistoricaldescription ofthe realitythat financialboomsandbustsoftencausedhugerealeconomicharm.[Kindleberger, 1978] But from the 1970s and 1980s the intellectual tide turned decisively in the other direction, with financial intermediation and the banking system disappearing from mostmacro-economicmodels.Gertlersuggeststhreefactorswhichhelpexplainthis unfortunatedisappearance. •
•
First,theimpactofModiglianiandMiller’stheoremwhichappearedtoprove that real economic decisions were independent of financial structure. Modigliani and Miller’s (MM) illustration of the theorem was at the micro level,atthelevelofthefirm.Butitwasassumedtoapplyalsoatmacrolevel. Andbelieversintheimportanceoffinancialstructure,asGertlerputsit,did nothaveargumentsexpressedinthesameformalmathematicalrigourasMM withwhichtosupporttheirassertions. Second,thewidermethodologicalrevolutioninmacroeconomicsinthe1970s, with the desire to base macroeconomic conclusions on robust and mathematical micro foundations. Laudable though this aim was, its implementation had a perverse effect. For it proved difficult to achieve 27|P a g e
mathematical rigour without making the simplifying assumption of homogeneous representative agents: and that simplification effectively abstractedfromthepossibilityofanyimperfectionsandcomplexitiesinthe financial contracting process. The financial system effectively became unimportantbyassumption. •
Third, the fact that advanced econometric techniques (vector autoregressions)appearedtosuggestthatmoneysupplyfluctuations,oratleast unanticipatedmoneysupplyfluctuations,couldbeimportantcausaldriversof realorpriceleveleffects.Whiletheinterpretationofthisinpolicytermswas debated, it appeared to reinforce the belief that if the financial system matteredatall,itwasbecauseofwhathappenedinthemarketformoneyas amediumofexchange.Therestofthefinancialsystemitseemed,couldbe largelyignored.
(ii)Financialfrictionsinmoderneconomics:conceptsandlimitations
Itwouldhoweverbeunfairtostatethatmoderneconomicshasentirelyignoredthe details of the financial and banking system. Particularly since the crisis there has been extensive effort to link the observed reality of financial instability to robust microfoundations.AndasVincenzoQuadriniarguesinarecentsurveyofliterature andconcepts,the20yearsbeforethecrisissawsignificanttheoreticalexplorationof theinherentnatureoffinancialfrictions,andsomeconsiderationof their potential role in macroeconomic fluctuations [Quadrini 2011; see also Brunnermeier, Eisenbach and Sannikov, 2102]. As a result, Quadrini argues, many post crisis attempts to understand the financial drivers of macro-economic stability rely on “approaches…[which]...arenotto newinmacroeconomics…[but]…basedonideas alreadyformalisedinthemacroeconomicfieldduringthedayandlast2½decades, startingwiththeworkofBernankeandGertler(1989).Inparticular: •
•
Considerable effort has gone into understanding real world drivers of the choicebetweenequityorotherstatecontingentcontractsandstandardfixed return debt contracts, moving beyond MM simplifications. Multiple papers haveexploredhowasymmetriesofinformationbetweenlenderandborrower (either ex-ante the lending decision or ex-post the realisation of project results) can, for instance because of “costly state verification” [Townsend 1979]createapreferencefordebtratherthanequitycontracts. Other work has built on this by observing that one response to imperfect information and agency problems is to lend against collateral, and has considered the potential macroeconomic implications of variations in borrowernetworth.Suchvariationscandrivecyclesincreditdemand,with exogenousshocks topresentorprospectiveproductivityproducingamplified results[e.g.KiyotakiandMoore1997].
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•
•
•
Inaddition several economists,startingwith the work of Ben Bernanke and MarkGertler[BernankeandGertler1989]haveconsideredtheimplicationsof variations in the net worth not of borrowers but of financial intermediaries such as banks, thus focusing on the lender as well as borrower drivers of creditcycleamplificationsillustratedinExhibit4. This strand of thinking has in turn been further developed by Marcus Brunnermeier and others in analysis of the self-reinforcing links between market liquidity, asset values and leverage, illustrated in Exhibit 5 [see e.g. Brunnnermeier,andPedersen,2009].HyunShin’sClarendonlectureson“Risk andLiquidity”setoutabrilliantlyclearexpositionofsucheffects[Shin2010]. Andtheideathatcreditmarketshavefundamentallydifferentdynamicsfrom other marketswasgivenformalexpression inStiglitzandWeiss’sexploration of how an Akerlof style “lemons” problem can produce a backward sloping supply curve for credit beyond some interestrate,with implications for the roleofbanksassuperiorscreenersofloanapplication,effectivelyperforming arationingfunction.[StiglitzandWeiss,1983]Thisinsightamongothersthen led on to Greenwald and Stiglitz’ conclusion, already mentioned, that the focusofourattentionshouldbeonthecreditcreationandallocationprocess ratherthanonmoneyasamediumofexchange.
