Between debt and the devil Adair Turner

Adair Turner became the chairman of the UK’s Financial Services Authority the day after Lehman Brothers collapsed. He was one of the most senior banking officials from 2008 until 2013, so it’s fair to assume that he’s seen more chaos behind the scenes of banking than most of us could even imagine. While he’s never written an expose or biography detailing his experience of trying to rescue a fundamentally broken banking system, key insights have informed everything he’s said and written since. His latest book, Between Debt and the Devil, is no different.

Released on 7th October 2015, the book explains that “our addiction to private debt” is what caused the financial crisis. The blurb shows that Turner’s thinking is close to the arguments Positive Money have been making for the last 5 years:

Between Debt and the Devil challenges the belief that we need credit growth to fuel economic growth, and that rising debt is okay as long as inflation remains low. In fact, most credit is not needed for economic growth – but it drives real estate booms and busts and leads to financial crisis and depression.”

Turner also debunks the big myth about fiat money – the erroneous notion that printing money will lead to harmful inflation.

“To escape the mess created by past policy errors, we sometimes need to monetize government debt and finance fiscal deficits with central bank money.”

The book is full of detailed analysis of the problems with the current banking system, the tendency for banks to create too much money, credit and debt; and to put most of that money into the property and financial markets rather than financing investment in the real economy. Most followers of Positive Money will be well aware of that analysis (A new era for monetary policy (video) and Overt Monetary Financing), so I won’t repeat it here.

Instead, let’s look more closely at what Turner advocates as solutions. He first covers the idea of prohibiting banks from creating money (before concluding, as he has before, that it is too radical). But he then strongly advocates the need for states to create money and distribute it into the real economy, either through government spending or direct payments to citizens.

Would stopping banks from creating money be a step too far?

Between Debt and the Devil discusses the long history of proposals to remove the power to create money from banks. During the Great Depression of the 1930s, a number of well-known American economists advocated this policy, even presenting it to President Roosevelt as a recovery plan (the idea eventually lost out to the New Deal). Since then, the idea has often resurfaced, most recently with the IMF working paper “The Chicago Plan Revisited” by Michael Kumhof (now a senior researcher at the Bank of England) and Jaromir Benes, in which they model the proposal and found it would be highly beneficial for the US economy. Turner also mentions Modernising Money, written by Positive Money’s research team, which argues for the same proposal.

But Turner lists “three [actually four] reasons for caution” about the idea of stopping banks creating money:

The first is banks can play a useful role in maturity transformation – turning short-term savings into long-term loans, and that it would be a shame to lose that maturity transformation function. This objection makes little sense to us, as the banks advocated in Positive Money’s proposals would still be able to ‘transform’ short-term savings into longer-term loans (in fact, that would be one of the main reasons for using a bank rather than going through, say, a peer to peer lender). It is possible to have maturity transformation without money creation, and so we’d dismiss this reason for concern outright (more here).

Secondly, Turner argues that without banks creating money, we would be reliant entirely on states to create money. The danger here is that they may create too much or use the money for the wrong or inefficient uses. As we’ll see below, Turner ends up advocating a greater role for the state in money creation, and argues himself that the power to create money can be kept under control so that politicians are not free to abuse it. So again, this seems like a weak reason for caution.

Thirdly, Turner highlights the risk that stopping banks creating money will alone be insufficient to constrain credit booms. Other parts of the financial sector may find ways to create equivalent substitutes for state-issued money, or so-called ‘near monies’, that can function as money in the economy. This is a risk to be aware of, but not insurmountable (and in any case, creating a substitute for money is much harder in practice than in theory). Logically, the argument that other measures would be needed in addition is not an argument against the proposal itself.

Finally, Turner states that the transition may be difficult, and that we have to consider where we are starting from and be pragmatic. But we would counter this by highlighting that it is possible to implement the proposals gradually, through a number of pragmatic steps, and without making anyone (or any bank) significantly richer or worse off (see page 33 here). If the destination is worth going to, the fact that the journey might be tricky is not an argument for staying where we are.

Turner concludes his discussion of these proposals as follow:

“Even if we reject the radicalism of the Chicago Plan [the original proposal to prevent banks from creating money], we should still embrace its key conclusion. We have to constrain and manage the quantity and mix of credit that the banking or shadow banking systems create.”

Central banks must create money for the real economy

Turner describes the current economic situation worldwide, and states that

“We will never get out of the current malaise, return inflation to target, or reduce debt levels unless we increase demand in our economy.” (p214)

Thankfully, there’s a clear solution to this problem:

“We can always stimulate nominal demand by printing fiat money: if we print too much, we will generate harmful inflation; but if we print only a small amount, we will produce only small and potentially desirable effects.”

This is completely consistent with Positive Money’s proposals. For too long we’ve relied on banks to fuel economic growth by creating money when they lend. The problem is that this leads to (a) new money being created too quickly when banks get over-confident, fuelling high house prices and financial market bubbles and (b) a huge build-up in private debt (i.e. debt of households, and to a lesser extent, businesses). What is needed now is for the Bank of England (or the European Central Bank or US Fed) to create money and spend it into the economy, without relying on any household or business to take on further debt. Whereas Quantitative Easing involved creating hundreds of billions of pounds (or dollars or euros) and putting that money into the financial markets, this policy would get money directly into the real economy, where it would create jobs and boost GDP.

