“Between Debt and the Devil: Money, Credit and Fixing Global Finance” by Adair Turner (2015)

This book is worth reading, if only because it challenges a number of preconceptions that bankers may have about the value of what they do. The book also benefits from the fact that author was the head of the UK Financial Services Authority during the GFC and thus had a unique inside perspective from which to observe what was wrong with the system. Since leaving the FSA, Turner has reflected deeply on the relationship between money, credit and the real economy and argues that, notwithstanding the scale of change flowing from Basel III, more fundamental change is required to avoid a repeat of the cycle of financial crises.

Overview of the book’s main arguments and conclusions

Turner’s core argument is that increasing financial intensity, represented by credit growing faster than nominal GDP, is a recipe for recurring bouts of financial instability.

Turner builds his argument by first considering the conventional wisdom guiding much of bank prudential regulation prior to GFC, which he summarises as follows:

• Increasing financial activity, innovation and “financial deepening” were beneficial forces to be encouraged
• More compete and liquid markets were believed to ensure more efficient allocation of capital thereby fostering higher productivity
• Financial innovations made it easier to provide credit to households and companies thereby enabling more rapid economic growth
• More sophisticated risk measurement and control meanwhile ensured that the increased complexity of the financial system was not achieved at the expense of stability
• New systems of originating and distributing credit, rather than holding it on bank balance sheets, were believed to disperse risks into the hands of those best placed to price and manage it

Some elements of Turner’s account of why this conventional wisdom was wrong do not add much to previous analysis of the GFC. He notes, for example, the conflation of the concepts of risk and uncertainty that weakened the risk measurement models the system relied on and concludes that risk based capital requirements should be foregone in favour of a very high leverage ratio requirement. However, in contrast to other commentators who attribute much of the blame to the moral failings of bankers, Turner argues that this is a distraction. While problems with the way that bankers are paid need to be addressed, Turner argues that the fundamental problem is that:

• modern financial systems left to themselves inevitably create debt in excessive quantities,
• in particular, the system tends to create debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate.

Turner argues that the expansion of debt funding the purchase or trading of existing assets drives financial booms and busts, while the debt overhang left over by the boom explains why financial recovery from a financial crisis is typically anaemic and protracted. Much of this analysis seems to be similar to ideas developed by Hyman Minsky while the slow pace of recovery in the aftermath of the GFC reflects a theme that Reinhart and Rogoff have observed in their book titled “This time is different” which analyses financial crises over many centuries.

The answer, Turner argues, is to build a less credit intensive growth model. In pursuing this goal, Turner argues that we also need to understand and respond to the implications of three underlying drivers of increasing credit intensity;

1. the increasing importance of real estate in modern economies,
2. increasing inequality, and
3. global current account imbalances.

Turner covers a lot of ground, and I do not necessarily agree with everything in his book, but I do believe his analysis of what is wrong with the system is worth reading.

Let me start with an argument I do not find compelling; i.e. that risk based capital requirements are unreliable because they are based on a fundamental misunderstanding of the difference between risk (which can be measured) and uncertainty (which cannot):

• Distinguishing between risk and uncertainty is clearly a fundamental part of understanding risk and Turner is not alone in emphasising its importance
• I believe that means that we should treat risk based capital requirements with a healthy degree of scepticism but that does not render them entirely unreliable especially when we are using them to understand relative differences in risk and to calibrate capital buffers
• The obvious problem with non-risk based capital requirements is that they create incentives for banks to take higher risk that may eventually offset the supposed increase in soundness attached to the higher capital
• It may be that Turner discounts this concern because he envisages a lower credit growth/intensity economy delivering less overall systemic risk or because he envisages a more active role for the public sector in what kinds of assets banks lend against; i.e. his support for higher capital may stem mostly from the fact that this reduces the capacity of private banks to generate credit growth

While advocating much higher capital, Turner does seem to part company with M&M purists by expressing doubt that equity investors will be willing to accept deleveraged returns. His reasoning is that returns to equity investments need a certain threshold return to be “equity like” while massively deleveraged ROE still contains downside risks that are unacceptable to debt investors.