Modern economics can thus beabsolvedofthe charge that ithas entirelyignored the details of financial structure. But what is fair to assert is that the insights developedin thisliteraturewerelargelyignoredinpracticalpolicyimplementation, and that limitations in methodological approach and in the breadth of issues consideredstymiedourabilitytoseehowseveretheproblemswhichcreditcycles cancreateare.Thus: •
•
While literature surveys can illustrate a rich range of relevant ideas, these appearedtocarryfewimplicationsforrealworldpolicy.AsQuadriniputsit, “Although these studies had an impact in the academic field, formal macroeconomic models used in policy circles have mostly developed while ignoring this branch of economic research. Until recently, the dominant structural model used for analysing monetary policy was based on the new Keynesian paradigm… [which]... incorporates several frictionssuch as sticky prices, sticky wages, adjustment costs in investment, capital utilisation and varioustypesofshock.Howeverthemajorityofthesemodelsarebasedon the assumption that markets are complete and, therefore, there are no financialmarketfrictions.” Andwhilethefinancialfrictionsexploredintheacademicliteraturewereable to provide micro explanations of macro fluctuations, Quadrini’s survey illustrates that in most cases the quantitative impacts suggested by the models were far smaller than those empirically observed in real world 29|P a g e
episodessuchastheGreatDepressionorthe2008crisis.Theoreticallyrobust analyses of financial frictions did not therefore challenge radically policy makers’assumptionthatfinancialfrictionscouldlargelybeignored. •
This failure to identify the potential scale of financially induced macro fluctuations,inturnseemslikelyto have reflectedtworelateddeficienciesin mostmodelstreatments: -
First, asBrunnermeieret al noteintheir 2012survey,most ofthe literature, and therefore their own summary in that paper, omits consideration of behaviourally driven “irrational” cycles in asset prices “despite the fact that we think the departure from the rationalexpectationsparadigmisimportant”. AsQuadrininotesin his review of the quantitative performance of different models, a crucial reason why they fail to predict macro fluctuations on the scale empirically observed is that the asset price variations which result from these models (and thus the changes resulting in borrowerorintermediarynetworth)arefarsmaller thanobserved in regular real world cycles, let alone in extreme bubbles and crashes.
-
Second,thevastmajorityoftheliteratureignoresthepossibilities of credit extension to finance the purchase of already existing assets,thuslargelyexcludingconsiderationofself-reinforcingcycles inthepriceofassets,suchaslandorlocationallyspecificbuildings, whichcannotbereproducedthroughnewcapitalinvestment.Even in most of the post crisis literature indeed, the dominant model remains one in which household savers make deposits in banks, which lend money to entrepreneurs/businesses to pursue 18 “investment projects”. The reality of a world in which the majorityofcreditisextendedtohouseholds,inwhichhouseholds are net borrowers from some banking systems, and in which in some countries only a small proportion (e.g. 15%) of bank credit funds “new investment projects” with much of it instead funding thepurchaseofexistingandnon-reproducibleassets,hastherefore 19 beenleftlargelyunexplored.
18
Thusforinstance,in GertlerandKiyotaki[2010]thebankintermediationchannelisdescribedas follows: “ Atthebeginning oftheperiodeachbankraisesdepositsfromhouseholdsin the retailfinancial marketatthe deposit rate Rt+1. After the retail market closes, investment opportunities for non-financial firms arrive randomly” 19
InfactKiyotakiandMoore[1997]isoneoftheminorityofmodelswhichdoesconsideranon-replicable capitalasset,i.e.,land.
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Orthodoxyontheeveofthecrisis
Ittherefore remains fairtosaythat the dominantpre-crisisorthodoxy was one in which theprocessof creditandpurchasingpowercreation,discussedsoinsightfully byWicksell andother earlyandmid-20thcenturyeconomists,waslargelyignored. Andthatorthodoxyremainsonlyimperfectlychallengedandrevised. Thus: •
Standardundergraduatetextbookdiscussionsofbankingandmoneystilltend topropagatethreemyths/simplifications.
•
•
-
First,thatbanksinsequence“raisedeposits”fromsaversandthen “make loans” to borrowers, ignoring their potential to create purchasingpowerexnihilo.
-
Second,thatbanksprimarilylendmoneytofirms/entrepreneursto fund investment projects, allocating funds between alternative uses,largelyignoringtheotherpotentialfunctionsandimpactsof banklending.
-
Third,thatthe“demandformoney”(i.e.,fortransactionsmoney”) isacrucialissue,andcanusefullybecapturedinthefunction f(i,y) ignoringtheendogenouscreationofshorttermfinancialassetsasa resultofcreditcreation,andignoringthecomplexityof thevarying featuresanddegreesof“moneyness”.
Advancedmacroeconomicstextbooksarealsolargelysilentontheroleof banks as creators of money, and on the potential importance of the aggregatebalancesheetlevelofresultingdebt. Similarly,thecanonicalstatementofNewKeynesianpricestabilitytheory, MichaelWoodford’s “Interestand Prices”isalmostentirelysilentonthe details of the financial and inparticular the banking system. [Woodford 2003] Woodford’s title is of course, a homage to Wicksell. And Woodford’s exclusive focus on our ability to maintain price stability through management of the short-term interest rate (or expectations thereof),mirrorsWicksell’sfocusinthefinalchaptersofhis“Interestand Prices” .ButWicksell’sanalysisofthedetailsofbankmoneycreationisleft unexplored:andwithit,thepotentialforinsightsintotheconsequencesof financialintermediationforissuesotherthanpricestability.
