‘Hitler may not have come to power if Germany had used helicopter money’
New Delhi: Businessman, regulator and author Adair Turner is well known for the role he played as chairman of the UK’s Financial Services Authority during the financial crisis of 2008. He took over the regulator’s job five days after Lehman Brothers Holdings Ltd went bankrupt on 15 September 2008. He is also chairman of the Institute for New Economic Thinking (INET), New York. In an interview in New Delhi during a recent visit, Turner spoke about applying some of the solutions he suggests in his book Between Debt and the Devil: Money, Credit and Fixing Global Finance to an emerging market like India. Edited excerpts:
If in the West it is the power of Wall Street that is able to push the boundaries in banking, in India it is crony capitalism that has contributed to the twin balance sheet problem. In the framework of your book, what would be your advice to solve it?
India’s bad debt problem is a bit different from the problem I address in the book. My theory is that the fundamental reason for the 2008 crisis and the difficulty of recovery from that, it was not just the financial sector, but the whole level of debt of the whole real economy—corporate and households—over 60 years. The debt-to-GDP ratio in the advanced economies went up from 50% to 100% for a set of reasons. If that occurs, and given that most of that growth of credit is against real estate, either residential, individual or commercial real estate, there is a process whereby that is accelerated reinforcing process, of more debt and higher asset prices, which then produces a crisis that is very difficult to escape from. We saw that cycle in Japan in 1980s, in Scandinavia in early 1990s and then with catastrophic effect in the US and many other countries in the run-up to 2008.
The Indian bad debt problem is not fundamentally the same as that because the biggest problem in India is lending for investment. One of the problems that the advanced economies have got is that most bank lending is not much to do with plant and machinery any longer, it is basically the purchase of real estate that already exists. But in India, bad debts are concentrated in large corporate entities which in the years where people thought the economy might grow 8-10%, invested in particular power stations and those are underutilized, low plant load factors because electricity demand has not grown as fast as they anticipated, because the economy has been slightly slow.
Also because there has been a major opportunity to improve energy efficiency which people had not anticipated. So, this is a very particular problem, the Indian bad debt problem, concentrated in heavy industry and of course, with a large role of the public sector banks rather than the private sector banks. So, it is a major problem, but it is slightly different from the one advanced countries have. However, India may get the more classic problem in the future if it allows the growth of lending against real estate to grow and grow. I would watch the danger of that, while still thinking about this particular problem that India currently has.
Three questions here. One, is India’s problem a better problem to have? Two, what would be the red flags that we need to look out for? When do you think the problem is getting out of hand? Three, are you saying that household leveraging is a bad idea whereas a country leveraging itself, because you speak about the ability of governments to print money to get out of a bad place, is better?
It is very, very important in thinking about debt to think about three different functions that it can perform in the economy. One is the function that is described in our economics textbooks. If you read an economics text book, you would imagine that what banks do is that they lend money to businesses to buy plant and machinery to invest, that’s what the text books assume, and we need to understand this assumption and we need to understand that sometimes that can run out of control with too much investment, and that is what happened in the power industry in India. There is a separate function that lending can perform and it is the predominant activity of banks in advanced economies today, which is to lend money to people to buy assets that already exist. And these assets are real estate. There is a role of debt in an economy, but its economic function is not the same as lending for investment. There is a third category which is lending to consumers so that they can spend money before they have the income. One of the crucial arguments of my book is that there has not been a distinction in the economics literature, between those three different functions of debt, but they have very different dynamics, different implications.
Do we need to think about good debt and bad debt?
I think I would be a little bit careful about calling it good or bad. But let me answer your other question first. Is lending to individuals bad? I think there is a role in an economy for individual loans, for instance mortgage debt, it can enable people to buy houses which they would not otherwise be able to. But you can have too much mortgage debt, and if mortgage debt is too easily available, funnily enough, it can be bad for the percentage of people who are in their own houses. In the UK, up to about 1990 easy mortgage debt was helping drive an increase in owner occupation. But then mortgage debt got so easy to get that people were simply buying to invest, to rent out to others, and because they were already wealthy, had slightly better access to credit than others; they were able to borrow more money and drive the prices of houses up, so that many people could not even afford the deposit for the mortgage debt. With mortgage debt, it is a complicated function where up to a certain point as a percentage of GDP, it helps drive greater ownership of houses and then when it is too easy it drives back down again. There isn’t good debt or bad debt in a very, very simple fashion...most debts can be good up to a certain level but we can have too much of it. This is one of the important parts of economic theory that my book is about. This has been underexplored in the past.