Turning to the arguments which I think raise very valid concerns and deserve more serious attention.

Notwithstanding my skepticism regarding a leverage ratio as the solution, the arguments he makes about the dangers of excessive credit growth resonate very strongly with what I learned during my banking career. Turner is particularly focussed on the downsides applying excessive debt to the financing of existing assets, real estate in particular. The argument seems to be similar to (if not based on) the work of Hyman Minsky.

Turner’s description of the amount of money that banks can create as being “infinitely elastic” seems an overstatement to me (especially in the Australian context with the Net Stable Funding Ratio (NSFR) weighing on the capacity to grow the balance sheet) but the general point he is making about the way that credit fuelled demand for a relatively inelastic supply of desirable residential property tends to result in inflated property values with no real social value rings true.

What banks can do about this remains an open question given that resolving the problem with inelastic supply of property is outside their direct control but it is obviously important to understand the dynamics of the market underpinning their largest asset class and it may help them engage more constructively with public policy debates that seek to address the problem.

Turner’s analysis of the downsides of easy monetary policy (the standard response to economic instability) also rings true. He identifies the fact that lower interest rates tend to result in inflated asset values (residential property in particular given its perceived value as a safe asset) which do not address the fundamental problem of over-indebtedness and may serve to increase economic inequality. His discussion of the impact of monetary policy and easy credit on economic inequality is also interesting. The banks providing the credit in the easy money environment may not necessarily be taking undue risk and prudential supervisors have tools to ensure sound lending standards are maintained if they do believe there is a problem with asset quality. What may happen however is that the wealthier segments of society benefit the most under easy money because they have the surplus cash flow to buy property at inflated values while first homebuyers become squeezed out of the market. Again their capacity to address the problem may be limited but Turner’s analysis prompted me to reflect on what increasing economic inequality might mean for bank business models.

In addition to much higher bank capital requirements, Turner’s specific recommendations for moving towards a less credit intensive economy include:

• Government policies related to urban development and the taxation of real estate
• Changing tax regimes to reduce the current bias in favour of debt over equity financing (note that Australia is one of the few countries with a dividend imputation system that does reduce the bias to debt over equity)
• Broader macro prudential powers for central banks, including the power to impose much larger countercyclical capital requirements
• Tough constraints on the ability of the shadow banking system to create credit and money equivalents
• Using public policy to produce different allocations of capital than would result from purely market based decisions; in particular, deliberately leaning against the market signal based bias towards real estate and instead favouring other “potentially more socially valuable forms of credit allocation”
• Recognising that the traditional easy monetary policy response to an economic downturn (or ultra-easy in the case of a financial crisis such as the GFC) is better than doing nothing but comes at a cost of reigniting the growth in private credit that generated the initial problem, creating incentives for risky financial engineering and exacerbating economic inequality via inflating asset prices.

For those who want to dig deeper, I have gone into a bit more detail below on what Turner has to say about the following topics:

• The way in which inefficient and irrational markets leave the system prone to booms and busts
• The dangers of debt contracts sets out how certain features of these contracts increase the risk of instability and hamper the recovery
• Too much of the wrong sort of debt describes features of the real estate market that make it different from other asset classes
• Liberalisation, innovation and the credit cycle on steroids recaps on the philosophy that drove the deregulation of financial markets and what Turner believes to be the fundamental flaws with that approach. In particular his conclusion that the amount of credit created and its allocation is “… too important to be left to bankers…”
• Private credit and money creation offers an outline of how bank deposits evolved to play an increasing role (the key point being that it was a process of evolution rather than overt public policy design choices)
• Credit financed speculation discusses the ways in which credit in modern economies tends to be used to finance the purchase of existing assets, in particular real estate, and the issues that flow from this.
• Inequality, credit and more inequality sets out some ways in which the extension of credit can contribute to increasing economic inequality
• Capital requirements sets out why Turner believes capital requirements should be significantly increased and why capital requirements (i.e. risk weights) for some asset classes (e.g. real estate) should be be calibrated to reflect the social risk of the activity and not just private risks captured by bank risk models
• Turner defence against the argument that his proposals are anti-markets and anti-growth.