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•
Finally,bothcentral bankandfinancialregulators,inthe decadesrunning uptothecrisis,movedawayfromanybeliefthatfinancialstructures,bank credit creation, or absolute levels of leverage, have macro-economic importanceinthefashionenvisagedbyHayek,FisherorGurleyandShaw. Central banks gravitated to an inflation targeting policy regime: price stability as the objective, and interest rates at the tool. Monetary aggregates were of interest only if they had consequences for future inflation:whenmoney/pricelevelrelationshipsappearedtobreakdown, they were therefore assumed of no importance. Quantitative reserve requirements were largely abandoned. As for financial regulators, whetherindependentorwithincentralbanks,therewasastrongtendency to treat the financial system as a market like any other, in which liberalisationwasthekeytocompetitiveintensity,marketcompletionand allocative efficiency, but with no focus on the possible macro consequencesofthegrowingsize,complexityandchangingshapeofcredit markets.
6.DEVELOPINGA NEWAPPROACH
Thepre-crisispolicyorthodoxydefinedpricestabilityastheprimaryanditseemed sufficient objective of central bank monetary authorities. Financial regulators meanwhile (whether located within central banks or outside) focused on applying prudentialrulesonaninstitutionbyinstitutionbasics.Thatapproachanddivisionof labourendedinthecrisisof2008andtheseverepostcrisisrecessionwithwhose consequenceswearestillstruggling.Anewapproachisrequired. Several elements of a new approach have already been put in place in many countries.Theimportanceofoverallfinancialsystemstabilityisnowrecognized:and newmacroprudentialtools,suchastheBaselIIIcountercyclicalcapitalrequirement, havebeenagreed.IntheUKtheestablishmentoftheFinancialPolicyCommittee, appropriately located within the Bank of England, establishes a clear responsibility forboththemonitoringofoverallfinancialstabilitytrendsandtheoperationofthe newpolicytools. Buttheanalysisofthislectureimpliesthatthesechangesdonotgofarenough.For theystilltendtodefinefinancialstabilityintermsofreducedprobabilityoffailure within the financial system rather than in terms of the macroeconomic instability which financial system developments can induce. They do not therefore address radically enough the fundamental role that the creation of credit and purchasing power plays within our economies and the risks that the resulting debt contracts create.
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The precise implications of this for policy and institutions require careful analysis, takingintoaccounttheinherentimperfectionofanypolicyregimeandthedanger thatpolicy–whileaddressingonesetofproblems–canitselfcreateothers. I will not therefore set out here a precise set of proposals. But let me at least proposefordebatesomeaspectsofamoreradicallychangedapproach.Itseems certain that central banks/regulators must focus on previously ignored issues and measures,andhighlylikelythattheywillhavetodeploynewtools. Themostimportantshiftinfocusmustbetotreatcreditflowsandresultingdebt stocksascrucialfactorsofmacroeconomicimportance,assessingtheshortandlongtermconsequencesof: •
•
•
Thelevelandevolutionofrealeconomy(aswellasfinancialsystem)leverage. RecentpapersbyAlanTaylorandMoritzSchularick[Taylor2012;Taylorand Schularick 2009] have already made an important contribution to our understandingoftheseissues. Thechangingmixofpurposesforwhichcreditisextended,andtheeconomic valueandriskimplicationsofeachdifferentcategory The complex and self-reinforcing relationship between credit supply, investmentandconsumptionlevels,andassetprices.
And the policy toolkit will need to equip central banks/ regulators with the ability effectivelytoconstrainbothcreditcyclesandthelong-termgrowthofleverage,both overallorinparticularcategoriesofdebt.Thisislikelytorequire: •
•
•
Amuchmorepowerfulcountercyclicalcapitalrequirementthanthatdefined by Basel III and with a different guideline for its application. The current guidelineproposesthatcapitalrequirementsshouldbeincreasedifcreditis growingsignificantlyfasterthantrend.Butthatimpliesthatgrowthincreditis always acceptable as long as the growth rate is steady, even if that growth rateis faster thannominalGDP and even iftherefore aggregate leverageis relentlesslyincreasing.Whenleverageis alreadyhigh, however,evensteady trendcreditgrowthmaybedangerous. The restoration to the policy toolkit of quantitative reserve requirements, whichmoredirectlyconstrainbankingmultipliersandthuscreditgrowththan doincreasesincapitalrequirements. Andtheapplicationofdirectconstraintsonborrowers,inparticularinsectors suchascommercialandresidentialrealestate.
Such a focus on such tools would amount to a very major shift from pre-crisis orthodoxy.Butthatorthodoxydidfail.Ournewapproachneedstobebasedona returntofundamentalanalysisoftherolewhichcreditcreationandresultingdebt 33|P a g e
contracts play in our economies, an analysis which was central to the work of Wicksell, Hayek, Fisher and more recently Minsky, but largely ignored by much of modernmacroeconomics.
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