Adair Turner Part 1

Good morning. I'm sorry not to be able to be with you in person in Stockholm. My subject that I'm going to talk about today is money and the credit cycle. When you actually see this lecture, I will be in China looking at issues to do with credit and money creation and the dangers that credit expansion in China is heading towards a crisis. So I will be in an appropriate place, but it would also be very appropriate for me to be talking about this in Stockholm, in Sweden, because I think the Swedish School of Economics, in particular and very particularly Knut Wicksell, had some insights into the nature of credit creation and what that does within an economy and the challenges that come from that, which were subsequently developed and explored by early and mid-20th century economists such as Hayek and Fisher, but which I will argue have been to a significant extent ignored or assumed as unimportant by much of modern macroeconomics. So in part, what I'm going to talk about this morning is a piece of intellectual history, but with a very clear conclusion. The conclusion is that the credit cycle and the level of leverage in an economy are crucial economic variables which we need to pay attention to and did not pay adequate attention to before the crisis. In order to pay attention to them and deal with them effectively, we need to go well beyond the current new conventional wisdom that we need to add financial stability as a parallel but separate focus to monetary stability. I will assert instead that we need a whole new mindset and an integrated approach, integrating across monetary policy and financial stability issues, in order to control and constrain the credit cycle. So that is the theme that I'm going to set forward. Can I just say a quick word on the technology of how we're going to do this, which I hope is going to work. Behind me on the screen, you will see that there are some slides which, however, you can't see because I am in the way of them. But I hope that you have been provided, either on a separate screen or with a physical printed copy of the slides, which I hope will help make the communication work a bit. In order to make sure that you can see where we are in the process, as I change the slides I will mention the number of the slide that we are on. Let me begin with Wicksell's fundamental insight, which was based upon the analysis of the way that credit extension creates purchasing power. Wicksell was already operating in an environment where most payments were no longer notes and coins; they were credit-based. He asked the question: what are the consequences of payments being based on the basis of credit rather than notes and coins? He began by pointing out that even if you had what he called a simple credit economy, in which credit was simply extended on a bilateral basis between businesses, that in itself would create additional purchasing power above and beyond that which exists on the basis of pure metallic money. But then he said, if you go beyond that and have what you call a system of organized credit, by which he meant a system with commercial banks and with deposit money as the fundamental form of payments, he asserted that that clearly created purchasing power and created it ex nihilo, out of nothing. That new purchasing power was created. I think if we look at the first slide, this is a fundamental insight. We sometimes say that what banks do is they take deposits from households and they then lend it to entrepreneurs or businesses. I think that is a bad description of what banks do. I think we need to fundamentally understand, as Wicksell asserted, that what banks do is they create both a loan (he assumed it was a loan to an entrepreneur) and the money in that entrepreneur's account. That creates purchasing power. The fact that it creates purchasing power crucially depends upon maturity transformation, on the fact that the loan is of longer tenor than the deposit. But that insight is, I think, fundamental, and I think too much lost in first, certainly our undergraduate economics textbooks, but even I think in more advanced economics. Wicksell then asked the question: okay, well if credit and in particular bank organized credit creates purchasing power, what constrains that purchasing power creation? Or do we have a problem that it can simply go on growing limitlessly and therefore create inflation? So he asked the question, and we turn now to my second slide: what is it that limits bank credit creation, and what is it that freely limits it before we introduce the idea of an authority attempting to constrain it? His assumption was that banks would freely choose to hold reserves, cash reserves or reserves at the central bank, and that the fact of those reserves, the need to hold those reserves in some proportion to the size of their balance sheet, constrained credit and money creation. But then he noted three ways in which the degree of those constraints would change over time. First of all, he said the more payments go through a giro system rather than a cash system, the more at the level of the total banking system you don't really need reserves because you don't have to deal with the fact that people will suddenly decide to take physical cash, paper cash or coin cash, out of the banking system. Secondly, and I think this was a really crucial insight, he asked the question: what if the banking system was organized as one bank rather than many competing banks? In that environment, you could be certain that when the entrepreneur who had received the loan spent the money from that loan, although it would leave his account, it would be bound to end up in an account of somebody else at that bank. He said the more that the banking system is organized as one bank rather than many banks, the less freely constrained it will be. Thirdly, he noted