Between Debt and the Devil

Money, Credit, and Fixing Global Finance

Adair Turner

• Publisher: Princeton University Press
• Year: 2017
• ISBN:
  9781400885657
• Topic: Economics
• Subtopic: Monetary Policy
• Index: Economics

Why our addiction to debt caused the global financial crisis and is the root of our financial woes Adair Turner became chairman of Britain's Financial Services Authority just as the global financial crisis struck in 2008, and he played a leading role in redesigning global financial regulation. In this eye-opening book, he sets the record straight about what really caused the crisis. It didn't happen because banks are too big to fail—our addiction to private debt is to blame. 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 explains why public policy needs to manage the growth and allocation of credit creation, and why debt needs to be taxed as a form of economic pollution. Banks need far more capital, real estate lending must be restricted, and we need to tackle inequality and mitigate the relentless rise of real estate prices. 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. Between Debt and the Devil shows why we need to reject the assumptions that private credit is essential to growth and fiat money is inevitably dangerous. Each has its advantages, and each creates risks that public policy must consciously balance.

PART I

Swollen Finance

FOR 40 YEARS BEFORE THE 2007–2008 CRISIS, finance grew far faster than the real economy, private credit grew faster than GDP, trading volume soared, and the financial system became far more complex. And as Chapter 1 describes, most experts were confident that increasing size and complexity had improved capital allocation, stimulated economic growth, and posed no threat to economic stability as long as inflation was low and stable.

But as the 2007–2008 crisis showed, that confidence was profoundly mistaken and was based on shaky intellectual foundations. For as Chapter 2 sets out, all financial markets can be imperfect, inefficient, and unstable, and finance has a distinctive ability to grow beyond its socially useful size, making private profit from activities that add no true social value.

Public policy should not therefore be driven by the assumption that ever more financial innovation, market completion, and liquidity is by definition good: less finance can be better, and policies such as financial transaction taxes might make economies more efficient.

But policy should also reflect the reality that state-driven capital allocation can be even more deficient, and that even imperfect financial markets can play valuable roles. Policy reform must therefore focus on the specific areas where swollen finance has the greatest potential to cause harm. That is above all where it creates excessive debt.

ONE

THE UTOPIA OF FINANCE FOR ALL

In the last thirty years, dramatic changes in financial systems around the world amounting, de facto, to a revolution have brought many … advances. We have come closer to the utopia of finance for all.

— Raghuram Rajan and Luigi Zingales, Saving Capitalism from the Capitalists¹

FINANCE LOOMS FAR LARGER in both advanced and emerging economies than it did 30 or 40 years ago. Few readers will need convincing of that fact. Newspapers and television programs report regularly on the huge size of global capital markets and trading activity. Financial centers such as New York, London, or Hong Kong have ballooned in importance. Huge bonuses paid to bank trading staff and management are highly contentious in many countries, but the money earned by hedge fund managers dwarfs that of mere bankers. Finance has become the destination of choice for top graduates from elite universities and business schools throughout the world. Some commentators talk about the “financialization” of our economies. It is an ugly word, but it seems to capture the reality: more finance, better paid, playing a more pervasive role in economic life.

Impressions often deceive. But in this case, sober analysis confirms what anecdote suggests. Significantly in most advanced economies but dramatically in the United States and the United Kingdom, finance has accounted for a growing share of national income. And across the world, in many different financial markets, trading activity has massively increased, its growth far outpacing that of real economic activity.

Finance has grown more rapidly than the real economy since modern capitalism first developed in the nineteenth century. Analysis by Andrew Haldane shows finance in the United Kingdom growing on average by 4.4% per year from 1856 to 2008, while the economy grew at 2.1%.²

But Haldane’s analysis also reveals big variations in growth over time. From 1856 to 1914, the value-added of UK financial services grew 3.5 times more rapidly than national income. The economy became more complex as industry grew at the expense of agriculture; companies issued bonds and stocks on public markets; individuals began to accumulate savings; and London became a financial center servicing global capital flows. As a result the financial industry became far more important.

From 1914 to 1970 finance grew less rapidly than total GDP, even though the economy, despite two world wars, grew faster than in the previous period: by 1970 finance accounted for a smaller share of a far bigger economy than in 1914. But from 1970 on, and in particular after 1980, the picture changed again. From 1970 to 2008 UK finance grew twice as fast as UK national income, with the outperformance becoming greater as each decade progressed.

The U.S. experience, illustrated in Figure 1.1, was similar. Between 1850 and the crash of 1929, finance’s share of national income grew from 2% to 6%, with a particularly strong increase throughout the 1920s. That share collapsed in the 1930s and even in 1970 stood at a significantly lower 4%. From 1970 to 2008 it more than doubled. In 2007 finance played a bigger role in advanced economies, as measured by share of GDP, than ever before.³

The growth of finance from the 1970s on, and the acceleration of that growth over the subsequent decades, would be an important issue for economic research even if we had not suffered the financial crisis of 2007–2008. Finance, after all, is not a consumer product or service, valued in itself, like a car or a restaurant meal or clothing. No one gets up in the morning and says “I feel like enjoying some financial services today.” Finance is a necessary function to enable the production of the goods and services we actually enjoy. And it makes up a large enough proportion of the economy that the cost efficiency with which the financial industry performs these functions has a significant impact on people’s living standard. Even if there had been no crisis, it would be worth asking whether we are getting value for money.

Figure 1.1. Share of the financial industry in U.S. GDP

Source: Philippon (2008) (as referenced by Haldane, Brennan, and Madouros 2010). Used with permission.

But it is the financial crisis of 2007–2008 that makes it not merely interesting but vital to ask searching questions about the economic impact of this huge increase in financial intensity. For the crisis and its aftermath have been an economic catastrophe, a setback to the success of the market economy system only previously matched by the two world wars and the Great Depression of the 1930s.

