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Debt, Money and Mephistopheles: How do we get out of this mess? Adair Turner

Cass Business School 6 February 2013


Money finance as normal procedure: Friedman and Simons ‘Under the proposal, government expenditures would be financed entirely by tax revenues or the creation of money, that is, the issue of non-interest bearing securities… The chief function of the monetary authority [would be] the creation of money to meet government deficits and the retirement of money when the government has a surplus” Milton Friedman, A Monetary and Fiscal Framework for Economic Stability, America Economic Review, Vol 38, June 1948

“The powers of the government to inject purchasing power through expenditure and to withdraw it through taxation, i.e. the powers of expanding and contracting issues of actual money and other obligations more or less serviceable is money – are surely adequate to price level control. … in other words, the monetary rules should be implemented entirely by, and in turn should largely determine, fiscal policy.” Henry Simons, Rules and Authorities in Monetary Policy, The Journal of Political Economy, Vol 44, No. 1, February 1936

2


Helicopters and old bottles: Friedman and Keynes “Let us suppose that one day a helicopter flies over this community and drops an additional $1000 in bills from the sky, which is, of course, hastily collected by members of the community”

Milton Friedman, The Optimum Quantity of Money, Chapter 1, (1969)

“If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines… and leave it to private enterprise on tried principles of laissez faire to dig the notes up again… there need be no more unemployment… and the real income of the country… would then become a good deal greater than it actually is.” John Maynard Keynes, The General Theory, Chapter 10, Section 6 (1936) 3


Levers and effects Fiscal policy: deficits or surpluses Monetary policy: - Interest rates - QE - Forward guidance Central Bank private credit support: - US “credit easing” - UK “FLS” Macro-Prudential Macro-Prudential policy: -policy: Bank capital and - Bank capital and liquidity liquidity standards

Prices

Aggregate Nominal Demand = Nominal GDP

Real output 4


Levers and effects O.P.M.F.

Fiscal policy: deficits or surpluses

Monetary policy: - Interest rates - QE - Forward guidance Central Bank private credit support: - US “credit easing” - UK “FLS” Macro-Prudential Macro-Prudential policy: -policy: Bank capital and - Bank capital and liquidity liquidity standards

Prices Aggregate Nominal Demand

Real output 5


Levers and effects

Aggregate Nominal Demand

Prices

Real output

Macro-Prudential policy: - Bank capital and liquidity standards

Division determined by • Spare capacity in labour or physical capital • Flexibility of price setting processes in labour or product markets 6


The “independence� assumption O.P.M.F.

Fiscal policy

Monetary policy

Prices

Aggregate Nominal Demand

Central Bank private credit support Macro-Prudential Macropolicy: Prudential - Bank capital and liquidity standards

Division of the effect between prices and real output is independent of the tools used to stimulate nominal demand

Real output 7


Possible contraventions of “independence� O.P.M.F.

Fiscal policy

Expect at ion c Sup p

Monetary policy

Central Bank private credit support MacroMacro-Prudential policy: Prudential - Bank capital and liquidity standards

ly e

nha

nc e

hannel?

Unconventional monetary policy or O.P.M.F. create expectations of future price effects?

me nt?

Aggregate Nominal Demand Supply enhancement?

Fiscal expenditure or credit support targeted to achieve supply increase as well as demand?

Prices

Real output

8


Friedman’s 1948 proposal: a simple illustration Suppose:  Nominal GDP = 100 and money supply = 50  Sensible aim is to grow nominal GDP at 4% per annum, allowing for 2% real growth and 2% inflation Then:  Equilibrium money supply growth might be around 4%  Appropriate increase in money supply is achieved by running fiscal deficit of 2% of GDP, financed entirely by money  Money supply grows by 2 (=4% for 50) 9


From fractional reserve to 100% reserve banking Fractional Reserve Banking Central Bank A

L Notes & Coins Reserves

Commercial Banks A

L

Reserves

Deposits

Loans

100% Reserve Banking Money supply

Central Bank A L Notes & Coins

Notes & coins & bank deposits

Deposit money = Multiple of reserves at central bank Total money supply = Multiple of base money