Is there a way for regulators to solve this problem without being paternalistic? Any metrics that prevent lending beyond a certain point if a person is overleveraged?
There is a vital role for good regulation in controlling the banking system. In the past we’ve tended to define what good regulation is simply in terms of preventing banks going bankrupt. But my argument is: that is an insufficiently wide definition of a problem. We can have a problem even if banks don’t go bankrupt. Because even banks that don’t go bankrupt can lend so much money that the level of leverage in the economy goes up, it gets so high that everybody begins to worry about it and then they cut their investment if they are a company and they cut consumption if they are an individual and that drives an economy into recession. We need to guard against that. How? We need sufficiently high capital ratios for banks so it can control the total amount of credit they can create. There is an enormous natural bias, certainly when economies get beyond a certain income level, naturally a rising bias for the banking system to gravitate towards lending against real estate. Even from a banker’s point of view, it is the easiest thing to do. As long as there is an asset, you can claim the property and sell it off. Throughout the advanced economies, there is a tendency for the banking system to get more and more focused on real estate lending. I am not arguing that you ban real estate lending. But we need to recognize that this is the naturally rising tendency to somewhat overdo it. Regulators should set slightly higher capital requirement for real estate, you do it through the risk weights, set it slightly higher than banks would naturally do for themselves. Banks can only be expected to focus on ‘am I going to be paid back,’ but they are paid back by an overleveraged borrower, who to pay back has cut consumption. And if there are simultaneously millions of such people, even good lending, seen from a banker’s point of view, can have a bad macroeconomic effect. We need to lean against that in regulation. This is not a broadly accepted point of view. The predominant attitude to regulation across the world is still that the focus is on making sure that the financial system itself is stable and does not go into crises. What I add to that argument is that we need to look at the indebtedness of the real economy.
Your solution seems to be that you only lend what you have.
There has been a huge mistake in the global approach to banking regulation going back decades to allow banks to operate as very highly leveraged entities.
Have you recommended a situation where banks can only lend what they have as deposits?
No, there are some people who take my argument to a very strong extreme. There were a group of economists in early 1930s in America who correctly understood that the (reason the) American economy was in a catastrophic mess by 1931 was the over-expansion of credit in 1920s. Economists like Irving Fisher and Henry Simons, although in most areas of the economy they were extreme free marketers, they thought the banks were so dangerous that in the upswing would run so far out of control that, essentially, they wanted to abolish banks. They wanted banks only to be able to lend long-term equity and debt, which essentially is to abolish banks. They talk about 100% reserve banks. Lending would not occur in banking system, banks would simply be holders of cash. In my book, I explore, should we go that far? And I think it is important that these are not crazy ideas, these are ideas of people who had observed the chaos created by an overactive expansion of credit. But I do think that we don’t need to go that far, and there is an impracticality of going that far. But once you realize that it is not mad to suggest that, you can pick a point on the spectrum which is a much higher level of capital or reserves than we currently allow the banking system to run on.
India has a concept called payment banks, where no lending is allowed. Do you think they would work?
What we have to see is that how will a payment bank compete with a classic bank that underprices its payment services. Banks have payment services to attract deposits and they often don’t explicitly charge or they undercharge for the actual process of payments. They get the benefit of the money they get as deposits. That makes it, in most parts of the world, in the UK, it would be very difficult for a payment bank to compete. Current accounts pay nothing for payments. Over time there will be a difficulty for payment banks, pure payment banks find it difficult to compete with payment and lending banks, because the others cross- subsidise the lending and the payment functions. I don’t know whether that is the case, but that is the question anybody with a payment bank shareholder will have to ask.
India has added 300 million new bank customers in the last few years. The predominant destination of household investment is still gold and real estate. Financialization is yet to really happen. What would be your message to regulators as this transition gets underway?