Inefficient and irrational markets

Turner acknowledges that market economies have proved superior to planned ones but argues that, left to free market forces, financial markets can generate activity that is privately profitable but not socially useful. There can be too much finance, too much trading and too much market completion. Turner notes that the faith in market based solutions was based on two theories 1) the efficient Market Hypothesis (WMH) and 2) the Rational Expectations Hypothesis (REH) but real world evidence contradict both hypotheses

• Human beings are not fully rational and, even if they were, market imperfections can produce unstable markets that diverge far from rational equilibrium levels
• Market imperfections are inherent and unfixable so greater reliance on them can make economies less efficient and less stable

Turner lists five factors explaining why bubbles and subsequent crashes are bound to occur

1. Human decision making is not entirely rational
2. The impact of this irrationality is not, as EMH suggests, independent and random but highly correlated, with unsophisticated investors tending to move as a herd and even professional investors subject to the same biases
3. The theory that rational arbitrageurs will bring prices rapidly back to efficient equilibrium levels may be valid for individual stocks and bonds, but is invalid in relation to the level of prices across the market because it is impossible to hedge the whole market
4. As a consequence of the first three factors, it can be entirely rational for sophisticated, thoughtful investors to act in ways that for a time drive prices even further from rational equilibrium levels
5. Both EMH and REH fail to recognise that the future is characterised by inherent irreducible uncertainty and not mathematically modelable risk

Dangers of debt contracts

Turner argues that the booms and busts that result in the greatest economic harm (rather than merely losses for speculators) are driven by procyclical credit supply (i.e. rapidly growing, easily available credit in the boom followed by a contraction of credit in the downswing). The potential for irrational exuberance exists in all assets markets but the potential for severe economic harm is greatest when it is financed by debt. Turner cites Kindelberger’s study of financial crises to support this conclusion. You can also see the point he is making reflected in the different impact of the “dot com” crash versus the GFC.

Turner notes that the dangers of debt should not be overstated. Modern economic theory sees debt contracts as vital to spur economic growth (This point also made by the RBA -RBA Speech : Financial Stability and the Banking Sector – Luci Ellis). In particular, debt contracts support capital mobilisation from savers who would be unwilling or unable to fund investment projects if all contracts had to take the form of equity. Turner also speculates that the development of “fractional reserve banks” (i.e. banks that hold only a small proportion of their deposits in liquid assets while lending out the rest on longer terms) probably played an important role in enabling economic development.

Set against the benefits, Turner identifies five related features that make debt potentially dangerous

1. Debt contracts can fool us into ignoring risk
2. Debt markets are susceptible to sudden stops in new credit supply as investors or bankers focus on risks they had previously ignored – these sudden stops in debt finance are far more harmful than equity because of need to rollover debt contracts
3. Debt contracts do not adjust smoothly when they become unsustainable
4. Asset price falls induced by the sudden stop in confidence and credit growth can further depress both confidence and credit supply
5. Falling asset prices can produce a deflationary debt overhang effect

Turner argues that these dangers are greatly increased by the fact that banks operating in modern economies with fractional reserve banking systems, are the primary source of money. Turner’s analysis is that part of the problem with outsourcing money creation to private banks is that central banks had gravitated to the belief that, provided interest rates were maintained at levels that ensured low and stable inflation, the amount of credit that the banking system created would be of no concern. Low and stable inflation was sufficient to ensure financial and macroeconomic stability. Turner identifies two main reasons why this assumption proved to be wrong.

