Economic Policy Must Address Excessive Private Sector Leverage

Adair Lord Turner, former Chairman of Great Britain’s Financial Services Authority and current Senior Fellow at the Institute for New Economic Thinking, will argue in a keynote address to the Federal Reserve Bank of Chicago on Thursday that central banks must be equipped in future to address the dangers of excessive private sector leverage, using both pre-emptive interest rate policy and macro-prudential policy tools.

Speaking at the sixteenth annual International Banking Conference sponsored by the Federal Reserve Bank of Chicago and the International Monetary Fund, Lord Turner will explore the central role that credit cycles and high leverage have played in advanced economies.

Specifically, he will stress that:

  • “Financial deepening” is not in always beneficial. In particular, if financial deepening is defined as an increase in total private sector credit to GDP, or of banking assets as a percentage of GDP, an increasing body of economic theory and empirical research suggests that beyond some threshold further financial deepening could be negative for long-term growth.
  • The harmful effects of high private-sector leverage had become clear in the aftermath of the 2008 financial crisis. A “debt overhang effect” was depressing demand as households and corporations (to different extents in different countries) sought to reduce debt levels that they now considered excessive. In most advanced economies the fiscal challenges were not the result of past public profligacy. Rather, they were caused by pre-crisis increases in private sector leverage followed by attempted post-crisis deleveraging.
  • Different types of credit perform different economic functions. In modern banking systems only a small proportion of credit takes the form on which most economics literature has tended to focus – lending to businesses to finance fixed or working capital investment. Credit extension is heavily biased towards lending against residential and commercial real estate.
  • Both the level of private sector leverage and the balance between different categories need to be recognized as matters of macroeconomic importance. Macro-prudential policy cannot therefore focus solely on financial system stability narrowly defined, e.g. a low probability of major bank failure. It must also seek to contain rapid credit growth and high levels of private sector leverage.
  • The macroeconomic policy toolkit available to central banks needs to include not only countercyclical capital buffers, but also direct borrower constraints such as maximum loan-to-value (LTV), or preferably loan-to-income (LTI), ratios.
  • The central importance of the credit cycle carries implications for the relationship between central bank monetary and financial stability objectives and policy tools. An increasingly coordinated approach will be required.

Lord Turner’s comments will focus on long-term policies required to avoid a repetition of the policy mistakes which led to current conditions. He will reiterate his belief, set out earlier this year in a lecture at the Cass Business School in London, that in some economies the deflationary impact of debt overhang is so great that the full range of available policies, including previously taboo options, need to be considered.

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