Reserves

Commercial Banks

Money supply

Notes & coins Reserves Deposits & bank Reserve deposits s

Deposit money = Reserves at central bank Total money supply = Base money 10


Laissez faire economics and the banking exception “in the very nature of the system, banks will flood the economy with money substitutes during booms and precipitate futile effects at general liquidation afterward” “private initiative has been allowed too much freedom in determining the character of our financial structure and in directing changes in the quantity of money and money substitutes.” Henry Simons, Rules versus Authority in Monetary Policy, Journal of Political Economy, Vol 44, February 1936. 11


Leverage in the real and financial sectors UK debt as a % GDP by borrower type (1987-2007), Debt Liabilities on B/S Corporate Household Financial

300%

USA debt as a % GDP by borrower type (1929-2007)

250% 200%

1987

Corporate Household

150%

2007

2002

1996

1990

1983

1977

1971

1965

1959

1953

1947

1941

1935

Financial 1929

Source: Oliver Wyman

100% 50% 10%

12


Private non-financial corporate deposits and loans: UK 1964 – 2009 40% 35%

Securitisations and loan transfers

Deposits

Loans

% of GDP

30% 25% 20% 15% 10% 5% 0% 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Source: Bank of England Tables A4.3, A4.1

13


Household deposits and loans: UK 1964 – 2009 100% 90%

Securitisations and loan transfers

Deposits

Loans

80%

% of GDP

70% 60% 50% 40% 30% 20% 10% 0% 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Source: Bank of England, Tables A4.3, A4.1

14


Private credit to GDP ratio and growth

Source: S. Cecchetti, BIS Working Paper No. 381 "Reassessing the impact of finance and growth"

15


Lending to UK business Percentage changes on a year earlier

50 40

All currency loans

30 20 10 0 -10 2012

2006

2000

1994

1988

1982

1976

1970

Source: Bank of England “Trends in Lending�

1964

-20 16


Lending to individuals Percentage changes on a year earlier

20

Unsecured Secured Individuals

15 10 5 0

2012

2010

2008

2006

2004

2002

2000

1998

1996

Source: Bank of England “Trends in Lending�

1994

-5 17


Japan-policy rate vs credit growth per annum 16 12 8

%

4 0 -4

Source: Datastream

Private credit growth (%pa)

Dec-11

Dec-09

Dec-07

Dec-05

Dec-03

Dec-01

Dec-99

Dec-97

Dec-95

Dec-93

Dec-91

Dec-89

Dec-87

Dec-85

-8

BoJ Policy rate 18


Sectoral financial surpluses/deficits as % of GDP: Japan 1990 – 2012 10 5 0 -5 -10

Source: IMF, Bank of Japan Flow of Funds Accounts

PNFCs

20 10

20 08

20 06

20 04

20 02

20 00

19 98

19 96

19 94

19 92

19 90

-15

Government 19


% GDP

Japanese government and corporate debt: 1990-2010

Source: BoJ Flow of Funds Accounts, IMF WEO database (April 2011), FSA calculations

20


Shifting leverage: private and public debt-to-GDP 140

120

UK UK

120 100

80 % GDP

% GDP

US

100

80 60

60 40

40

20

20 0 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Household

Public

Source: ONS Note: PNFC = private, non-financial corporates; Public = central and local government

Household

PNFCs

160 140

Public

PNFCs

Source: BEA Note: PNFC = private, non-financial businesses; Public = federal, state and local government

Spain

120 % GDP

0 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011

100 80 60 40 20 0 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Household

Public

PNFCs

Source: ECB Note: PNFC = private, non-financial corporates; Public = central and local government

21


Alternative possible targets Price and real output / employment focused

Exclusively price focused  Alternative inflation rate measures (e.g. excluding “one-ff” tax or commodity price effects

Blanchard et all

 Higher inflation rate (permanently or for a period of time)

 Circumstance contingent future guidance (loose policy till unemployment below x%)

Federal Reserve, Autumn 2012

 Money GDP growth rate (as permanent rule or temporarily)

 Guidance implying loose policy even after inflation rate back on target

 Money GDP level trend

 Price level trend Carney, December 2012

Woodford, August 2012 22


UK inflation: Bank of England forecasts and actual 6 5 4 3 2

Aug 09 Projection

Aug-10

Aug-11

Actual CPI

2013Q2

2013Q1

2012Q4

2012Q3

2012Q2

2012Q1

2011Q4

2011Q3

2011Q2

2011Q1

2010Q4

2010Q3

2010Q2

2010Q1

0

2009Q4

1 2009Q3

%

Inflation target

23


Public debt to GDP: US and UK National debt as % of GDP

300 250

% GDP

200 150 100 50 0 1930

Source: DMO, ONS

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

24


GDP Growth rates 1950 – 1970 Real annual average GDP growth %

Nominal annual average GDP growth %

US

US

UK

UK

Germany

Germany

France

France

Japan

Japan 0

2

4

6

8

10

12

14

16

0

2

4

6

8 % p.a.

