Adair Turner, former chief of the UK Financial Services Authority, is the new chairman of the Institute for New Economic Thinking. He tells DW calibrated use of the ECB's balance sheet could end the eurozone crisis.
INET is a network of top-flight economists founded in the wake of the 2007-8 global financial crisis, generously funded by several intellectually ambitious billionaire philanthropists. Its mission: To reinvent economic theory and reconnect it with the real world. Adair Turner took over INET's reins on the occasion of the network's sixth annual conference in Paris.
DW: Lord Turner, you've been giving talks about how to deal with the consequences of huge debts left hanging over an economy after asset price bubbles burst - like the real estate bubbles in Spain and Ireland. How does your approach differ from that of German economic policymakers?
Adair Turner: The Bundesbank was ahead of many other central banks in that it was skeptical of pure inflation targeting. It had a policy of managing monetary aggregates as well as interest rates. But the Bundesbank's idea was that if the money supply is growing too fast, that's a forward indicator of inflation. Actually it's not. It's a forward indicator of an asset price bubble. When the bubble eventually pops, the result is deflation, not inflation. The reason is that when people try to "deleverage," or pay down debts on a net basis, that causes the money supply to shrink - and aggregate demand to shrink with it.
Why does the money supply shrink when bank debts are repaid?
Banks create the circulating money supply when they grant credit to borrowers. Bank debt and bank credit - the latter is what we commonly call "money"– are two sides of the same coin, mirror images on banks' balance sheets. When bank debts are paid off, both the debt and the money used to pay it off disappear.
If more bank debt is repaid than is created in a given time period, the result is a reduction in the circulating money supply, and that means a reduction in purchasing power. The result is a recession, or even a depression. The economist Irving Fisher described the basic process in the 1930s in his theory of "debt deflation."
Germans don't like being in debt and don't like their governments endlessly piling up debt, either. Isn't there some other way of dealing with the aftermath of a bubble?
Yes, there is. But you need an additional tool to prevent deflation in the face of general deleveraging. You have to allow the central bank to give carefully calibrated amounts of debt-free money to governments to spend into circulation.
But Eurozone rules prohibit central bank funding of governments.
Yes. The prohibition was put in place at the Bundesbank's insistence, because of a fear that if any monetary financing of deficits were allowed, governments would get carried away, print far too much money and create hyperinflation.
Now, a medicine can be a cure in small doses, yet be a dangerous poison in high doses. But does it therefore make sense to forbid that medicine from being used at all? No. What you need is sensible rules about dosages and procedures for carefully monitoring how the patient responds to them - and a qualified doctor who administers and adjusts dosages based on the observed results.
The ECB's balance sheet could be used to end the eurozone crisis. The way forward is to set clear rules in advance, defining under what conditions, how and to what extent financing of eurozone government deficits with sovereign ECB money would be allowed.
The rules should leave decisions about how much monetary stimulus the ECB provides entirely up to the ECB. The central bank would retain its policy independence. We'd merely be giving it a new tool to improve its ability to manage monetary aggregates and prevent depressions.
Sometimes central banks face the opposite challenge - inflation, not deflation. Does the ECB need additional tools to take money back out of circulation when the economy is overheating?
The ECB has a large stock of sovereign bonds on its balance sheet. When it sells bonds back into financial markets, reserves are moved from investors' balance sheets onto the ECB's. That's a basic tool the ECB already has.
Alternatively, the central bank could impose reserve ratios on banks - the amount of central bank reserve money they need to hold as a proportion of their loan book - and it could increase the required ratio when the economy is heating up, to constrain commercial banks' ability to make new loans.
One can imagine a variety of additional possible calibration mechanisms - ways to either increase or draw back money from circulation as needed - depending on the state of the economy. As long as the rules are clear and well designed, there's no risk that monetary financing of government deficits would get used to excess.
What we need right now is a injection of fiscal spending to increase investment and aggregate demand - and because governments feel constrained by their existing debt burdens, the best way forward is for the central bank to provide debt-free money to European fiscal agents to spend into the economy, money that needn't be paid back. That's the medicine the Eurozone needs at present to overcome its doldrums.
The Eurozone needs other medicines too - including structural reforms in various regions to improve competitiveness. But such reforms cannot restore growth by themselves, since they tend to put downward pressure on wages and hence on spending-power.
Robust demand has to be restored as well. That requires offsetting governments' and households' desire to deleverage, or reduce their net debt levels, with a source of debt-free money of similar or greater size. The ECB could provide that. Ironically, we currently have a rule against using precisely the medicine that could restore demand-led growth to the eurozone.
Lord Turner became head of the UK's FSA on September 20, 2008 - a week after Lehman Brothers went under - and steered the UK's main financial regulator through the ensuing five years of crisis and post-crisis management. Previously, he'd been a director, vice-chairman or chairman of a redoubtable list of private and public sector institutions and regulatory committees.