Adair Turner (1): Right on the case for radical reform

One person who fully grasps the urgent need for more radical reforms is Lord (Adair) Turner, former head of Britain Financial Services Authority. He also specifies what reforms he feels are needed and makes an eloquent plea for them. These two features set his contributions apart from 90% of writings on the topic. Here I focus on his recent paper “Escaping the Debt Addiction”.

He argues that developed economies have relied on credit (or rather “leverage”) to achieve adequate economic growth, but that inevitably leads to crisis. If this is the case, we do not know how to grow in a balanced and sustainable way. Growth in private leverage was a major cause of the crash of 2007/08 and “the main reason why the post-crisis recession has been so deep and the recovery so weak”.

His argument is worth looking at in some detail:

1. Credit is important essentially as it is one of only two ways of avoiding a chronic lack of purchasing power that would result from a purely metallic currency. The other is for the state to print enough money, a course advocated for many years by James Robertson and the Positive Money School. (In their view, the function of creating the national money supply should be transferred from commercial banks as a source of private profit to the central bank as a source of debt-free public revenue, to be spent into circulation by the government for public purposes).
2. But this freedom to create credit leads in practice to a rise in private debt to income ratio – leverage – that beyond a certain point becomes extremely damaging. Even surplus countries such as Germany, Japan and China, base their export-led growth on credit-financed consumption in debtor countries: Pre-crisis it seemed as if the growth of average was acceptable – now we can see it went too far: “debt contracts fool us”. We cannot do without such contracts; they are needed to overcome the asymmetry of information which would stymie capital formation in an all-equity world. But we easily ignore default risks. When recession sets in, credit is depressed not only by the damage to banks’ finances but also by lack of demand from companies and households
3. Central banks focus on inflation “led us astray”. Central banks should focus on credit and money creation even if they know it will not cause inflation. But how are they to do this? If they had raised interest rates pre-crisis to reduce credit growth they would have produced lower GDP and below-target inflation. A dilemma, indeed.
4. There are different types of credit. The relationship between credit growth and house price rises was the main origin of the crisis. The supply of credit is elastic while the supply of “locationally specific” real estate is inelastic. Focus on traditional monetary aggregates, as the ECB does in its monetary policy-making, is misguided as money is not held primarily any longer for transactions purposes – thus the money supply is not a good forward indicator of inflation.
5. Rising levels of inequality was another “driver” of the crisis. Lord Turner’s argument here is that rising inequality may raise savings above ex ante intended investment, leading to demand deficiency. This can be offset by increased credit but that again is high-risk, especially where consumption is financed by borrowing against housing. Indeed, the mortgage markets may have contributed to increased inequality because preferential access to credit is enjoyed by the wealthy (and leveraged buy-to-let landlords) while high-priced credit often traps the poor.
6. Global imbalances on current account are another driver of crises. Countries that experienced rapid growth in credit, pre-crisis, spent much of it on imports, fuelling current account deficits. Traditionally freedom of capital flows has been praised by economists, but recent flows have not been beneficial – such as the flow “uphill” from China to the US, used mainly to finance consumption, exacerbating cycles in credit and asset prices and wasteful real estate investment. Post crisis, deficit countries have to cut back on imports but surplus countries feel no obligation to expand.

To sum up, beyond a certain point, growth in private sector debt and leverage is harmful; yet to deal with it adequately requires dealing with the fundamental drivers of this pattern. We have not actually reduced total leverage since 2007-08, but rather shifted it around. Austerity may have been unavoidable, but QE works merely by stimulating the very growth in private debt that got us into this mess – inequality is rising further and the recent “taper panic” shows the international implications remain complex. Is it necessary deliberately to engineer a spell of high inflation? Somehow we have to find a way to grow without relying on increased debt.

The measures taken so far in response to the crisis are inadequate; “a more radical reform programme is required.” There is a big agenda.