10

12

14

16

Source: BEA (US), ONS (UK), FSO (DE), Cabinet Office (JP), Madison, FSA calculations

25


UK public debt deleveraging: 1945 – 1970 60

300

UK GDP

Public debt : GDP

250 200

Nominal value of UK public debt and GDP

40 £ bn

% GDP

UK public debt

50

150 100

30 20

50

10

Source: DMO, ONS 0

Source: DMO, ONS

0

1945

1950

1955

1960

10.0

1965

1970

1945

1950

1955

1960

1965

1970

UK inflation and nominal interest rates

9.0

Consumer price inflation

8.0

3 month treasury bill rate

7.0

%

6.0 5.0 4.0 3.0

Source: DMO Note: CPI is derived from RPI after 1947 and the national accounts consumption deflator before

2.0 1.0 0.0 1945

1950

1955

1960

1965

1970

26


Source: Central Banks -0 8

pr -0 8 Ju l-0 8 O ct -0 Ja 8 n0 A 9 pr -0 9 Ju l- 0 9 O ct -0 Ja 9 n1 A 0 pr -1 0 Ju l- 1 0 O ct -1 Ja 0 n1 A 1 pr -1 1 Ju l-1 1 O ct -1 Ja 1 n1 A 2 pr -1 2 Ju l- 1 2 O ct -1 Ja 2 n13

A

Ja n

Central Bank policy rates 6

European Central Bank

5

Bank of England

Bank of Japan

4

US Federal Reserve

3

2

1

0

27


Central Bank balance sheets as %GDP Japan Japan

EU

EU

UK

UK

US

US

28


Source: Bloomberg Jan-13

Jan-12

Jan-11

Jan-10

Jan-09

Jan-08

Jan-07

Jan-06

Jan-05

Jan-04

Jan-03

Jan-02

Jan-01

Jan-00

Jan-99

Jan-98

Jan-97

Jan-96

Jan-95

Jan-94

Jan-93

Jan-92

%

Jan-91

Jan-90

Japan – 10 year nominal yield 9

8

7

6

5

4

3

2

1

0

29


UK trends in lending: % 12-month growth rates 20

(% 12-month growth rates)

15 10

%

5 0 -5 -10 2012Q4

2012Q3

2012Q2

2012Q1

Source: Trends in Lending, data as of 04/01/2013

2011

2010

2009

2008

2007

Lending to UK businesses Consumer credit

Secured lending to individuals 30


Gross lending to and repayments by UK nonfinancial businesses (ÂŁbn) SME gross lending

LB gross lending

SME repayments

LB repayments

60 50 40 30 20 10

Source: Bank of England, Trends in Lending, January 2013

2012 Q4

2012 Q2

2012 Q1

2011 Q4

2011 Q3

2011 Q2

0

31


Post-facto money finance: US 1940 to 1951 High powered base money

60

40 30

Source: Friedman and Schwarz, Monetary History of the United States

1955

1954

1953

1952

1951

1950

1949

1948

1947

1946

1945

1944

0

1943

10

 No subsequent reversal / ‘exit’ 1942

20

 Post-facto permanent money finance

1941

Federal Reserve commitment to keep interest rates at 2.5% buying bonds to achieve target

50

1940

Large wartime budget deficits ‘funded’ by government debt issues

32


Japanese Government debt as % of GDP Gross debt minus Government + social security holdings 30.6% of GDP Minus Bank of Japan

%

46% of GDP

Minus Japan Post 33.7% of GDP

Minus domestic commercial banks

Source: Bank of Japan, data as at end 2012, Japan Post Holdings accounts end March 2012

33


34

Varying actual and appropriate policies: McCulley and Pozsar’s framework Private Sector "M M"

