Debt, Money, and Mephistopheles: How Do We Get Out of This Mess? 7 8 r e p Adair Turner a P l a n o i s a c c O 0 3 Group of Thirty, Washington, DC About the Author Adair Turner has combined careers in business, public policy and academia. In April 2013, he became Senior Fellow of the Institute for New Economic Thinking (INET). From September 2008 to March 2013, Lord Turner was Chairman of the UK Financial Services Authority, and from January 2008 until spring 2012, Chair of the Climate Change Committee. He became a cross-bench member of the House of Lords in 2005, and was Chair of the UK Pensions Commission from 2003 to 2006, and of the Low Pay Commission from 2002 to 2006. He is the author of Just Capital – The Liberal Economy (Macmillan 2001), and Economics after the Crisis – Objectives and Means (MIT Press 2012). He is a Visiting Professor at the London School of Economics and at Cass Business School, City University; a Visiting Fellow at Nuffield College Oxford; and a Trustee and Chair of the Audit Committee at the British Museum. Prior to 2008, Lord Turner was a non-executive Director at Standard Chartered Bank, United British Media, and Siemens UK; from 2000 to 2006 he was Vice-Chairman of Merrill Lynch Europe, and from 1995 to 1999, Director General of the Confederation of British Industry. He was with McKinsey & Co. from 1982 to 1995, building McKinsey’s practice in Eastern Europe and Russia between 1992 and 1995. He was Chair of the Overseas Development Institute from 2007 to 2010. Lord Turner studied History and Economics at Caius College, Cambridge, from 1974 to 1978, and was college supervisor in economics from 1979 to 1981. ISBN 1-56708-161-4 Copies of this paper are available for US$30.00 from: The Group of Thirty 1726 M Street, N.W., Suite 200 Washington, D.C. 20036 Tel.: (202) 331-2472 E-mail: [email protected], www.group30.org Occasional Paper No. 87 Debt, Money, and Mephistopheles: How Do We Get Out of This Mess? Adair Turner Published by Group of Thirty© Washington, D.C. May 2013 This Occasional Paper was adapted from a speech given by Adair Turner on February 6, 2013, at the Cass Business School in London. Contents List of Exhibits iv Abbreviations v Introduction 1 1. Policy Levers and Aggregate Demand: Price and Output Effects 6 2. Milton Friedman, Money-Financed Deficits, and Narrow Banking 11 3. Leverage and Financial Stability: Deleveraging and Deflation 15 4. Targets: Should We Move Away from Current Inflation Rate Targets? 19 5. Achieving the Chosen Target: Monetary and Macroprudential Levers 24 6. Fiscal Policy Stimulus 28 7. Overt Money Finance: Advantages, Dangers, and Required Constraints 31 8. Possible Implications by Country: Some Initial Thoughts 43 9. Conclusions 48 Exhibits 51 Bibliography 69 Group of Thirty Members 2013 73 Group of Thirty Publications 77 List of Exhibits Exhibit 1: From fractional reserve to 100% reserve banking 51 Exhibit 2: Leverage in the real and financial sectors 52 Exhibit 3: Private nonfinancial corporate deposits and loans: UK 1964–2009 52 Exhibit 4: Household deposits and loans: UK 1964–2009 53 Exhibit 5: Private-credit-to-GDP ratio and growth 53 Exhibit 6: Lending to UK business 54 Exhibit 7: Lending to individuals 54 Exhibit 8: Japan policy rate vs. credit growth per year 55 Exhibit 9: Sectoral Financial surpluses/deficits as % of GDP: Japan 1990–2012 55 Exhibit 10: Japanese government and corporate debt: 1990–2010 56 Exhibit 11: Shifting leverage: Private and public debt to GDP 57 Exhibit 12: UK inflation: Bank of England forecasts and actual 58 Exhibit 13: Public debt to GDP: US and UK 58 Exhibit 14: GDP growth rates 1950–1970 59 Exhibit 15: UK public debt deleveraging: 1945–1970 60 Exhibit 16: Central Bank policy rates 61 Exhibit 17. Central Bank balance sheets as % GDP 61 Exhibit 18: Japan 10-year nominal yield 62 Exhibit 19: UK trends in lending: % 12-month growth rates 62 Exhibit 20: Gross lending to and repayments by UK nonfinancial businesses 63 Exhibit 21: Post-facto money finance: US 1940–1951 63 Exhibit 22: Japanese government debt as % of GDP 64 Exhibit 23: Varying actual and appropriate policies: McCulley and Pozsar’s framework 64 Exhibit 24: Private and public leverage cycles 65 Exhibit 25: Varying actual and appropriate policies: McCulley and Pozsar’s framework 65 Exhibit 26: Fiscal adjustment required for long-term debt sustainability 66 Exhibit 27: Nominal GDP in four major economic areas: 2007–2011 66 Exhibit 28: GDP growth of developed economies 67 Exhibit 29: Breakdown of nominal GDP growth from trough: 2009–2012 67 iv Abbreviations CCB countercyclical buffer ECB European Central Bank GDP gross domestic product IMF International Monetary Fund NGDP nominal gross domestic product OMF overt money finance OPMF overt permanent money finance QE quantitative easing v Introduction It has been five-and-a-half years since the financial crisis began in summer 2007 and four- and-a-half years since its dramatic intensification in autumn 2008. It was clear from autumn 2008 that the economic impact would be large. But only slowly have we