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Debt and deleveraging: Long term and short term challenges

Debt and deleveraging: Long term and short term challenges

21 November 2011

Speech by Adair Turner, FSA Chairman Presidential Lecture: Centre for Financial Studies, Frankfurt
The financial and economic crisis which began in 2007 and intensified in 2008 has lasted longer than most policy makers anticipated. For a time in 2009 to early 2010 it seemed as if the period of crisis had passed, and that we could concentrate on reforming the financial system to make it sounder for the future. From 2010 onwards it became clear that recovery would take far longer than originally supposed. The US and the UK economies have recovered more slowly than hoped and a new stage of financial crisis has arisen from the interconnection within the Eurozone between sovereign debt and bank solvency concerns. Japan, which in 2007 seemed at last emerging from two decades of low growth, price deflation and rising government debt, has again faced all three effects. We are far from out of this crisis: it is far deeper and more difficult to escape than many of us initially thought. People tend to allocate blame for a crisis according to their ideological pre-disposition. When the crisis first broke, many commentators in Continental Europe blamed the excesses of Anglo-Saxon finance capitalism, financial liberalisation, overpaid bankers, and an explosion of private debt. Over the last six months in contrast, the criticism has flowed the other way undisciplined governments, and a Eurozone project which ignored market realities for political reasons are blamed by many in Britain and America for the slow pace of recovery. But while these criticisms come from different directions, both are right. The crisis has resulted from the combination of over confident faith in free financial markets and structural flaws in the Eurozone construct. And underlying both has been a failure to recognise the central importance to economic and financial stability of debt and leverage levels in general and bank credit creation and leverage in particular. That failure has left the economies of the developed world with levels of leverage in private non-financial sectors, in the financial system, and in the public sector which threaten financial instability and/or prolonged economic stagnation. Both getting out of this deleveraging trap, and building a sounder system for the future, requires that we recognise clearly the depth and the nature of this problem.
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This evening therefore I will focus on the role of debt in the economy, making three arguments. First, that we cannot rely on free markets to ensure that private bank credit creation is optimal either in overall quantity or sectoral allocation and that our past regulation of bank capital and liquidity was not just a bit but hugely deficient. We need, and have begun, radical prudential policy reform. And we need to monitor credit creation as a crucial macroeconomic variable, and use macro-prudential policy levers to influence its scale and allocation. That implies that Bundesbank doctrine was quite right to assert that current price stability is not a sufficient definition of monetary and financial stability, but also implies that the more fruitful focus of analysis and of policy levers is on credit supply rather than money supply. Second, that at the core of the Eurozones problems was a failure to recognise that sovereign debt issued by a nation which no longer has its own currency is quite different from sovereign debt issued by a currency issuing power.1. Such 'subsidiary sovereign' debt as Charles Goodhart has called it must be subject to market as well as political disciplines.2 And in an ideal world, such debt would be held primarily outside the banking system. Third, the deleveraging challenge we now face, as a result of our past failure to control adequately either private debt or public debt creation, is so severe that it is likely to require a response which combines all of the possible mechanisms debt

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servicing, debt write-down, and forms of controlled debt monetisation. The aim of this lecture is therefore to be clear about some of the underlying causes of the crisis, in order to clarify some of the principles that must guide solutions. What it does not do is to propose the specific steps which the Eurozone authorities should take to manage the transition from the current sub-optimal architecture to a more stable system. Designing those steps requires complex trade-offs between ideal endpoints, political constraints, and the practical realities of a present position which in an ideal world would never have been reached in the first place. Clearly it is for the Eurozone authorities to make those complex and difficult trade-offs.

Private debt creation

A modern market economy needs financial contracts. In theory these could all take equity form, and in theory if they did so economies would suffer less macroeconomic instability. That point was well made in 1934 by the Italian economist Luigi Einaudi, in an elegant short article entitled simply 'Debts'.3 But as Einaudi then went on to argue, in the real world fixed debt contracts (and indeed fixed wage contracts) have arisen to meet human desires for greater certainty over future income than would be delivered in a world where all contracts took an equity form. Therefore we have debt contracts both those through which individual savers finance productive investment by businesses, and those which achieve life cycle consumption smoothing some households saving and others borrowing, in particular in the form of mortgages to buy houses. And the potential for such debt contracts as well as equity contracts, was almost certainly important to the willingness of savers to commit funds and to the level of capital investment which helped drive the economic transformation of the last 200 years. These debt contracts can be in non-bank form: individuals can buy the corporate bonds of businesses making real investments. But they can also be intermediated by banks, and bank intermediation introduces two new features and potential advantages. First, a pooling function, with the funds of multiple savers indirectly financing multiple borrowers, delivering diversification benefits, and facilitating the extension of credit not just to large corporates who can access bond markets but to households and SMEs who cannot. Second, a maturity transformation function, which enables households and corporates to hold shorter term financial assets than liabilities, and which may as a result facilitate long-term real investment.4 As Walter Bagehot argued persuasively, such features can play an important role in enabling the mobilisation of savings, and the development of joint stock fractional reserve banks played an important role in the development of the mid-19th century British economy.5 So the existence of debt contracts and of banks, both responds to important human preferences and can facilitate economic development. But debt contracts also create important potential risks and these risks become severe if debt contracts and maturity transformation are present on too large a scale, or if their scale is volatile through the cycle.
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Distinctive characteristics of debt