Deleveraging Surpluses

Deficits

Leveraging Deficits

"Fat Inflation Tails" Crowding Out

Deflation Risks No Crowding Out

Inflation Risks "Crowding In"

"Fat Deflation Tails" Economic Depression

Surpluses

"B B" Austerity

Fiscal Policy

Stimulus

y

Unorthodox

Conventional Rates

"Z B"

x

QE

Monetary Policy

Source: McCulley and Pozsar

34


35

Private and public leverage cycles

Source: McCulley and Pozsar

35


36

Varying actual and appropriate policies: McCulley and Pozsar’s framework Private Sector "M M"

Deleveraging Surpluses

Unconv. Radical Nuclear

Rates "Z B" Monetary Independence

Source: McCulley and Pozsar

t n m M k c l o V s r v e R

h c r u t e s A n i a l P

Surpluses

Conventional

-

r t p o c i l e H

y e n o M

Deficits

Leveraging Deficits

"B B" Austerity

Fiscal Policy

Stimulus

y

x

QE ~

FMC

36


Two Policy options Option 1

Option 2

Several £100bns of QE with commitment to future reversal

Several £10bns of OMF of increased fiscal deficit (tax cuts or public spend increasing) … with commitment that this will be permanent

+ Funding for Lending

+ Relaxation of bank capital and liquidity standards Which will:

 Be most effective in stimulating nominal demand?  Have least adverse side-effects? 37


Fiscal adjustment required for long-term debt sustainability Actual today

Spain 69

Cyclical adjusted primary balance 2011 -5.1 -3.7

UK 82 US 103

-5.3 2.0

Net Debt

Italy 120 Japan 126

Cyclical adjusted primary surplus 2020-2030

-7.7

Required adjustment

5.5

+ 10.6

5.7

+ 9.4

7.5

+ 12.8

7.6

+ 5.6 12.6

To get to 60% debt to GDP by 2030

Gross Debt

Debt as % of GDP 2011

Required for debt sustainability

+ 20.3 To get to 80% debt to GDP

38


Money finance via Japanese banking system?

Commercial Banks Government

Government Current and bonds at close deposit to zero interest accounts at zero interest

Money claims of Japanese households & corporates

 Close to money financing of deficits  Closer still if government owns banks  Which it does in case of Japan Post

39


Nominal GDP in four major economic areas: 2007 – 2011 115

Q1(Q1 2007 == 100 GDP 2007 100)

110 105 100 95

UK

US

Source: ONS, BEA, Eurostat, Cabinet Office (Japan)

EA

Q2 2011

Q1 2011

Q4 2010

Q3 2010

Q2 2010

Q1 2010

Q4 2009

Q3 2009

Q2 2009

Q1 2009

Q4 2008

Q3 2008

Q2 2008

Q1 2008

Q4 2007

Q3 2007

Q2 2007

85

Q1 2007

90

JPN

40


Developed economies’ GDP growth Q1 2007 = 100

Source: McCulley and Pozsar

41


Break-down of NGDP growth from trough (2009) to peak Δ Prices (GDP deflator)

Δ Nominal GDP UK: +10.4% US: +12.0% Eurozone: +7.1%

UK: +8.1% US: +5.2% Eurozone: +3.8%

Δ Real output UK: +2.2% US: +6.5% Eurozone: +3.1% 42


Breakdown of NGDP growth from trough: 2009 to 2012 UK

US

Eurozone

0%

20%

40%

60%

80%

Share of NGDP change due to prices Share of GDP change due to real output

100%

43


Faust (Part II) and OPMF: how bad was it? “Mephistopheles leaps to a single conclusion, that there has been too much deflation and austerity and what was lacking was money. There is, he says, plenty of gold and silver beneath the earth, and the Emperor simply needs to issue pieces of paper in the form of claims against the underground metallic treasure. The Emperor is suspicious of this clever advice. But everything in the empire improves as a consequence of the introduction of paper money. The generals are pleased because the soldiers are paid once more, the treasurer finds that he can pay off all the debts, tailors are busily making new clothes, ladies become more willing to embark on well paid romantic adventures, the property market booms.� Harold James, Germany should re-read Goethe’s Faust Part II, Financial News, October 2012 44


Slides from Turner 2013