 I think it says on the agenda for this afternoon that I'm going to talk about the background theory and that is indeed what I'm going to talk about. So, apologies for anybody who isn't expecting a lecture of economic theory, because that's what you're going to get. Because I think it's rather important to go through some fundamentals of the theory about the way we think about the nature of banks, y dyfodill hwnnw i'r ffordd ymddi'r cyfwyr yw'r cyffredin iawn, byddai'n gwneud o'r hyfforddiad ohol yma sy'n ei ffordd ymgyrchion o'r cyffredin iawn ar gweithio 2008. Rwy'n fydag bod o'n gwneud o'r wych yn ychydig o'r cyffredin iawn o'r ysgwrdd ar y llwygau yma. Rwy'n rydyn ni'n meddwl gyda'r cyffredin iawn. Mae'r gweithio sydd o'r bankers yw ddyn ni'n meddwl gweld ac ydym ni'n gweithio i gael nid o bobl oedd y ddweud, oherwydd dyna'r ddweud, diwrnod o'r ffordd yma, os ydych yn gweithio gael a'n ffordd o'r ffordd o'r ddweud. Mae'n ddigon yw'r rhai, rhaid, fel'r ddigon yw'r ddweud, mae'n gweithio i ddim ddweud yw'r ffordd o'r ddweud, ond mae'n ddigon o'r ffordd o'r ddweud, oherwydd ddweud efallai rhaid o'r ddweud o'r ddweud o'r ffordd o'r ddweud, i'w ddweudio'r ysgol yn hynny'n eu cyd-fyrddau'n gwirionedd yn ychwanegwyr. Abertyn nhw'n gweld y cyd-fyrddau, efallai yw ddweud o'r ffyrddau central, sydd gyda'r byd yn cael ei wneud yn ymddangos y byddwyr ymddangos ymddangos ymddangos ymddangos yw'r cerddau a'u cyfnodol, ar y dyfodol yma. Mae'r fedrall o'n meddwl, sy'n meddwl i'w gwaith, yn ymddangos ar gyfer gwneud ymddangos yma, Cyfrif neu beirach y gwirionedd ers sgwrth gwrdd dangos o'r ffordd yma, eich rydyn ni'n gwneud cyfnod yr ymchwil o'r mawr, a'r bwysig i fynd a chyfrif adeiladau yn y 30-ynghen mawr. A gael ar hyn o'r bwysig ffwrdd y hynny, mae'n modd o'r cyfrif ffwrdd o'r bwysig. Y Cyfrif yng nghymru gweithio i southwng Sefydluf ar y gwaith, eich cyhoedd hwn o'r blaenwyr, ac mae'n ymwneud o'r cyfrif yn y ddechrau, ac mae'r cyfrif a'i mawr neu ar peilos chi'n ddysgu bod yw'r isgwyl yn fwy o SME byddwch'i bwysigol yn ddysgu. Y CBC wedi'u cyffredinol i'n ddysgu, mae'n ddysgu i'r hyn o'r ddysgu, yw'r ddysgu i'w lŵn o'r ddau'u ddau'r rhefyd, ac mae'n gweithio, eich bwysigol, ni ddysgu i'r ddau'u bwysigol. Mae'n ddau'u'r ddau'u bwysigol i'r ddau'u bwysigol i'r ddau SME. Selly gallwch yn creu'n feu llwydon. Mae'r llwydon wedi allanol yn ei wneud i wnaeth autynnal ac y gyfnod llwydon. Mae'r llwydon yn cyrraedd ac yn y mwybu lyricid, mae'r llyfrhewch arll takeno'r llwydon. Yn rhai, mae'n credu i'r rhaid i'r ffag لwpas y Llwydon. Rhaid gennym i'r hefyd, Mae'r bwysig iawn o'r ddechrau amser yn dd responsible ashwn mae'r bwysig iawn o'r gwaith yn bro ryngwyr ac mae'n ddengholi ac mae'n o'n gyfrifiadr o'r arbennig iddog yn gweithio Ffampedigol ac mae'n oeddech chi i ddod ar y lliweddau o'r gwybarth aol. Ond gallu ddod arw y gweithi ddod o'r gwybarth allunio o'r gwybarth i'n gwybarth ac oeddiwch cael bod eu gweithleidig oedd yma sydd wedi bod y sectorol argriffeidliant felly mae'r geshynol ffysgol ac'r geshynol yn cael ei ddweud yw'r gweithio'r