The risks arise because of the particular nature of debt contracts and the particular nature of banks. (Slide 1).6 Debt contracts can create rigidities, myopia and contagion dangers. These derive essentially from the different actual and observed probability distributions of payouts for debt instruments which are quite different from those for equity instruments (Slide 2). Returns on equity can vary significantly above and below the modal expectation and that fact is transparent to the investor on a continual basis. Equity markets can certainly suffer from irrational exuberance, but the fact that equity returns are potentially variable is always transparently clear. The return on debt contracts by contrast has a skewed probability distribution. In most states of the world the return is positive but capped: but there is a small percentage probability of highly negative returns. This has two consequences. First, potential myopia, since as Gennaioli, Shleifer and Vishny (2010) have argued, investors in debt contracts may suffer from local thinking the assumption that the favourable distribution of payouts which is observed in the good times is the full probability distribution, an assumption which then adjusts rapidly and disruptively at the first sign of bad news, as neglected risks are suddenly brought into consciousness.7 As a result, Gennaioli, Shleifer and Vishny argue,

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the existence of many credit contracts and securities may owe their very existence to neglected risk. And as a result, investors/savers in debt instruments may themselves take on liabilities and commitments which only appear sustainable on the basis of incomplete assessments of the risks involved. Second, potential rigidities in default. Equity losses are typically suffered in a smooth and controlled fashion: the equity price falls, and the investor is as a result poorer, but in many cases without a disruptive event. Debt losses by contrast occur via disruptive processes of default and bankruptcy. As Ben Bernanke has pointed out in a complete markets world, bankruptcy would never be observed.8 But in the real world, bankruptcy and default processes induce fire sales and non-smooth changes in apparent wealth, and if they occur on a large scale simultaneously across the economy, can produce harmful economic shocks. In addition, debt contracts need to be continually rolled over: as a result new credit supply is vitally important to the economy. Equity instruments are typically permanent, they do not need to be continually replenished each year: as a result an economy could function for a period with new equity issue markets completely closed. Debt contracts in contrast have finite terms. Without continual refinancing, many otherwise solvent firms would go bankrupt. Oscillations in new debt supply are therefore potentially far more harmful than oscillations in new equity supply. And banks do not just intermediate financing flows taking pre-existing savings and funnelling them to users of funds they create bank money, with bank deposits and bank lending rising in a self-generating cycle. As a result they can create asset price inflation and, potentially, excessive increases in aggregate nominal demand.9 Because of these features, the relative role within an economy of debt contracts and the aggregate scale of bank or shadow bank credit intermediation, are not, as some economic models have tended to assume, neutral factors in the economy, but crucially important.10
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Drivers of excessive and volatile leverage

So the total scale of debt contracts in the economy, and aggregate levels of leverage, are vital potential determinants of financial and economic stability. So too is the volatility of total debt commitments and leverage, the rate of change over time. But private market dynamics, left to themselves and subject to our past regulatory approaches, can and have in some countries resulted in levels of leverage which are sub-optimally high, sub-optimally volatile, and with credit supply suboptimally allocated. Four factors at least can combine to drive leverage to sub-optimally high levels in the boom period. (Slide 3). Two are inherent and derive from the distinctive characteristics of debt contracts discussed above. First, Minsky type credit and asset cycles (Slide 4) through which credit extension drives increasing asset prices and in particular the price of residential and commercial real estate which generates self-reinforcing changes in the expectations and apparent wealth of both lenders and borrowers, which generate further credit extension and further asset prices.11 The process we saw clearly in many housing markets pre-crisis, such as the US, Spain, Ireland and the UK. (Slide 5). Second, unstable and self-reinforcing perceptions of credit risk, with the market price for risk falling to an excessively low level in periods of boom and then adjusting rapidly when problems emerge. This phenomenon is clearly evident in the yields on corporate bonds and in financial institution CDS spreads in the pre-crisis and post-crisis period (Slide 5), and is well explained by Gennaioli, Shleifer and Vishnys theory of local thinking and neglected risks. These unstable perceptions of risk and inappropriate pricing in turn form inputs to the Minsky cycle. These two factors are inherent to the nature of debt contracts. Their potential existence provides a strong rationale for public policy interventions which will guard against potential excesses and volatility. In fact, however, far from effectively offsetting these risks, we have introduced public policy biases and made major regulatory policy mistakes which have exacerbated the inherent risks. First, through a general tax favouritism for debt over equity instruments, which is a pervasive tendency within corporate tax regimes, and in some countries of personal tax regimes also. Second, through a catalogue of profound errors in the design of our prudential regulation of banks and shadow banks which combined to leave us by 2007 with a massively over-leveraged financial sector free both to extend excessive credit to the real economy, and to create excessive intra-financial system risks. These errors included: A willingness to let banks operate with combinations of capital and liquidity requirements which made them highly