• All credit extension is built on debt contracts with the potentially dangerous features listed above
• Most credit in advanced economies is not used to finance new capital investment; Turner explores this idea further in a chapter (four) titled “Too much of the wrong sort of debt”.

Too much of the wrong sort of debt

Turner argues that if credit is used to finance consumption, it is more likely that the debts created will subsequently prove unsustainable. Turner focuses in particular on credit extended to finance the purchase of existing real estate and the rising importance of real estate based wealth. He argues that much of this wealth reflects not the constructed value of the buildings but the urban land on which the buildings sit. Turner argues that the changing pattern of consumption increases the relative importance of locationally desirable land; i.e.

• As people get richer, they choose to spend their income on a different mix of goods and services of which property features highly
• The supply of desirable locations to live is however often scarce leading to higher property prices
• The fact that real estate has appreciated in value in turn gives further impetus to the effect as real estate has become an asset class in which people invest not only to enjoy housing services but also in expectation of capital gain
• Turner notes that, prior to the mid-twentieth century, banks in several advanced economies were restricted, or at least discouraged, from entering real estate lending but these trends are now reinforced by a bias on the part of banks, and prudential regulation, to lend against the security of real estate assets
• Turner argues that the credit and asset price cycles described above are “… not just part of the story of financial instability in modern economies, they are its very essence”.

Liberalisation, innovation and the credit cycle on steroids

Turner notes that financial crises have occurred ever since money and debt were created but that they have become more frequent over the past 30-40 years. He describes this most recent period as the credit cycle on steroids. He ascribes this pumping up of the credit cycle to deregulation of financial markets over the 1970s-1990s and three factors in particular.

1. First, restrictions on the quantity of lending, either in total or for specific sectors, were removed
2. Second, the distinction between different types of financial institutions were eroded – with banks increasingly free to combine retail, corporate and investment banking activities and even non non-bank activities
3. Third, short-term interest rates were increasingly relied on as the only policy lever required to manage the economic cycle.

As the 1990s and 2000s progressed, Turner describes policymakers becoming increasingly convinced that any initial problems generated by financial liberalisation had been contained by the development of the new technology of securitised credit intermediation and the application of new and more sophisticated risk management techniques. Turner’s analysis of why these innovations failed to achieve their objective covers familiar ground

• With regard to securitisation, Turner argues that:
  • First, many of the credit risks apparently moved off bank balance sheets were not transferred to natural end investors but were held within the trading books of the same or other banks.
  • Second, even when credit risks were moved off balance sheets, maturity transformation risk was not removed from the system.
  • Third, the system fatally undermined incentives for good credit analysis, and
  • Fourth, derivatives were used not only to hedge risks but also to generate them on a huge scale.
• With regard to risk management, Turner focuses on two aspects of Value at Risk models he deems to be flawed, both in their precise design and their fundamental assumptions.
  • First, they fail to recognize that the future is governed not by quantifiable probabilistic risk but by inherent uncertainty and therefore tend to exclude the possibility of the extreme events that are central to financial crises.
  • Second, even in more normal times, they have pernicious procyclical effects. If traders become less risk averse and volatility declines, these models suggest that smaller haircuts are acceptable: they therefore allow traders to take bigger positions, which leads to price rises, rising confidence, and reduced volatility in a self-reinforcing cycle. When risk aversion and volatility rise, conversely, they give a further twist to the cycle of falling market activity and declining asset prices.

The above analysis leads Turner to conclude that “The amount of credit created and its allocation is too important to be left to bankers; nor can it be left to free markets in securitized credit”.

