By Lynn Parramore and Adair Turner
Adair Turner, Chairman of the Board of the Institute for New Economic Thinking and former Chairman of Britain’s Financial Services Authority (2008-13), is the author of a new book that takes aim at economic and political orthodoxies, Between Debt and the Devil: Money, Credit, and Fixing Global Finance. As Turner sees it, policy makers and economic thinkers across the globe remain in thrall to the belief that only unfettered financial markets deliver the best for societies. The resulting bias favors fixed rules and mathematical models often wildly out of touch with real world conditions. Turner calls for a reality check — the recognition that circumstances change, that the future is uncertain, and that we need flexible approaches to shifting market circumstances at a time of inequality and instability. He warns that taboos against printing money and disproportionate fears of fiscal deficits are keeping central banks from taking crucial measures to stimulate economies. These taboos and fears also make us blind to the threat of out-of-control private debt and credit wasted on real estate and speculation rather than growth that lifts everyone. For Turner, thinking radically is the most practical way forward.
Lynn Parramore: You’ve noted that economies have become dangerously focused on credit in recent decades and that rising inequality is connected to this trend. Can you explain the link?
Adair Turner: If you look back at the story of advanced economies over the 20 years before 2007, you see an interesting pattern. During that period, the total value of national income — what economists call “nominal GDP,” meaning income unadjusted for inflation —grew at about 5 percent per year in a reasonably steady fashion. The central banks patted themselves on the back and said: This is great! Things are running smoothly. We’ve got the “Great Moderation.”
Yet during all of that time, the value of all credit, unadjusted for inflation, grew at about 10 to15 percent per year. At the time, it seemed like we needed that pace of credit growth, but when you think about it, if your credit is going to grow at 10-15 percent per year in order to get your 5 percent GDP growth per year, eventually you’re going to have a problem. This isn’t a stable system. In my view, one of the reasons that it seemed that credit had to grow faster than total income was rising inequality.
LP: Why are people borrowing more when inequality is rising?
AT: The richer people, when they get another $100,000, or another million, or 10 million, don’t tend to spend it as much as the poorer people would if they got another $100 or $1,000 or $5,000. All the empirical evidence suggests that the rich tend to consume a lower proportion of income than middle and lower-income people. So rising inequality can lead to a major problem with the demand for goods and services. The rich aren’t spending their additional money, so overall, more money gets taken out of the economy. Unless the richer people decide to invest their money, there would be a slowdown in the economy. This idea goes back to economists like John Maynard Keynes and Alvin Hansen.
But before 2007, we didn’t have a slowdown. Instead, the savings of the rich ended up going through the financial system and being lent to middle and lower-income people, who had 30 years of no real income increase whatsoever. The figures for the U.S. are really quite startling. If you look at the bottom 20 or 25 percent of the population, their real wages haven’t gone up for about 35 years! Meanwhile, the incomes of the top 1 percent have gone up 200 percent. This is a dramatic increase. The savings at the top have to go somewhere. At the bottom, there is a group of people who don’t feel that they’re participating in the growing prosperity, so they become very vulnerable to the delusion that if they borrow the money and buy a house, they’ll make up for their lack of real wages by house prices always going up.
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LP: For a while, it seemed to work. People felt like their house was the ticket to prosperity.
AT: Yes, for the decade leading up to 2007, a whole lot of people who weren’t getting raises felt that they were doing ok because they managed to buy a house that was going up in price. But it all came to an end, a catastrophic end. Rising inequality can create a more highly leveraged economy, and it can then make the economy vulnerable to a crash like 2008. And in that crash, the really malign thing is that the crash itself tends to further increase inequality because it tends to be the people at the lower end of the wealth distribution who were highly leveraged and had to borrow lots of money to buy their house. In the downswing, they lose all the wealth they’ve got.
There’s a wonderful illustration of this by Atif Mian and Amir Sufi in their book, House of Debt. They show that the process of debt-fueled booms and busts is a very effective way of periodically redistributing wealth from the poor to the rich.
LP: What can we do about this? Are we making any progress in stabilizing the financial system and getting all this private debt and inequality under control?
AT: I do think that we need far more radical policies than we’ve had so far. I spent 4 ½ years of my life from September, 2008 to March, 2013 deeply involved in all of the details of the re-regulation of the global financial system. I was the chair of the main policy committee of the international Financial Stability Board and deeply involved with designing Basel III, which overhauled rules on banking. I was knee-deep in the nitty-gritty. I would defend what we’ve done and I think that the job we did has helped make the financial system itself more stable, and therefore less likely to cause a rapidly-developing crisis of the sort that developed in 2007-8.
That is the good news, but I think we’ve made almost no progress at all in dealing with the fundamental drivers of economies that are too reliant on debt. We have not dealt with the fundamental fragilities that arise from inequality, from the bias of the lending system towards real estate, and from global imbalances. I think we are still stuck in a post-crisis malaise — you see it less in the U.S. but you can clearly see it in Europe or Japan. Even in the U.S., the pace of job creation has picked up, but employment rates are still well below what they were in 2007. Real wages have not gone up. The capitalist system is not delivering those decade-after-decade increases it promised. We’re not where we should be in terms of our national economies. We don’t know how to get out of this malaise and I think we now have to consider more radical policies. That’s key to moving forward, particularly in Europe and Japan.
We need more radical policies so that we don’t just repeat the debt-fueled booms all over again and do another blow-up in 2025 or 2035.