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vulnerable. This was based on an erroneous assumption that increased bank leverage delivered social as well as private benefits.12 A century ago many countries ran banks with far higher capital ratios than recently (Slide 7) but we still had growing market economies. Those ratios came down dramatically by mid-century, but the banks of mid-century had the offsetting risk mitigation of very high liquidity ratios, as a result of large holdings of government debt. 13 From the 1960s onwards, however, we allowed liquid asset ratios also dramatically to decline. Bank riskiness is a function of both capital and liquidity: by the early 21st century, we had allowed banks to become excessively risky. A fatal failure to understand and offset the risks created by the growth of traded securitised credit, structured credit and credit derivatives. These developments were lauded as new technologies capable of making the financial system less risky, but in fact resulted in the proliferation of intra-financial system debt contracts contracts among banks and shadow banks rather than between them and the real economy which increased the vulnerability of the system to sudden changes in perception, sudden recognition of previously neglected risks. Excessive growth of these contracts and complexities was facilitated by the official endorsement of VAR-based risk assessment models which were fundamentally flawed, and by the setting of regulatory requirements for trading book capital which were woefully deficient. And an overconfidence in market efficiency and rationality which not only accepted but positively welcomed an increasing tendency of bank market participants and shadow banks to base assessments of credit risk and of appropriate credit pricing, not on their own credit analysis, but on the observation of the price set by liquid markets. This approach, explicitly applauded by the IMF in its April 2006 Global Financial Stability Report,F effectively hardwired the dangers of local thinking which Gennaioli, Shleifer and Vishny have highlighted. These errors of prudential policy were massive. The financial system pre-crisis was unstable as a result of the cumulative effect of several decades of profound intellectual error and faulty policy design. Those errors, combined with the inherent characteristics of the debt creation process, have result in three inevitable but harmful developments. First, (Slide 8) a very significant growth in several countries of aggregate cross-economy leverage, including higher and in some cases excessive leverage in real sectors of the economy unsustainable debt burdens of some households and corporates. Second, and strikingly apparent from Exhibit 8, a huge growth in leverage within the financial sector, as a result of the proliferation of intra-financial system claims and trading contracts, which has created risks over and above those which result from real economy leverage. Third (Slide 9) the potential for highly volatile credit creation, with credit growth rising far more rapidly than nominal GDP growth in the pre-crisis period, but then crashing to very low or in some cases negative levels, with the danger that asset prices and credit supply could now interact in a Minsky deleveraging cycle (Slide 10). Left to itself, the free market can generate credit and asset price cycles which are harmful, and levels of leverage from which it is very difficult to escape without the danger of deflation and reduced economic activity. And left to itself the free market may allocate credit excessively towards those activities which are capable of generating asset price increases, since in the upswing these categories of credit appear low risk. In the UK, between 1990 and 2008 all of the increase in bank credit extension to non-financial corporates as a percent of GDP was accounted for by commercial real estate lending, with the aggregate leverage of other corporate sectors (as measured by percent of GDP) actually declining (Slide 11).
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Required policy levers and reforms

A free market can generate both harmfully high and harmfully volatile leverage. What policy levers should we deploy to offset that danger? The answer I believe lies not in any change in the objectives of monetary policy nor its operation via interest rate changes, but in the combination of radical reform to static prudential rules and the deployment of macroprudential through-the-cycle levers. Tendencies to excessive credit creation can occur even when current inflation is low and stable, as it was pre-crisis. Before the crisis indeed, the attainment of reasonably low and stable inflation was among the factors which fooled us into believing that we had achieved a Great Moderation, in which the risks of financial and macroeconomic instability had been permanently reduced. Stable and low current inflation is not a sufficient definition of financial and monetary stability. But it does not follow that we should in response use interest rates more aggressively to lean against credit and asset price cycles. This is not so much because of the often noted difficulty of knowing if and when a bubble is actually occurring, but

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rather that an interest rate policy response is unlikely to be optimally effective given the low interest rate elasticity of borrower demand for loans to finance asset purchase in the face of expectations of future asset price increases. The level of private sector leverage within the economy, whether arising from banking or shadow banking sectors, and its change over time and sectoral allocation, must therefore be recognised, as they were not before the crisis, as vital indicators of potential financial and macroeconomic risk. And the policy response needs to combine three elements. First, very significant increases in the static across the cycle prudential standards for bank capital and liquidity. Such standards will now be introduced through the Basel III reforms.15 Second, major reforms to our capital and liquidity regimes for trading activity, to prevent a repetition of the pre-crisis growth of intra-financial system risks. Significant reforms have already been made within Basel 2.5 and Basel 3. Further reforms are likely to be appropriate and may well emerge from the Basel Committee fundamental review of trading book capital and from the Financial Stability Boards shadow banking project. Third, the deployment of macro-prudential tools which can lean against the cycles of excessive exuberance followed by harmful deleveraging. These tools clearly need to include countercyclical bank capital requirements as envisaged in the Basel III regime. But given the strong tendency for excessive credit extension to be concentrated in particular categories of credit such as real estate finance, they will likely also need to include policy levers which directly address those credit and asset cycles, whether via variation of capital weights specifically relevant to those sectors, or via the variation of loan-tovalue ratio limits which constrain borrower as well as lender behaviour.
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Money supply or credit supply as the policy focus?

This implies of course, that achieving a stable inflation target is not sufficient to ensure long-term financial or macroeconomic stability. Which in a sense vindicates the long-term Bundesbank insistence that central banks interested in long term stability cannot focus solely on the current rate of inflation and short term inflation prospects. But whereas that insistence was expressed in a focus on indicators of money supply, on the liability side of bank balance sheets, my argument is instead for a strong focus on credit supply on the asset side bank balance sheets. Of course in practice these two are closely linked bank balance sheets grow because money and credit are created in a self-reinforcing cycle: over the last 50 years, for instance, both household lending as a percent of GDP and household deposits as a percent of GDP, have increased dramatically in the UK. (Slide 12). As a result, monitoring money supply trends will often alert us to concerning trends in credit and leverage. But an explicit focus on credit and leverage is likely to be more fruitful than a focus on money for three reasons. First because there is no necessary relationship between money supply and future inflation, given the different functions which bank money can perform, with several countries, for instance Japan and the UK, displaying long-term secular decline in measures of the velocity of money circulation (Slide 13). Second, because credit and asset price cycles could do harm to the real economy even if they never resulted in excessive current inflation. A credit boom followed by bust can wreck economic havoc, even if inflation stays low in both the boom and the bust. Third, because the rigidities created by leverage could arise as a result of excessive non-bank and shadow bank credit as well as bank credit. We therefore need to look carefully at all forms of credit intermediation and not just those which have a counterpart in bank balance sheet money. So money and credit matter. But not because the growth of money is a robust predictor of future inflation. Instead because the growth of real economy leverage, and of bank and shadow bank balance sheets, can create rigidities and instability risks which when they crystallise may produce harmful deleveraging and deflationary risks.