Private credit and money creation

The fact that the primary source of additional purchasing power and thus of aggregate nominal demand in advanced economies is private credit and money creation underpins much of Turner’s thinking in this book. One interesting fact is that this fundamental feature of advanced economies did not result from overt public policy choice—it evolved over time – Turner’s description of this process of evolution is summarised below:

• Initially in many cases these liabilities took the form of actual bank notes (in the United Kingdom private banks could issue their own notes up until 1844; in the United States until 1863)
• But subsequent restriction of this right made no difference to the banks’ ability to create money, and purchasing power: a deposit in a commercial bank is as much money as a banknote issued by a commercial bank.
• As a result, the development of private banking helped expand purchasing power in line with output potential.
• But from the very start, the process was unstable. In all the leading economies the nineteenth century was punctuated by banking crises in which purchasing power was first rapidly created and then destroyed in bank failures, with private bank notes and deposits becoming worthless.
• Over time central banks and regulators therefore increasingly sought to constrain the instability or offset its consequences.
• Over the past 30 years, central banks in advanced economies largely abandoned any explicit focus on the total amount or the allocation of private credit created.
• They continued to worry about the solvency and stability of the banking system itself but they gravitated to the belief that as long as inflation was held at a low and stable level, the amount of private credit and money being created was bound to be appropriate.
• And policy based on that belief appeared to deliver a remarkable Great Moderation, with nominal demand growing at a pace compatible with low inflation and steady real growth.
• But the Great Moderation of steady nominal demand growth and low inflation ended in disaster, because rapid credit growth produced excessive leverage, financial crisis, and post-crisis debt overhang

Credit financed speculation

Turner argues that

• Most credit in advanced economies is used to finance the purchase of existing assets, in particular real estate.
• This form of credit creation does not stimulate nominal GDP to the same extent as credit extended directly to finance new real investment or consumption
• As a result it can grow to excessive levels that cause eventual crisis without that growth ever producing an increase in inflation and without it being necessary to economic growth.
• Moreover, the importance of wealth effects over the credit cycle may be influenced by wealth distribution and may be asymmetric over time:
  • in the upswing of the cycle wealthy people may leave their consumption expenditure largely unchanged even though their wealth has increased;
  • but in the downswing poorer people who are highly leveraged may cut expenditure significantly in the face of falling net worth while wealthy people will not be as impacted,

Turner notes that Keynes called transactions in already existing assets “speculation,” and he uses the same term. He notes however, that purchasing existing assets often does not feel like speculation to the individuals concerned: it entails ordinary families borrowing money to purchase a decent family home. Turner also cautions that we should not assume that mortgage lending to finance existing assets is socially valueless, simply because it is unrelated to the mobilization and allocation of capital.

Inequality, Credit, and More Inequality

Turner makes some interesting observations about inequality and finance, arguing that:

• Rising inequality can make unsustainable credit growth essential to maintain economic growth but the increasing use of credit can foster yet further inequality; e.g.
  • Within societies at any time, richer people are likely on average to save a higher proportion of their income.
  • Rising inequality could therefore lead to a rising average desired savings rate and to a deflationary impact on aggregate demand, unless offset by other factors.
  • Credit can be that other factor.
  • Richer people may save more, but their savings can be channelled through banks and other financial institutions to provide credit to poorer people attempting to maintain or increase consumption despite stagnant or falling real incomes.
• Asset price fluctuations also inevitably produce winners and losers. Leverage increases both the gains and the losses.
  • Differences in access to credit, in the price paid for credit, and in the capacity to survive asset price downswings and benefit from the subsequent upswing can therefore play a major role in exacerbating inequality.
  • Superior access to credit in volatile economic circumstances has often been crucial to the accumulation of large fortunes.
  • Conversely, at the lower end of the income distribution excessive borrowing can often lead to falling wealth. In residential mortgage markets, for instance, poorer people, with lower initial wealth endowments are likely to face higher interest rates and may need to be more highly leveraged to afford a home. In addition they are usually more vulnerable to unemployment and income loss during recessions. As a result they are more likely, in the downswing of the cycle, to fall into negative equity and to suffer repossession, losing the opportunity of recouping losses in the subsequent upswing.
  • The supposed benefit of consumer credit is that it enables smoothing of consumption across the life cycle within a total lifetime income constraint. But if people borrow at very high interest rates, their lifetime resources available for consumption are significantly reduced

Capital requirements and risk weights

With respect to capital adequacy, Turner endorses Admati and Hellwig’s (The Bankers’ New Clothes) proposal that banks should hold equity capital equal to 20–25% of the gross unweighted value of their assets, increasing effective equity requirements by some four or five times.