Such policies are now being discussed by the new Shadow Chancellor John McDonnell, and have been endorsed by a wide range of economists, as well as those from the financial sector who have seen current policies failing.

The money that the Bank of England created could be used either to finance government projects, or to finance a one-off or monthly payment to every citizen in the country. Turner emphasises this second policy, often referred to as ‘helicopter money’ (as if the money dropped out of a helicopter into the hands of citizens). Such a policy, he argues, would be significantly better than what we’ve tried to date:

“[C]ompared with a pure monetary stimulus [such as QE], [helicopter money] works through putting new spending power directly into the hands of a broad swath of households and businesses, rather than working through the indirect transmission mechanism of higher asset prices and induced private credit expansion. It does not rely on regenerating potentially harmful private credit growth nor does it commit us to maintaining ultralow interest rates for a sustained period of time.”

“Ideally, the major advanced economies should have implemented Bernanke-style helicopter money drops in the immediate aftermath of the 2007-2008 crisis. If we had done so, the recession would not have been so deep, and we would now be further advanced in escaping the debt overhang.”

If only… But there may still be time to correct past mistakes, and this policy is still needed.

What about the risks? One is the possibility that putting more money into the system (and boosting spending and the health of the economy) will encourage banks to start another dangerous credit boom. Turner argues that this can easily be avoided, through restrictions on banks creating money, via various regulations (i.e. leverage ratios can be increased in order to offset any money creation by the state). Although he doesn’t say so, this approach might be one feasible transitional path towards stopping banks creating money altogether: as the state creates a greater percentage of the additional money that enters the economy, the restrictions would be increased to limit what banks can create.

A bigger risk of course is that once the creation of money in the public interest becomes popular, people will demand more of it. Politicians with direct control may want to overuse the policy, and those with independent central banks may try to pressure the central bankers into creating more money when it is politically advantageous (i.e. before every election). But again, Turner argues that it is fairly easy to overcome these risks:

“So should we lock up the medicine and throw away the key? I don’t believe so for two reasons. It is in principle possible to design institutional mechanisms to place appropriate constraints on excessive use. Second, because the alternative route to nominal demand growth – private credit creation – is just as dangerous. We face a choice of dangers, not inevitable perdition on the one side and perfection on the other.”

“There is no reason the use of monetary finance [i.e. money creation by states to finance public spending or payments to citizens] cannot be appropriately constrained within precisely the same discipline of central bank independence. Central bank committees that today vote to approve interest rate movements or quantitative easing operations could also be given the power to approve or disapprove either a Bernanke-style helicopter money drop or a one-off government debt write-off.”

Indeed, at Positive Money, we believe that with the relevant institutional mechanisms central banks should always be allowed to create money for spending directly into the real economy whenever aggregate demand is below a certain threshold. In this sense, monetary-financing for the real economy could be an additional instrument added to the central bank’s ‘tool box’. This is not to suggest that monetary-financing would be used for funding government deficits, rather it could be another macro-economic tool at the central bank’s disposal to help manage aggregate demand within the economy.

With interest rates at the zero-bound level for the last six years it is clear that they are not an efficient tool for stimulating aggregate demand in the real economy. If anything, the reduction of interest rates combined with conventional QE has helped to increase asset prices to all-time highs and has led to a number of bubbles in financial markets – increasing financial instability. Thus, injecting central bank money into the veins of the real economy would not only do a better job of stimulating demand, but would also reduce future financial instability.

From an economic standpoint, there are a number of reasons for allowing central banks to create money for the real economy. The Chinese economy has hit a slump and potential global growth rates are consistently being revised downwards. Threats of deflation are looming, and even core inflation (inflation stripped of oil and commodity prices) is at extremely low levels – indicating a slump in aggregate demand. The World’s leading economic institutions (i.e. IMF, BIS, OECD etc.) are all warning that current monetary policy is increasing financial instability. Meanwhile, both public and private debt levels are at all time highs (since 2007 global debt has increased by $57 trillion).

Allowing central banks to create money for the real economy would trigger a boost in aggregate demand without a corresponding increase in net debt and without promoting further financial instability. The ratio of debt to income could be lowered, as increased spending would take place without governments increasing their budget deficits and without the private sector increasing levels of borrowing. Lower debt to income ratios would make our financial system more resilient to potential shocks. Central banks would also be better equipped to deal with such shocks if they were permitted to create money for the real economy.

Between debt and the devilUltimately, it is a breath of fresh air to have someone of Lord Turner’s calibre offer an analysis and proposals that are outside of the box and that have genuine potential to achieve what current policy-makers are all trying to do but cannot. Indeed, we thoroughly encourage anyone trying to get a better understanding of money, debt and credit cycles to read Between Debt and the Devil. Not only does it provide an accurate understanding of many of the problems emanating from the current monetary system, but it also offers an excellent understanding of the potential solutions and why these solutions are the next logical step in generating growth and increasing financial stability.

*The book will be launched at the LSE event on October 21st, 6.30 – 8.00, with Lord Turner and Robert Peston in conversation about the arguments.