Public debt of full sovereigns and subsidiary sovereigns

Initially this financial and economic crisis seemed primarily one of private debt, different in nature from many of the previous crises, of which profligate fiscal policies were often the key cause. The problem seemed one of out of control bankers, traders and private borrowers, not out of control governments. But the latest twist of the crisis, is very much one of public debt particularly in the Eurozone, but with rapidly rising public debt levels also in the US, the UK and of course Japan (Slide 14).

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That in part reflects a crucial feature of the deleveraging challenge that I will consider in my third section the fact that once you have high leverage as a result of developments in one sector of the economy, it is very difficult to reduce it, rather than simply shift it to another sector. The story of Ireland and Spain in particular is one of countries which entered the crisis with low levels of government debt but whose public finances deteriorated rapidly as a direct result of the bursting of the private sector debt bubble. But in some other countries in particular Italy and Greece, the problem was directly one of excessive public debt. And the fact that Irish and Spanish government debt problems arose as a result of the crisis, does not make them any less concerning once they have developed.
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Distinctive characteristics of sovereign debt

Sovereign debt is a very particular form of debt, usually providing to the lender few of the rights which typically accrue to a creditor who has lent money to private households or corporates. When a sovereign defaults, the lender cannot typically seize tangible assets nor an ongoing business: loans to sovereigns do not convert in default to equity claims on the national economy. Economists such as Eaton and Gersovitz (1981) and William Kline (1995) have indeed explored the theory of why anybody is willing to lend money to foreign sovereigns, given the lack of typical creditor rights.16 But as Carmen Reinhart and Kenneth Rogoff have described, there is a long history of lenders willing to keep extending credit to their own or to other sovereigns until unsustainable debt levels are reached.17 They also illustrate that the resulting defaults have not been limited to foreign or foreign currency claims. That phenomenon of excessive credit extension is in part simply the product of a cycle of irrational exuberance and over optimistic credit assessment which can apply to sovereign debt just as much as to private debt. Just as private sector credit spreads first fell to excessively low levels pre-crisis, and then shot up as creditors bought into their consciousness the previously ignored possibility of default (Slide 5) so too with the spread between Greek and German debt (Slide 15). Bonanzas and sudden stops, credit booms and credit crunches, are features of credit supply to both private and public sectors.

Policy bias drivers of excess sovereign debt

But just as with private debt so with public, we have exacerbated the risks through policy biases and mistakes. Excessive private debt has been encouraged by tax favouritism for debt and woefully inadequate capital and liquidity requirements. And in relation to sovereign debt, particularly of developed countries, we have increased the risk of excessive borrowing by strongly favouring sovereign debt in our banking systems (Slide 16). We typically treat the sovereign debt of developed countries as zero weighted for capital purposes. We treat sovereign debt as a highest quality liquid asset in our liquidity regulations. And sovereign debt is typically treated as the highest quality collateral in central bank monetary and liquidity operations. Given the favouritism that we have accorded sovereign debt in banking system regulation, we should not be at all surprised that excessive government debt is often created, and that a significant proportion of it is held by the banking system.

Distinguishing full sovereign and subsidiary sovereign debt

That implies that in building a sounder financial system for the future, we will need to reconsider our prudential approach to sovereign debt. But a new and better approach should logically also make a clear distinction between two quite different categories of sovereign debt, which Charles Goodhart in his recent paper labelled Fully sovereign and Subsidiary sovereign. Fully sovereign bonds being those issued by a sovereign authority which is also a currency issuing authority US T Bonds for instance. Subsidiary sovereign bonds, being those issued by a political unit, such as the nations of the Eurozone, which are not themselves currency issuers. The risks involved in these two categories of debt to bond holders, to banking systems and to the overall economy are quite

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different. In the case of fully sovereign debt, the debt can at the limit be monetised, turned into money. That in itself of course creates a new risk that monetisation will create inflation and/or currency depreciation and that repayment will be in devalued real terms. But provided such monetisation or depreciation arises in a controlled fashion, for instance within the constraints set by the pursuit of low inflation targets, those risks are different in nature and degree from those which are created by the danger of default. And for a financial intermediary whose liabilities as well as assets are denominated in the currency of the issuer, the risk of devalued real repayment does not change the importance of the fact that in nominal terms the bond is very close to risk free.18 By contrast, subsidiary sovereign debt carries a potential nominal repayment risk as well as real repayment risk. Circumstances can develop, and have in Greece, in which the nominal debt cannot be fully repaid, nor monetised by the national authority. The launch of the Euro resulted in Eurozone nations, to use Goodharts terms, being transformed from full sovereigns to subsidiary sovereigns, but without enough clear thinking about whether such a construct could work and if so how. It is clear in retrospect that such a structure can only work if there is some combination of: disciplines which ensure that subsidiary sovereign debt could never rise to unsustainable levels; and/or mechanisms to allow controlled sovereign debt restructuring/default without such restructuring having a major disruptive effect on the financial system and the economy. In fact neither of these conditions was adequately put in place before the launch of the Euro, indeed quite the opposite. And central to the problems which emerged, has been the role of banks as major holders of subsidiary sovereign bonds. The fact that banks have been incentivised by regulation to be major investors in sovereign bonds, has helped create an internal and external demand which has made it easier for sovereigns to keep issuing debt until unsustainable levels have been reached. And it has meant that if and when concerns develop about the sustainability of subsidiary sovereign debt, those concerns necessarily spill over into concerns about the soundness of the banking system. Any long-term stable Eurozone system, will therefore have to include some constraints over subsidiary sovereign debt issuance, achieved either politically or via the market, or more likely via both. The political route would necessarily involve some significant degree of Eurozone political integration, and would pose important questions about the derivation of political legitimacy. The market discipline route is difficult to imagine being effective unless subsidiary sovereign debt is largely held outside the banking system, by non-leveraged investors, on whom losses could be imposed without fear of financial instability. And that would imply that the current favouritism towards sovereign debt, inherent in prudential capital liquidity requirements and in central bank collateral rules, should in future apply only to fully sovereign debt, and either not apply at all or to a far lesser extent to subsidiary sovereign debt. But the Eurozone of course does not have fully sovereign debt debt issued by a political authority which is also a currency issuer. It does not have Eurobonds. As a result it does not have a pan-Eurozone instrument treated by financial markets as undoubtedly risk free in nominal terms a key explanation of the phenomenon that while the Eurozone in aggregate has a debt to GDP ratio slightly lower than the US and UK, and far below Japan, and external current account and balance sheet positions better than the US and the UK, its average interest rate paid on government debt is far higher. (Slide 17). And if bank regulation and central bank practice did move to a more appropriate and less favourable treatment of risky subsidiary sovereign debt, the Eurozone banking system would not have a natural risk-free asset to hold as the highest quality liquid asset, nor would the ECB have an undoubted quality asset against which to conduct monetary operations. It is therefore difficult to imagine a long-term sustainable structure for the Eurozone which does not make a clear distinction between fully sovereign debt and subsidiary sovereign debt, entailing both a less favourable treatment of subsidiary sovereign bonds in the banking system and the issuance of Eurobonds. Different propositions for the relative role of such Eurobonds and for the transition towards them have been proposed by Delpla and Weizscker in their paper for the Bruegel Foundation, and by the German Council of Economic Experts.19 One possible ideal structure (Slide 18) could entail Eurobonds issued as joint liabilities, up to some maximum % of eurozone GDP, with national governments free to issue national bonds in addition, but with such national bonds held largely outside