Interestingly, he supports their proposal but not necessarily for the reasons they give. In particular, Turner expresses doubt that investors will be willing to accept deleveraged equity risk returns. So he seems to be contesting the pure Modigliani and Miller thesis they advance and placing himself in the camp of equity investor requiring “equity like” returns.

Turner’s support for higher capital appears to flow from his book’s central argument which is that we must constrain private credit growth. Much higher capital requirements would therefore be valuable both for financial stability reasons and for helping reduce the credit intensity of growth. In Turner’s ideal world, bank equity requirements would be much higher than agreed on in the Basel III negotiations, and Admati and Hellwig’s 20–25% is a reasonable target. Admati and Hellwig have argued that the supply of credit would not be reduced by higher leverage. Turner takes the opposite side of this debate but argues that constrained credit supply is actually desirable.

In addition to higher minimum ratios applied throughout the economic cycle, Turner argues that we need policy levers that can lean against the cycle. He notes that the Basel III capital regime has introduced a countercyclical capital buffer that can be increased in the face of rapid credit growth and removed if credit growth is anaemic but the new regime suffers from two deficiencies.

• First, the guideline for applying the buffer defines excessive credit growth in terms of credit’s own long-term trend. On that basis, he argues, credit growth of 10% versus nominal GDP growth of 5% would be perpetually acceptable as long as credit growth was steady, even though leverage would be relentlessly rising.
• Second, the maximum envisaged buffer, set at 2.5%, will not be sufficient. he argues that central banks should apply much larger countercyclical buffers if necessary to curtail credit booms, and they should consider applying them if leverage is already high and credit is growing faster than GDP, even if credit is growing in line with past trend.

Turner also argues for additional policy tools that can discriminate among different categories of credit extended; i.e. risk weights should be calibrated to reflect social not private risk so that capital requirements against specific categories of lending should ideally reflect their different potential impact on financial and macroeconomic stability. This is very different to the current international capital rules which are designed around a completely different philosophy.

Turner acknowledges that the current approach may be entirely rational from a bank’s private perspective and the resulting equity cushion sufficient to absorb losses. But he argues that current risk weights fail to allow for the fact that lending against real estate which is relatively safe for the individual bank can still contribute to aggregate instability through the asset price booms it helps create and the debt overhang it leaves behind. Central banks / regulators therefore need to ensure that capital requirements for different types of credit reflect systemic and macroeconomic risks that it will never be rational for individual banks left to themselves to take into account.

Anti-Markets and Anti-Growth?

Turner recognises that the reform agenda he sets out represents a dramatic rejection of the pre-crisis orthodoxy. Some elements of it—such as the importance of countercyclical capital requirements—are already accepted by most central banks and financial regulators. But others go far beyond the post-crisis consensus in two ways: first in focusing on the level of leverage as well as the pace of credit growth, and second in arguing that we must influence the allocation of credit among alternative uses.

He recognises that these elements will be criticized as dangerously interventionist, replacing the allocative wisdom of the market with imperfect public policy judgements.

His response is that

• He believes he has demonstrated that free markets in credit creation can be chronically unwise and unstable so we have to do something.
• He is not proposing to intervene in the allocation of credit to specific individuals or businesses;
• But we must constrain the overall quantity of credit and lean against the free market’s potentially harmful bias toward the “speculative” finance of existing assets.
• Less credit does not necessarily mean less growth, (i.e. since a large proportion of credit is not essential to economic growth; does not produce a proportionate increase in nominal demand; and leads to crisis, post-crisis debt overhang, and recession).