the fact that at least in his time, international payments were not entirely done on a credit basis; there still was movement of precious metal, gold bullion, or at least claims to precious metal, gold bullion. He said that the fact that there was still a metallic money anchor would somewhat more constrain credit creation than you would have if an economy was entirely closed, or indeed if the entire world economy also fundamentally made payments on a credit basis. Now those three insights, I think, are very important to what then happened over the subsequent 100 years. I'm going to argue later that those three constraints change over the 100 years and they make the credit cycle less and less constrained. I'll come back to that later. But Wicksell's fundamental insight, if I return to it on the next slide, slide three, is that banks create credit and purchasing power, and the way he believed that this was constrained, beyond the constraint that would freely arise from banks' behavior, would be if a central bank made sure that the money rate of interest, which was influenced by the central bank, was equal to the natural rate of interest, where the fundamental concept of the natural rate of interest is pretty much equivalent to the MPC as I call it there, the marginal productivity of capital. I think Wicksell's insight into the nature of credit creation was fundamental. I think in two ways, Wicksell's insights are still limited. One, he assumes that all credit is extended to entrepreneurs to make real new physical investment, and that turns out not to be true, and I'll come back to that. Also, he assumes that the fundamental problem that we're dealing with here is whether too much credit creation creates inflation; it's a price stability issue. I think that is a limiting assumption. It is the assumption which most modern macroeconomics and pre-crisis central bank orthodoxy has also accepted: that the fundamental issue is price stability. A subsequent series of economists, and I'm going to talk about Hayek, Fisher, Minsky, and Simons, I think correctly identified that credit creation had a set of other implications that go beyond price stability, and it's those that I would like to explore. But before turning to those points, I think it's useful to step back and consider the role of credit relative to other options to create adequate demand. Because if Wicksell is right that credit creates purchasing power, I think it is useful, if we now look at slide four, to think about credit creation as one of two alternative ways to make sure that nominal demand, aggregate nominal demand, is adequate within an economy. Let's think about the problems which, of course, people did think about at the time of Wicksell, about a pure metallic money system, a system of a gold standard. If it was truly pure metallic money and there was no either simple credit or organized bank credit, then clearly the money supply would be constrained by precious metal resources. Of course, many people in the late 19th century worried about the implication of that, and they said here is the problem: if our money supply is constrained by real precious metal resources, it may be that we can only achieve an adequate level of real growth if we have a downward flexibility of wages and prices, and it may be that downward flexibility of wages and prices is in itself disruptive to real growth or is unattainable. It is also the case that in an environment of pure metallic money, you can, as the early economists described, have savings actually taking the form of pure hoarding. If somebody saves in a pure metallic money environment and actually puts metal coin under the bed, it is truly removed from the economic circulation in a way which is not true of savings within an environment which has a credit system and bank money. So there can be a set of problems to do with an inadequacy of aggregate nominal demand. Now, of course, if we believed that the economy is so flexible in terms of real wages and prices that it will automatically get to a reasonable equilibrium whatever the money supply, then this doesn't matter. But actually, most modern macroeconomics and most policy has converged to the belief that the optimal way to run the macroeconomy is to have a low and positive inflation rate, and therefore a rate of nominal GDP growth which is, let us say for an advanced economy, in the region of 4% or so, allowing for 2% real growth and maybe 2% inflation. If that is the case, if that is the optimal way to run a modern economy, you have an issue of where does that aggregate nominal demand come from. I think it's useful to think about two alternative ways that it can come. First of all, it can come from pure fiat money creation: a state can create money and can spend it, it can run an unfunded fiscal deficit and cover it with money. As I'll say in a minute, there have been environments where that has been a successful way of stimulating economies, but we have tended to be very wary of that as a way forward for creating aggregate nominal demand. Credit creation is an alternative way of doing it. So one of the ways to think about private bank credit and money creation is it is a way of creating aggregate nominal demand, demand growth, in a way which is an alternative to pure fiat money demand growth. If you look at some 19th century commentators such as Walter Bagehot, they were convinced that the development of the banking systems in countries like England had enabled an expansion of aggregate nominal demand which was not possible in a country like France, where Bagehot said the trouble is that extra saving can take the form of pure hoarding. So I'd like to suggest that it's useful to think about pure fiat money creation and private bank money creation as two alternative ways of overcoming the problems created by the limits of metallic money.