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the banking system and subject to clearly understood default risk. Clearly any such proposals raise major issues about how the Eurozone would impose collective discipline over the scale of issuance of any Eurobonds. And clearly also any such proposal raises complex and difficult issues about how to transition from todays flawed structure. But the current Eurozone architecture, which has resulted both in high levels of subsidiary sovereign debt as a percentage of GDP, and the large scale holding of that subsidiary sovereign debt by the banking system has combined with the excesses of private credit creation to create a highly dangerous situation.
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Managing the deleveraging challenge

The developed world has got itself into a really severe position, as a result of two major policy, intellectual and political failures. A failure to understand the importance of real economy and financial sector leverage and of the inherent instability of private credit creation processes. As a result we lauded financial liberalisation, financial innovation and increased financial intensity as drivers of a great moderation, at the very time that they were creating enormous risks. And a failure to face the reality that a stable Eurozone would require quite different roles and rules for fully sovereign and subsidiary debt from those which existed in a system in which all the countries were full currency-issuing sovereigns. The former failure had intellectual roots in what many continental Europeans criticise as over confident and simplistic AngloSaxon laisiez-faire economics. The latter failure had roots in what many Anglo-Saxons criticise as continental European willingness to pursue a political project with insufficient attention to economic realities. Together they have combined to put us in a mess. One is reminded of Keyness words in 1931 We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand.20 But while Keynes believed that the muddle was colossal, he also believed that the problem was manageable. That no catastrophic Great Depression was inevitable provided that there was resolute action by central banks to start the machine again. Can we have that confidence today? In the previous two sections I have described aspects of long-term policy required to create a more stable system for the future. Much higher across-the-cycle prudential standards combined with macro-prudential countercyclical policy levers to prevent the excessive build up of real economy and financial sector leverage. And reformed prudential approaches to the treatment of subsidiary sovereign debt, to ensure better market discipline of sovereign debt issuance, and to reduce the dangers of a toxic interconnectivity between sovereign and bank solvency and liquidity concerns. But you could reasonably say that describing the long-term solutions the solutions which we would apply if we were designing the system anew is the easy challenge. The far bigger one is what to do now given the mistakes we have made and the situation which we face as a result. The fundamental problem is that we have too much debt in the system private and public combined. To create a more stable system we need to deleverage, in both private and public sectors, to different degrees in different countries. But once you have excessive leverage, it is very difficult to delever without depressing the economy. In the immediate aftermath of the bursting of a private leverage bubble, leverage across the economy tends not to actually reduce, but simply to shift from private to public sectors (Slide 19). But if the private sector and the public sectors attempt simultaneous deleveraging across all countries simultaneously, it is extremely difficult to do that without depressing nominal demand, with potential for self-reinforcing downward deflationary spirals of the sort described by Irving Fisher (Slide 20).21 We face indeed the danger that the very policies which we know are essential for greater long-term stability higher capital

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and liquidity requirements in the banking system and sounder fiscal policies underpinned by disciplines on public debt issuance may in the short run produce deflationary effects which depress our economies and thereby undermine our ability to delever. There are no easy answers to the dilemmas we now face. But one thing is clear: that in managing our way through these challenges, maintaining adequate growth in aggregate nominal demand will be of fundamental importance.
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Four routes to deleveraging