India has this very specific situation of investing in gold, it is not there anywhere (else) in the world; India is unique in the world, where gold comprises a significant amount of household savings. It is quite difficult for economists from a different environment to get our brains around to what that means. Real estate is the predominant form of household wealth everywhere in the world. In the advanced economies, 70% of all household wealth will be in real estate. One of the things that people do as they get richer is that they buy more real estate. In pleasanter parts of town. Logical thing to do. After a while, as people get richer, they’ve got so much clothes, food, washing machines, one of the most obvious things to do (is) you want a really nice place to live. Nothing wrong with that. But it does create major financial stability danger. If you take real estate as the most natural form of wealth holding in a rich economy, if you take that it is the easiest thing for a bank to lend against. Put that together, there is a huge possibility to unleash a self-reinforcing cycle where more credit is given to buy more real estate, where everybody thinks that real estate will go up further and buy more. People who did not want to be part of that spiral are forced to become a part of it as they will otherwise be not able to afford it. As economist (Hyman) Minsky pointed out, the way in which banks lend more against assets and price goes up, it is inherent to financial instability...The cycle of credit against real estate is not a part of the story of instability; it is pretty much the whole story. I argue very strongly that regulators and central banks have to watch very carefully as economies grow to manage and control and temper down that credit cycle. Otherwise the credit real estate cycle, it can run out of control. In Thailand, Korea, Indonesia crashes in the past have all a lot to do with real estate. The whole of the problem in Japan and the long period of slow growth, was indeed real estate. And indeed the country that we all need to worry about, China. India is a long way behind but it is beginning to develop. The regulators should keep an eye on it.
You speak about helicopter money (this is a hypothetical, unconventional tool of monetary policy that involves printing large sums of money and distributing it to the public in order to stimulate the economy) being a solution sometimes in a crisis. You talk about the limits of monetary policy and using the fisc to cut taxes and give money away to people. In 2009, India’s big farm loan waiver just before a general election ended up fanning inflation. While a government can inflate away its debt, the people finally pay. I worry about legitimizing helicopter money in a country like India where pre-election giveaways cause so much damage.
This is a problem. As (former Federal Reserve chairman) Ben Bernanke has suggested, under certain circumstances it is fine to use helicopter money. I would not recommend it in an emerging economy like India. The concept is this: if you first create too much private debt—that’s what we did across the advanced economies before 2008—you enter a situation where you have so much debt in the economy that none of the normal classic levers work; you can cut the interest rates to zero, but if people have decided they have too much debt, they are determined to pay down the debt, even if the interest rate is zero; that is clearly what happened in Japan in the 1990s and that is what happened in the US and UK after 2009. So, you then enter a situation, how am I going to get the economy going again? Some people say we should use fiscal deficits paid by the issue of debt and those undoubtedly are stimulants to the economy. All the advanced economies agreed to do that initially, but after a while, people worry about how am I going to pay back that debt. You seem to be stuck, monetary policy will not work. The fiscal policy seems constrained, by oh my god, how will I repay? What Bernanke said to the Japanese in 2003, if you are really stuck in that position, realize that you can have the central bank print some money, give it to the government which spends it. Either on tax cut or public expenditure.
If Germany had done that in 1931, you might never have had Hitler coming to power. There are extreme circumstances when it is possible to do this. The absolute legitimate worry is that, if you make it obvious to the politician that this is possible, won’t they want to do it all the time, in particular in the run-up to an election, rather than in only specific circumstance of a post-crises deflation.
The classic attitude to helicopter money of economists has been: yes, Adair, yes, Bernanke, I agree with you that in theory it is the best policy, but the trouble is, we can’t introduce it without the political risk that it is misused. Broadly speaking, I think, in the UK, Japan, US, we could control that political risk. We could give to our independent central banks the authority to determine how much helicopter money is appropriate. I think in India, or in Brazil or Indonesia, if you first admitted that it was possible, you will start getting situations, not where the central bank was making an independent decision, but were being told to it by the prime minister or the finance minister.
I think this is a policy which in the developed economies in conditions of post crises deflation can be introduced and can be subject to discipline. I would not recommend it in emerging markets which don’t have that long-term history of robust central banks’ independence from the instructions of government.
Would the US election results have been different if they had used helicopter money in and after 2009?
I think it might have been a better thing to do in 2009. America was one of cases where the existing policy mix worked better. There was also an intermediate step where you run a large fiscal deficit in the classic fashion, which is funded by debt, but where the central bank then buys the debt, saying that it will sell it back. But we don’t know if it will. That is what eventually worked in the US. In the UK, we should have done it. In the US, the economy was actually, in the second half of the second (Barack) Obama term, it was not doing all that bad. I think you can’t put down Donald Trump’s victory to the economy doing badly in the short term. I think what he tapped into was rising inequality and various people who lost out, not just in the last two years, but it was a rising resentment for 20-30 years.
