Lord Turner, formerly chairman of the Financial Services Authority and a student at the University of Cambridge in the 1970s, argues that driving out the instability caused by debt and credit creation systems is the best way to avoid future crises
As ex-chairman of the FSA – my four and half years began on 20 September 2008, five days after the collapse of Lehman Brothers – I am deeply involved in global debates about re-regulating the financial system. The more I think about what occurred and why the crisis produced such a deep recession, the more I feel that many of the explanations given up to now, although valid to a point, don’t address the fundamental problem.
Many of those explanations focus on issues to do with the stability of the financial system, but work within the framework of a market failure hypothesis, whereby you assume that if you can fix the incentives and relationships in the system everything will be fine. But we cannot understand either the origins of the crisis of 2008, or why recovery was so difficult, without considering the fundamental drivers of this inherent instability.
I believe that one has to look at the debt creation system and the credit creation system as major causes of instability. Over the past 30 years economists have assumed that credit growth was required to achieve GDP growth, but there is now plenty of evidence to suggest that, actually, excessive levels of private debt are likely to produce instability.
The fact that private sector credit grew faster than GDP in many advanced economies, so increasing leverage, was one of the main reasons for the crash. So I would argue that the drivers of instability are the nature of debt contracts and the fact that banks can create limitless credit.
At the same time, the fact that human beings are not rational entities all the time means that markets are capable of acting in an unstable and irrational fashion. The net effect is a divergence far from equilibrium level. That undermines both the rational expectations hypothesis and the efficient markets hypothesis. I think the two big errors of modern economics are to accept those hypotheses while ignoring the fact that banks can create money and credit.
Then there’s an extra twist: the instability created when credit is extended not primarily to finance new business investment, but to finance assets that already exist, in particular real estate and land – the supply of which is absolutely limited. And in advanced economies a majority of wealth is held in real estate. If you have credit and money that can be created in limitless amounts alongside demand for land you create self-reinforcing credit and asset price cycles.
In my view there are three possible drivers of why the economy is so credit intensive: one is the real estate asset phenomenon; the others are rising inequality and global imbalances. Economic inequality will tend to generate pressure for credit growth. If consumers borrow unsustainably to make up for shortfalls in income, that will create debt overhang, which may be exacerbated if consumers then borrow against the rising value of housing.
Global imbalances mean countries with a current account surplus may in effect be experiencing economic growth based in part on credit growth in other countries. There can be a direct link to real estate, for example if the Chinese surplus is funding mortgage lending in the US.
We need policies that try to manage the quantity and the mix of credit in a way that is outside the orthodoxies of the past. We cannot do that solely by pulling on interest rates. Instead, we need reforms to regulations and central bank policy far beyond those agreed so far, to reduce the tendency of financial systems to produce too much debt; in particular debt to finance real estate purchases.
Both the quantity of credit created and the mix of purposes for which it is used should be treated as economic variables to be managed actively through policy. One thing we can do is be willing to set, at the regulatory level, higher capital requirements for lending against real estate than for lending against non-real estate. We need fewer tax incentives to buy real estate. We should impose much tighter controls on mortgage lending and on other sources of credit, such as payday loans.
We also need to consider the broader picture more carefully when considering regulation and policy. We need measures designed to mitigate the effects of rising inequality. And we need to address national current account imbalances.
One of the great difficulties before the crisis was that financial regulation was seen as separate from macroeconomics. When I took over at the FSA we had a very strong institutional separation between what we were doing as regulators and what the central bank did, dealing with macroeconomics. That was a huge error. I think that error is being rectified now, but not to a great enough extent.
Tackling the global imbalances that contribute to instability in the financial system is much more difficult. The free flow of capital across the world in some respects is beneficial – in the case of long-term debt capital, for example. But short-term movements of bank debt capital back and forth across borders can be destabilising. If we insist that major global banks have to set up separately capitalised subsidiaries in different countries we should discount their complaints about not being able to move capital frictionlessly around the world, because there is no sign that this is beneficial and it can be destabilising.
Such reforms could enable the creation of a more stable economic system, where credit growth and national income increase at the same pace, alongside low, positive inflation. If we do not formulate policies that address the growth of credit to finance the purchase of limited supply existing assets, in particular real estate, as well as policies that aim to reduce inequality and global imbalances, we will continue to suffer further outbreaks of instability and crises in the future.