realized just how large. All official forecasts in spring 2009 suggested a far faster economic recovery than was actually achieved in the four major developed economies—the United States, Japan, the eurozone, and the United Kingdom. UK gross domestic product (GDP) is now around 12 percent below where it would have been if it had continued the pre-2007 trend growth rate, and latest forecasts suggest that the UK will not return to 2007 levels of GDP per capita until 2016 or 2017. In terms of the growth of prosperity, this is truly a lost decade. This huge harm reflects the scale of precrisis financial folly—above all, the growth of excessive leverage—and the severe difficulties created by postcrisis deleveraging. And failure to foresee either the crisis or the length of the subsequent recession reflects an intellectual failure within mainstream economics—an inadequate focus on the links between financial stability and macroeconomic stability, and on the crucial role that leverage levels and cycles play in macroeconomic developments. We are still crawling only very slowly out of a very bad mess, and still only slowly gaining better understanding of the factors that got us there and that constrain our recovery. We must think fundamentally about what went wrong and be adequately radical in the redesign of financial regulation and of macroprudential policy to ensure that it does not happen again. But we must also think creatively about the combination of macroeconomic (monetary and fiscal) and macroprudential policies needed to navigate against the deflationary headwinds created by postcrisis deleveraging. In the field of macroeconomic management—the management of aggregate demand to support, as well as possible, low inflationary real growth—two issues are central: appropriate targets and appropriate tools. In respect to both, precrisis certainty has been replaced by wide-ranging debate. 1 Targets. In the precrisis period, a dominant consensus reigned; most central banks focused on the attainment of low but positive inflation rates, often expressed in formal symmetric targets. Now debate rages. Olivier Blanchard, Chief Economist of the International Monetary Fund (IMF), floated in 2010 the possibility of temporarily higher inflation rate targets (Blanchard, Dell’Ariccia, and Mauro 2010). The Federal Reserve has adopted a policy stance explicitly contingent on the rates of unemployment and inflation. Mark Carney, Governor of the Bank of Canada, has suggested that the issue of nominal GDP targets should at least be encompassed within the debate (Carney 2012). And Michael Woodford, a prominent theoretician of precrisis monetary policy orthodoxy (Woodford 2003), argued at Jackson Hole, Wyoming, in August 2012, for an explicit target to return to the level of nominal GDP that would have resulted from the continuation of precrisis trends (Woodford 2012). The issue of appropriate targets clearly will be and should now be a subject of intense debate. Tools. But important as the issue of appropriate targets is, the more fundamental issue is what policy tools are needed to achieve, in an optimal fashion, whatever the chosen objectives or targets should be. More fundamentally, even if we did decide to set a new target—such as one related to nominal GDP—we might not be able to meet it except through the use of policy tools that produce damaging side effects on future financial and thus macroeconomic stability. The question is, by what means can we and should we seek to stimulate or constrain aggregate nominal demand. Before the crisis, the consensus was that conventional monetary policy, operating through movements in the policy rate and thus affecting the price of credit/money, should be the dominant tool with little or no role for discretionary fiscal policy and no need for measures focused directly on credit or money quantities. Postcrisis, a wide spectrum of policy tools is already in use or under debate, such as: • Interest rates have been reduced close to zero bounds. But central banks can and have implemented quantitative easing (QE) operations. • QE can be extended to a still wider range of assets than government bonds, and central banks can get into the business of directly subsidizing commercial bank lending as, for instance, through the Bank of England’s Funding for Lending Scheme. • And the case that fiscal policy can be an effective tool of demand management in circumstances when interest rates are at the zero bound has been forcefully restated by Brad DeLong and Larry Summers (2012). At the extreme end of this spectrum of possible tools lies the overt money finance (OMF) of fiscal deficits—“helicopter money”—permanent monetization of government debt. This extreme option should not be excluded from consideration for three reasons: • Because analysis of the full range of options (including OMF) can help clarify basic theory and identify the potential disadvantages and risks of other less extreme and currently deployed policy tools; • Because there can be extreme circumstances in which it is an appropriate policy; and 2