There are only four ways through which to achieve deleveraging: real growth; debt servicing; debt restructuring/default; or. some combination of inflation and/or financial repression which reduces the effective real burden of accumulated debt. The one we are all in favour of is real growth: that is the easy thing to say. And it is clearly therefore a priority for the new governments of Greece and Italy, and for other highly indebted Eurozone countries that they seek to identify and remove any structural barriers to medium-term real growth.22 But we also need to be realistic about how far real growth can possibly come to the rescue. Faced with todays high government debt burdens, some commentators are reassured by the post-war experience of the UK and US (Slide 21) which successfully reduced public debt burdens of 250% and 120% of GDP in 1945 to below 50% by 1970. But these reductions (Slide 22) were achieved with real growth rates of 3 and 4% respectively, and with nominal GDP growth rates of between 6 and 7%. Post-war Germany, France and Japan achieved still faster increases in real and nominal GDP. Such growth rates were achieved, however, in specific circumstances which, in many countries do not pertain today. Rapid workforce growth as a result of demographic factors, particularly in the US. And the potential for European countries, including the UK to achieve rapid catch-up towards a then distant technological frontier. Given the more limited opportunities for rapid real growth today, and the fact that our current high levels of public debt are now accompanied, as they were not in post-war Britain or America, by high levels of private debt, we have to recognise that the deleveraging challenge today is in some ways more serious than that which we faced at the end of the Second World War. The second route to deleveraging is debt servicing, paying down accumulated debts. And clearly that is an important part of the solution. Many countries need to reduce their public debt levels: many individuals and some corporates need to pay off debt as well. But if all countries and sectors try to do this simultaneously we will depress aggregate nominal demand, resulting in slow growth in nominal GDP. And whether low nominal GDP growth takes the form of lower real growth or low or negative inflation, that will make deleveraging via debt service more difficult and potentially impossible. The policy dilemmas that this creates have been explored by Richard Koo in his analysis of the last 20 years of slow Japanese growth and mild deflation, in which Japanese nominal GDP grew by only 0.7% per annum (and by only 0.1% per annum from 1992 onwards).23 In Koos account, after the late 1980s credit and real estate bubble burst and the Minsky cycle swung into a deflationary direction, Japanese corporates became so determined to pay down debt and repair their balance sheets, that this created a balance sheet recession in which the classic monetary policy lever of low inflation rates entirely lost any stimulative power. Koo makes a powerful case that in this context large Japanese public deficits were both: the natural consequence of deficient demand deriving from this corporate sector deleveraging; and essential, since without them Japan would have suffered not just two decades of low growth, but a full blown 1930s US style Great Depression. The question to which Koo does not provide an answer, however, is how the very large Japanese public debt stock, once accumulated, can ever be reduced. Thirdly, of course, there is debt default, restructuring, negotiated reduction the various mechanisms for reducing the value of debt by imposing losses on creditors. And obviously this too is an unavoidable part of the solution. This has now been

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recognised in the case of Greece, and as I argued above, mechanisms to allow controlled restructuring/debt reductions will have to be included in any future sustainable arrangements for subsidiary sovereign debt, and indeed they are already envisaged in the plans for the European Stability Mechanism. Private debt default and restructuring is also part of the mechanism for reducing private sector leverage. And across both public and private sectors, the system cannot be stable without the discipline of an ex-ante recognition of the possibility of default. But too much reliance on default and restructuring can drive a deflationary spiral of the sort described by Irving Fisher. In the US, household sector deleveraging is progressing somewhat faster than in the UK (Slide 23), partly as a result of a higher level of mortgage default. But that higher level of default is also a major factor currently depressing US consumer confidence and nominal demand. So while real growth, debt servicing and default/restructuring are clearly elements in the deleveraging process, the question cannot be avoided whether the optimal solution will not also need to include inflation, if necessary achieved by unconventional monetary policies such as quantitative easing or even more overt forms of public debt monetisation.24 That issue was clearly put on the table by Blanchard, DellAriccia and Mauro in February 2010, when they posed the question Should the inflation target be raised?25 And Kenneth Rogoff has, in a number of interventions, suggested that deleveraging across the developed world economies might be best achieved if we accepted a period of significantly higher inflation than typical central banks targets, for instance, as much as 4% or 6%.26 How should we assess these arguments? Well what is certainly the case is that previous major periods of deleveraging have often been accompanied by inflation above current typical target levels, and by buoyant growth in nominal GDP (Slide 24). Post-war Britain did not achieve a dramatic fall in the public debt ratio from 1950 to 70 by paying down nominal debt, but rather by achieving 7% growth in nominal demand, with 2.7% real growth combined with 4.3% average inflation.27 And what is certainly also the case is that determined central banks can increase aggregate nominal demand, and create inflation or indeed hyper-inflation, if they buy government debt in sufficient quantity, and/or if they are willing to fund new public deficits with central bank money. That fact should not be in doubt, as Ben Bernanke has persuasively argued.28 Rather the pertinent questions are whether it is desirable to do so, and whether it is possible to select just the optimal level of inflation, or whether inflation is a somewhat binary phenomenon, either very low and stable, or potentially accelerating and very high. And there are good reasons for being wary about throwing away the benefits which low and stable inflation have given us, and realistic about the ease with which debt burdens can be reduced via debt monetisation and higher inflation. The ability to reduce debt stock burdens via increased inflation depends crucially on the structure of existing debt contracts. Only if contracts are fixed in nominal terms and are long term in maturity, does a previously unanticipated increase in inflation help reduce the real debt burden. If instead debt stock is short term and/or variable rate, then the use of increased inflation as a means to achieve debt reduction will be undermined by increases in nominal interest rates. Roger Bootle and Julian Jessop illustrate that actual debt maturity structures in many countries may severely constrain the potential.29 And in the historic periods in which moderate (rather than hyper-inflation) did play an important role in reducing debt burdens (such as the UK in the post-war era) the process depended crucially on a degree of financial repression, on financial systems, which restricted investor choice in ways which made it possible to fund new government debt at interest rates below current inflation levels (see the period 1945 55 in Slide 24). The case for higher inflation targets or for price level targets is not therefore clearly compelling.30 But that conclusion is completely compatible with the belief that amid a deleveraging cycle it is vitally important to ensure that inflation targets are symmetric, that positive inflation is actually achieved and that, as a result, nominal aggregate demand and nominal GDP maintain a reasonable growth path. Japans path of nominal demand growth over the last 20 years, continued over the last four, has made aggregate economy level deleveraging (public and private combined) close to impossible (Slide 25). And the deleveraging challenge in the UK, US and Eurozone will become far more difficult, and potentially impossible, if aggregate nominal demand growth is not maintained at a reasonable pace. Achieving that nominal demand growth, and hitting symmetric inflation targets of, let us say, 2%, may well in turn only be possible if central banks are free to use the full range of possible levers, including those of quantitative easing i.e., temporary debt monetisation which have been deployed by the Bank of England and the Federal Reserve. And that brings us back to design flaws within the Eurozone structure.