The ‘buyer beware’ markets we have in finance have their roots in the version of economics that utility maximizing economic agents will evaluate choices rationally. Disclosure and financial literacy were the tools to deal with information asymmetry and competence. But we know that disclosures are written by lawyers and you need a degree in law, finance and patience to understand them. If behavioural economics moves the argument from (American economist Richard H.) Thaler’s ‘Econ’ to a ‘Human’, does the market not go from a ‘buyer beware’ to a ‘seller beware’ one?
This is a complicated set of issues. INET was set up after the 2008 crisis in the belief that the standard neo-classical economics had done a really lousy job of equipping us with an understanding of how that crisis was created. Neo-classical econ had told us stories of efficient markets, that in turn depended on rational expectations, this was just not true, they were not good descriptions of reality and they led us seriously astray. This was in the arena of macro economics and stability of the overall economy. I think they have also led us astray—what is the relationship between the financial industry and consumer?
Once you start challenging the idea of rational expectations in markets, it is not clear that you can get good results simply by rationality and disclosure. I was the chair of a pension fund in the UK and people had been saying British people are under-saving for a future pension, what we therefore need is to educate people more. We need the private sector to make sure that they fully understand what the charges are if they are educated to want to save, they will save. If there is lots of disclosure, they will save in an efficient way. It turned out that both propositions were wrong.
That individuals in their savings decisions are incredibly heavily influenced by ‘nudge’ factors, the ability of somebody to suggest what the answer is. The crucial insight here is if you ask somebody when they join a company—do you want to join the pension plan, you might get 40% of the people saying they do, if you simply turn the answer the other way round, we will put you into the pension scheme unless you sign here to opt out, you might find that only 10% opt out. This is a complete breach of rationality. Huge empirical evidence that framing of the question changes behaviour.
The UK has a government (that) encouraged (a) pension scheme in which everybody in the country is naturally enrolled into a pension unless they opt out. This has been successful beyond our wildest dreams. This shows the power of behavioural economics. This is based upon understanding people the way people really behave, rather than starting from the assumption of rationality. In the area of personal financial services there may be a role for these nudge factors, may also be a role for categories of price regulation because disclosure-based regulation tends to produce pages and pages of disclosure which nobody ever reads.
2008 was a giant case of misselling mortgage products to people who could not afford those products. You cannot ever have enough information to decode all the products you need. The problem will always arise in the household.
You cannot entirely divorce the prudential issues with conduct issues, but you cannot entirely define it in conduct issues. Part of the problem in the US was undoubtedly that banks and non bank lenders deliberately encouraging people into contracts where there was no reason expectation that they will be able to pay back. The whole thing was like a ponzi scheme, it only worked as long as the price went up. Borrower borrowed under teaser rates in the belief that the house prices will go up and they would go to another provider to get another contract and get another loan.
On the investor side, people were packaging up these loans into securities and selling it to investors who did not understand, on both sides. You need to deal with that issue and that’s where the conduct can have an impact on the macro prudential. You can have macro prudential issues, even if you had a perfect conduct regime.
You can have an environment where you lend money to people who are able to pay back their debts, if it is too much debt in the economy, the very fact that they do pay back their debt, is what tanks the economy into depression.
Who decides what level of leverage is just right?
You cannot avoid a regulatory authority having a point of view on what the level of leverage should be. But, the crucial thing is to escape from the idea that we need highly leveraged banks in order to drive the economy forward.
There has been a tendency to think that if we don’t allow highly leveraged banks there won’t be enough credit and the economy won’t grow. But there are other ways of making sure that economy grows through monetary and fiscal policy, rather than through creating banks. This has been really quite fundamental intellectual mistake, the belief that we need very highly leveraged banks.
Before the crises, if you were a bank lending against mortgages and if you said, if your risk weighting for mortgages be low, like 10%, you could actually get away with an equity ratio that was 0.2%, you could essentially be, 500 to one leverage. None of them were quite that high. But what we did after the crisis, we very significantly increased the requirement of capital in the banking system. If I was able to do it again, if I were a benevolent dictator of a greenfield economy, so don’t have to compromise with other people’s view or transition issues, I’d still go for a higher capital ratio. I think this should be significantly higher than we’ve set them.