LP: If you could wave a magic wand and put one of these radical policies into action, which would you choose?
AT: Today, because the Eurozone is in a very vulnerable position, I would like to see a small, coordinated fiscal expansion in all the countries of the Eurozone simultaneously. We would have to do it in that coordinated fashion across all member states because there isn’t a central federal budget within the Eurozone system. We could have a proportionally equal fiscal expansion in each of the member countries, financed as a one-off by the European Central Bank. Now if you print that, many people in Germany will just sort of explode over their morning coffee! But I have argued this in Germany and I have very good relationships with many German economists. Lots of them share my analysis of how we got it into this mess but they are very wary of agreeing to my proposal for how we get out.
LP: Do you think it could really happen, this expanding of public spending?
AT: There’s a very particular reason why this won’t happen in Europe. You asked me if I could wave a magic wand, right? Waving a magic wand means that you are free from all the classic, nasty, tricky bits of politics. In Europe, those are even more difficult than in any other country. Suppose you said, ok, I’m going to expand public expenditure in all these countries simultaneously. The German taxpayer, with perfect legitimacy, will say: Do you promise me that this public expenditure is honest and clean, and not some of the corrupt practices that we’ve seen in Greece? Can you really credibly promise me that this is one-off? That it will be moderate? That having agreed to it this year, you won’t come back next year and say, oh, let’s do a bit more of it? Convincing people is difficult enough even in one country with one central bank and one electorate that feels it’s part of one nation.
To achieve that degree of coordination and trust within the extraordinary, wonderful, and yet difficult thing that is the European Union — it is probably just impossible. What I say in the book is that the Eurozone will have to progress to a much greater degree of federalization with an element of a federal budget, federal taxation, and federal expenditure. If it can’t agree to that, it would be better to break up.
There need to be changes in who does what. There need to be changes to the constitution of Europe. I fault myself: I didn’t get it right in the late 90s. I was, in principle, in favor of European monetary union. But I think the experience has clearly shown that this is an incomplete political and economic union. The unsustainability of the political constitutional form has made the impact of the debt overhang even worse in the Eurozone than in countries such as the U.K. or the U.S. In the latter two, debt overhang has still created huge problems, but they haven’t been multiplied and made even worse by an inappropriate set of constitutional structures.
LP: To move forward, do we need to fundamentally change the way we think, particularly about the financial system?
AT: My work suggests two particular areas which economic theory has not paid enough attention to. One it used to pay attention to, and then it forgot. This strange amnesia concerns the role of the banking system in creating credit, money and purchasing power. It is absolutely fundamental to how a monetary economy works.
There were economists of the early 20 th century like Knut Wicksell, Friedrich Von Hayek, and John Maynard Keynes to whom that was obvious. Also Irving Fisher, Henry Simons, and Milton Friedman in his earlier writings. Then something very odd happens in the 1960s and 70s — economists stopped talking about the banking system and the credit system. We then develop a set of modern monetary economics—whether New Keynesian Economics or New Classical Economics — where we imagine that we can think about the dynamics of the macroeconomy without a rich understanding of the banking system and without understanding that the banking system creates credit, money and purchasing power.
We have got to go back to that. We’ve got to integrate that within our models and integrate that within our thinking. And reading some books written as much as a hundred years ago is a good starting point. In my book I quote, at some length, a book by Knut Wicksell called Interest and Prices, published in 1904. Remedying this amnesia is one of the priorities of the Institute for New Economic Thinking, so ironically we have to start by reminding ourselves of some old thinking.
The second crucial area of economic theory, which I think is more new because the phenomenon is new, is that we need to focus on the importance of what economists refer to as irreproducible existing assets, and particularly land. Everybody’s probably heard of Thomas Piketty and his Capital in the Twenty-First Century, a very important book. Piketty describes very significant increases in the ratio of wealth to national income, rising in many advanced economies from about 2 to 3 in 1950 to about 4 to 6 today, and he develops a theory of why that occurred. But what is striking, when you look at Piketty’s own figures, is that in countries like the U.K. and France and in several others, though not quite to the same extent, the majority of all wealth resides in the value of urban real estate. And the vast majority of the increase in the wealth-to-income ratio, which Piketty describes, comes from the increase in the value of urban real estate. The majority of that increase derives, in turn, not from new construction investment but from the increase in the value of land.
If you pick up an economic textbook, it will always describe capital like this: capital in year two is the same as capital in year one, plus net investment in that period. We have complicated mathematical theories of the determinants of returns on capital, returns on labor, in which we talk about two factors of production, capital and labor.
Well, it turns out that there is a lot in the economy that you can’t think straight about unless you add a third thing, which is land, where the value of that in year two has got nothing to do with new capital investment. It’s the land in the previous year, plus or minus what happened to the price. That makes land quite different in the economy.
LP: Are these two things related, the role of the banking system and the distinct role which land plays in the economy?
AT: Yes. You need these two things together to understand how modern economies really work. Instability mostly comes from the interface between the fact that the banks (or shadow banks) can create credit, money, and purchasing power in infinite quantities if we don’t constrain them, and the fact that credit is primarily created to fund the purchase of urban real estate and land, which is somewhat fixed in supply. In economics, when you put together a highly elastic thing and a highly inelastic thing, you create extraordinary potential for turbulence, volatility, and for unstable prices. Both of those issues are largely absent from the way we have taught economics over the last 50 years.
2016 October 29