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Debt and deleveraging: Long term and short term challenges

In the face of the deleveraging challenge, it is essential to have a central bank free to use all the levers including variants of quantitative easing to ensure that nominal demand is maintained at a level compatible with positive inflation. But if all public debt is subsidiary sovereign debt, it is impossible to conduct quantitative easing operations without the resulting purchase of specific national bonds being seen as an open invitation to national debt indiscipline. In an ideal future system therefore, the prohibition on the ECB monetising subsidiary sovereign debt would continue to be a highly desirable feature. And any operations to support national governments which have got into debt positions which the market will no longer willingly fund, should, to the extent appropriate at all, be the responsibility of fiscal rather than monetary authorities . But in that ideal system, there would also need to be a role for a Eurozone aggregate budget which could be run at a deficit for the purposes of automatic stabilisation And while ECB purchase of national subsidiary sovereign debt would be undesirable, the ECB would need to be free to purchase Eurozone level debt in quantitative easing operations if necessary to offset a debt deflation trap. The Eurozone as constructed has managed to combine features which simultaneously undermine subsidiary sovereign debt discipline and which constrain central bank freedom to take the measures required to avoid deflation traps. Alongside radical reform of the private financial system, major reform to the Eurozone structure is essential.
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Summary conclusions
Larry Summers has stressed that the central paradox of a recession which follows a credit boom, is that while we got into the mess through too much borrowing, and too little saving, too high levels of leverage in public, corporate, household and financial sectors if we all try to get out of it just by saving more, borrowing less and deleveraging, by paying off our debts, we will produce a still deeper recession which drives leverage, at least for a time, still higher. The implication is that we need policies to smooth the path of deleveraging: but if we do that, the danger is that we never actually remove the vulnerabilities that have built up. How to square the circle? What combination of policies is now required, both to create a sounder long-term system and to get us out of present problems? The answer is that the optimal solution must combine radical reforms which address both the excesses of the private financial system and the structural faults of the Eurozone, and that the transition must be underpinned by policies which maintain aggregate demand. The starting point has to be clear recognition that: The level of debt in a economy is fundamental to its financial and economic stability, and free markets can result in aggregate debt levels far above optimal levels, in volatile levels of debt, and in sub-optimally allocated debt. Sovereign debt is a very particular form of debt and subsidiary sovereign debt quite different from full sovereign debt. The Eurozone construct was flawed because of a failure to face that fact. Deleveraging is a huge challenge, which cannot be smoothly achieved unless aggregate demand is adequately maintained. This analysis pushes us towards a combination of radical reforms and policy actions: Private leverage and bank maturity transformation has to be constrained by capital and liquidity standards far higher than those which had developed pre-crisis. We must not divert from the Basel III reforms. And we need powerful macroprudential levers to contain credit and asset price cycles. The Eurozone architecture needs to combine tight political and market discipline of subsidiary sovereign debt with the creation of Eurobonds, and with an acceptance that if necessary the ECB can conduct quantitative easing operations at the Eurozone aggregate level. Aggregate demand has to be maintained, and if necessary should be via the ultimate tool of central bank debt monetisation. And central bank radicalism in monetary policy is a preferable way to maintain aggregate nominal demand than devices which delay the application of prudential standards, since these will only maintain nominal demand at the expense of also maintaining dangerously high leverage.
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Debt and deleveraging: Long term and short term challenges

1. There are other dimensions of the current Eurozone position and in particular the existence of large external imbalances between different

countries, and the resulting need for adjustments in relative traded sector competiveness which this lecture does not address. The root causes of those external imbalances however, lie in a combination of the two dimensions which this lecture does explore indiscipline in private debt creation and in public debt issuance.
2. Charles Goodhart, Globalisation and Financial Supervision, Where Next? Paper delivered at Bank of England/NBER Conference, London

September 2011. Forthcoming NBER publication.

3. Luigi Einaudi, Debts, in Luigi Einaudi, Selected Economic Essays, Palgrave Macmillan 2006. First published as Debiti, La Reforma Sociale

XLI, volume XLV No 1, January 1934.

4. By enabling households to hold shorter term financial assets than liabilities, this should in theory produce a term structure of interest rates more

favourable to long term borrowing and investment

5. Walter Bagehot, Lombard Street, a description of the money market, introductory chapter, Cosimo Classics 2006. 6. While these features are most obviously present when credit is intermediated via banks, it is important also to recognise that both these

features and the risks which accompany them, can be created via complex networks of relationships among non-bank institutions and markets which in aggregate perform bank like functions (the shadow banking system). The extent to which such shadow banking activities create money equivalents is explored by Gary Gorton and Andrew Metrick , Regulating the Shadow Banking System, September 2010. See also Adair Turner, Reforming Finance: Are We Being Radical Enough? Clare College Distinguished Lecture, February 2011.
7. Nicola Gennaioli, Andrew Shleifer and Robert Vishny, 2010, Neglected Risks, Financial Innovation and Financial Fragility, FEEM Working Paper

No 111, September 2010.