We cannot therefore avoid the questions: Which aspects of this growing financial intensity were beneficial and which harmful? Which led to the crisis, and how radically must we now reform to prevent a repeat?

Increasing Real Economy Borrowing … and Saving

The first step is to identify which specific financial activities contributed most to finance’s remarkable growth. Research by Robin Greenwood and David Scharfstein shows that two factors dominated.⁴

First, finance made much more money out of providing credit to the economy, and in particular credit to households. Second, asset management activities and profits grew dramatically; that growth reflected increased fees flowing to a wide range of financial institutions such as securities firms, mutual funds, hedge funds, and venture capitalists. But it also entailed the extensive trading, market-making, and funding activities that form inputs to the asset management process.

Figure 1.2. Private domestic credit as a percentage of GDP: Advanced economies, 1950–2011

Source: IMF Working Paper 13/266 Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten. Authors: C. Reinhart and K. Rogoff, December 2013.

Other aspects of finance also grew, but less dramatically. Insurance for instance grew slowly as a percentage of GDP but without the sharp acceleration in growth that marked debt and asset management–related activities.

Greenwood and Scharfstein’s findings reflect a startling and important fact—that the role of debt in the U.S. economy, and in most other advanced economies, grew dramatically. Finance made lots more money from providing credit, because households and companies borrowed much more. In 1945 total private sector debt—household and business combined—was about 50% of U.S. GDP; by 2007 it had reached 160%. In the United Kingdom in 1964, total household debt stood at 15% of GDP; by 2007 it was 95%. In Spain total private debt was 80% in 1980 and 230% by 2007.⁵ Figure 1.2 shows the picture for all advanced economies combined. The private sector became dramatically more leveraged: households—and in some countries, businesses—owed much more debt relative to their income.

Increasing borrowing also helps explain rising asset management revenues. For every debt in an economy, every financial liability, there has to be some matching asset. Sometimes that match may be easy to see: a corporate bond owed by a business can be an asset owned by a pension fund. Sometimes the match is indirect and more difficult to discern: a mortgage debt indirectly funded, through multiple intermediate steps, by investors in money market mutual funds.

But overall the growth of debt liabilities as a percentage of GDP had to be matched by increases in fixed income assets, by money or bonds of some sort. In the United Kingdom household bank deposits grew from 40% to 75% of GDP between 1964 and 2007;⁶ in the United States money market funds grew from zero in 1980 to $3.1 trillion in 2007.⁷ Institutional holdings of bank debt and of non-bank credit securities also dramatically increased, indirectly or directly funding increased borrowing.

Fixed-income financial assets thus inevitably grew as a percentage of GDP, rising in the United States from 137% in 1970 to 265% in 2012.⁸ So too did financial assets in an equity form. Total U.S. equity market value rose from 58% of GDP in 1989 to 142% in 2007.⁹ There were many more assets to manage, so the business of managing assets grew.

Part of the reason finance grew is therefore simply that the real economy—households and businesses—owed more financial liabilities and owned more financial assets. To assess the impact of increasing financial intensity, we must therefore assess whether this increased use of financial services by the real economy was beneficial.

In most other sectors of the economy we wouldn’t even ask such a question. If people choose to spend more of their increasing income on a particular service—more restaurant meals or travel—we usually trust that they have used their income in the way best suited to increase their welfare. But financial services are different, because their provision and consumption can have important effects on overall economic growth and stability.

Seen from the asset side, increased financial consumption might appear clearly beneficial: people holding more financial assets sounds like a good thing. But the dramatic increase in private sector leverage had important and harmful effects. Indeed, a central argument of this book is that the high level of private debt built up before the crisis is the most fundamental reason the 2007–2008 crisis wrought such economic harm.

Increasing Complexity in the Financial System

But the dramatic acceleration of finance’s growth that occurred after the 1970s was not just the result of greater use of financial services by real economy households and businesses. Equally striking is that for each unit of financial services consumption by the real economy, the financial system itself did far more, and more complex, activities.

One way to capture that increased complexity is shown in Figure 1.3, which sets out the scale of debt liabilities in the U.S. financial system. It illustrates the gradual growth of corporate leverage and the more significant growth of household leverage. But the most striking feature of Figure 1.3 is the growth of intrafinancial system assets—of debt and other contracts between different financial institutions. Financial institutions did much more business with one another than they had done before 1970.

Look at the typical bank balance sheet in the 1960s, and apart from government bond holdings and cash, it was dominated by loans to and deposits from households and businesses. In the United Kingdom in 1964 loans to the real economy plus government bonds and reserves at the Bank of England accounted for more than 90% of aggregate bank balance sheets.¹⁰ By 2008 much more than half the balance sheets of many of the biggest banks in the world—such as JP Morgan, Citibank, Deutsche Bank, Barclays, RBS, or Société Générale—were accounted for by contractual links, whether in loan / deposit or in financial derivative form, between these and other banks, and between them and other financial institutions, such as money market funds, institutional investors, or hedge funds.

Figure 1.3. U.S. debt as a percentage of GDP by borrower type

Source: Oliver Wyman.

That reflected in part a dramatic increase in trading activity. Financial institutions buy and sell financial instruments back and forth between each other to a far greater extent than they did 40 years ago, and financial trading has grown dramatically relative to underlying real economic flows. The value of oil futures trading has gone from less than 10% of physical oil production and consumption in 1984 to more than 10 times that of production and consumption now.¹¹ Global foreign exchange trading is now around 73 times global trade in goods and services.¹² Trading in derivatives played a minimal role in the financial system of 1980, but it now dwarfs the size of the real economy; from zero in 1980, the total notional value of outstanding interest rate...