8. Ben Bernanke, Non-Monetary Effects of the Financial Crisis, in Essays on the Great Depression, Princeton University Press, 2004. 9. Richard Werner, New Paradigm in Macro-Economics: Solving the Riddle of Japanese Macro-Economic Performance: Palgrave Macmillan 2005,

provides an insightful analysis of the distinctive characteristics of bank credit creation. See also Adair Turner, Credit Creation and Social Optimality, Southampton University, 29 September 2011
10. As Alan Taylor and Moritz Schularick note in a recent paper In the monetarist view of Friedman and Schwartz (1963) and also in the recently

dominant neo-keynesian synthesis, macro economic outcomes are largely independent of the performance of the financial system. Credit booms gone bust, monetary policy, leveraged cycles and financial crises 1870 2008. NBER working paper 15512. November 2009.
11. Hyman Minsky, Stabilising an Unstable Economy, McGraw Hill 2008 (first published 1986). 12. In debates about the Basel 2 reforms , some regulators saw it as an objective to ensure efficiency n the use of bank equity capital. But while,

as result of limited liability and tax deductibility of debt interest, there is clear private benefit from minimising bank equity capital (i.e. increasing leverage) there is no necessary social benefit in doing so.
13. As will be discussed in Section 2, government debt is not necessarily risk free. But, using the terminology explained in Section 2, the full

sovereign debt of the UK and US, as currency issuing powers , was at the time effectively risk free in nominal terms.
14. IMF Global Financial Stability Review, April 2006, which noted that by enhancing the transparency of the markets collective view of credit risk

credit derivatives provide valuable information about broad credit conditions and increasingly set the marginal price of credit.
15. A strong case can be made that in an ideal world, bank capital requirements should be increased to a level significantly above those which

Basel III will establish. This case is well made by, for instance, David Miles, Ying Yang and Gilberto Marcheggiano, Optimal Bank Capital, Bank of England external MPC Unit Discussion Paper No 31, January 2011. The appropriate policy response starting from the present position needs however to reflect not only the ideal end point but the challenges of transitioning to a higher level of capital without harmful deleveraging. Basel III, as a result of its simultaneous reforms to required bank capital ratios and to the definition of both numerator and denominator, will very significantly increase bank capital requirements, it is an appropriate compromise between ideal and transitional considerations.
16. Jonathan Eaton and Mark Gersovitz, Debt with Potential Repudiation, Theoretical and Empirical Analysis, Review of Economic Studies 48

(April 1981), discussed in William Klein, International Debt Re-examined, Institute for International Economics, 1995, Chapter 1, Page 10-21, Debt Theory.
17. Carmen Reinhart and Kenneth Rogoff, 2009, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press. 18. As Reinhart and Rogoff have pointed out fully sovereign domestic debt is not entirely risk free even in nominal repayment terms. In extremis a

government may decide to default or restructure rather than to monetise, as the Russian government did in respect to local currency debt (GKOs) in 1998. And even nations which had apparent histories of always paying their debts, such as 19th century Britain, in fact sometimes performed forms of debt restructure ( e.g. via adjustment to interest rates). In general however e the probability of nominal value default/restructuring of fully sovereign debt is low, and the greater risk to investors has typically been monetisation and inflation rather of nominal default/restructure.
19. Jacques Delpla and Jacob von Weizscker, The Bluebond Concept and its Implications, Bruegel Policy Foundation, March 2011. 20. John Maynard Keynes, The Great Slump of 1930, The Nation and Athenaeum, December 1930.

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Debt and deleveraging: Long term and short term challenges

21. Irving Fisher, The Debt Deflation Theory of Great Depressions, Econometrica 1 (4), p 337-357. 22. The initial impact of some structural reforms which increase medium-term growth prospects may, however, be to depress consumer confidence

(e.g. through the impact on employment security ) and thus short-term demand and growth.
23. Richard Koo, The Holy Grail of Macro-Economics, Lessons from Japans Great Depression, John Wiley and Sons, 2009. 24. A wide spectrum of debt monetisation options can be defined. These range from QE operations which entail the temporary purchase of

existing debt stock (with subsequent reversal via resale of the debt purchased) to the overt and permanent finance of increased fiscal deficits with no intention of future reversal (Friedmans helicopter money). In fact, however, since it would be possible for apparently permanent operations ( helicopter money) to be reversed by subsequent overfunding of fiscal deficits ( withdrawing money from circulation) and possible conversely for an apparently temporary operation (such as QE) to become de facto permanent since never subsequently reversed, the essential difference between the options resides solely in the expectations which they generate as to future central bank actions, which are in turn influenced by the legal objectives of the central bank (e.g. inflation targets) and by the credibility of its commitment to those objectives.
25. Olivier Blanchard, Giovanni DellAriccia and Paolo Mauro, Rethinking Marco-Economic Policy, IMF Staff Position Note, 12 February 2010 26. See, e.g., Kenneth Rogoff, The Bullets Yet to be Fired to Stop the Crisis, Financial Times, 8 August, 2011 27. Looking further back it is sometimes pointed out that Britain was able to reduce a debt burden of 260% at the end of the Napoleonic Wars to

30% in 1914, while also sticking to the gold standard, and paying significant real interest rates. That, however, was in the context of a state which performed such minimal functions apart from fighting wars that it was able continuously from 1815 to 1850 to devote more than 50% of all government revenues to debt servicing.
28. Ben Bernanke, Japanese Monetary Policy, A Case of Self-Induced Paralysis, in Mikitani and Posen, Japans Financial Crisis and its Parallels

to US Experience, Institute for International Economics, persuasively argues the case that a central bank willing to use all available tools can always if it wishes stimulate aggregate nominal demand.
29. Roger Bootle and Julian Jessop, Does Inflation Offer a Way Out of the Debt Crisis?, Capital Economics, 13 June 2011. 30. Price level targeting could be seen as essentially a device to facilitate a period of above target inflation while maintaining a clear target based

discipline to constrain the extent and duration of the inflation overshoot.

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