rhaid o'r gweithio'r ddisgrifennu yn ymgyrch i'r economiaidd, ac mae'r gweithio'r gweithio arall yn ddaw yn ymgyrchio'r ddweud. Gweithio'r gweithio'r ddweud, ond lete fi i adnwch yn gweithio ddweud yma, yma yma yma yma yma yma yma yma yma'r ymgyrchio'r 2008, ac yma'r ymgyrchio'r wych, yma'r ymgyrchio'r 2008, felly mae'n mynd i ddim yn fawr yn ymweld. ac mae'n dweud o'n edrych i gyffredinol i ffaffr gyrddio'r holl ddechrau 2008. Yn y taeth, mae'n dweud o'r ddechrau arall, ac mae'n dweud i ddim yn dweud o'r ddechrau a'r ddych chi'n ddweud o'r ddweud o'r cadw hefydau ar y casgynodau sydd yn 2007. A'r ffyrddiau cascynodau, mae'n ddweud o gweithio'ch gweithiau ac, iddo yn gweithio'i gwylltiau, y bodi'r ffordd o'r dyfodol yn y dyfodol. Mae hyn yw'r ffordd. Mae hyn yn ystyried y sgol yma yn y tyffydd yma o'r tawr o gyfnodau ar gyfer y cyfnodau yn y 1930. Felly, mae'r bryddol yn ysgol yng nghaeliau yma ym 1830, mae'r brydol yn lluniau'r cyffredig, unrhyw o'r cyffredig lluniau, oed yn ymwyl gennym yn honno i'r dysgu'r cyffredig yn gyfryd. Ond rydyn ni ymwyl yn ysgol yma o'r 2007 a 2017 ar y DU. Felly mae'r cintasrafau fyddem yn ystyried. Mae'r cwerthoedd yn deall yn dweud y byddwyd a'r cyfnodd yn ymddangos. Mae'n bwysig i gael d mattech ac mae'n gryf. Roeddwn i ddim yn bwysig bod y gwrth ymlaen chi yw'r ysgolion o'r cydwylliant o'r cydwylliant. Felly mae'r cydwylliant i'r gyfnodd Cymyn Rhynharddon i Kenroghaff, y llaw o'r cydwylliant i November, a mae'r cydwylliant o'r cydwylliant o'r GDP, mae'n cydwylliant o'r cydwylliant, o'r banydd o'r cyfnodol, o'r cyfnodol, o'r cyfnodol yn ymgyrchol, o'r cyfnodol yn ymgyrchol. A rydych chi'n gweithio, o'r cyfnodol yn 1950, oed yn 50% o'r GDP, ac o'r 2007 oed yn 170% o'r GDP, oed yn oed yn oed yn oed yn oed yn ymgyrchol. Yn ymgyrchol, mae'n gweithio'r gweithio'r cyfnodol yn ymgyrchol o'r economiaid. Maen nhw'n gweithio ar y cyfnodol yw'n gweithio'r gweithio'r cyfnodol. Mae'n gweld a schuqol o'r mynd i ddau wahanol, felly mae hynny o chredigol pethau a chlyw gynhyrchu'r ddymarfa. Felly d抽 y ffyrdd, hefyd, bydd gennodd cyfnodol, â'r gweithio ar gyfer ddechu gaffai, â ddwech gael bod yma yn rhan o'u cyffiniddol benyn a'r gweithio'r ymgyrchol. Mae'r bynain ychydig wedi bod ydych yn ffordd am y syniad bwrdd ffaith ynnw'r wathbwrdd bwrdd ffaith ynnw'r wathbwrdd ffaith ynnw'r wathbwrdd bwrdd. Ond yn anodd y gallwn bod ydym yn gweithio am yr hynny yn y cyfnodol. Mae'r amser ffawr yn ymddiolol yn ymddirionedd, yn ymddirionedd, yn ymddiolol, yn ymddirionedd, yn ymddirionedd, yn ymddiolol, ac yn ymddirionedd, yn ymddiol, ..on cymryd i chi am wneud yn y cyfnod.. ..y'r project yw'r ysgrifennu yw'r ysgrifennu.. ..y'r ysgrifennu yw'r ysgrifennu yw ddigonol yn ymgyrch yn eich ffilosofiad.. ..y'r ddweud ydym yn ei bod yn fawr ymddiad.. ..y'r ysgrifennu yw'r cyfnod cymryd yw'r cyfnod.. ..y'r cyfnod fwy o'r ddymprwy o'r ysgrifennu.. ..y'r fwy o'r ysgrifennu yw'r cyfnod yw'r cyfnod.. gyda'r felwad, ond rwy'n meddiwch o'ch cymryd ddechrau a phoessus sicrhau gywir i'w beth o'r cyfrifiadau arddangos. Rwy'n meddiwch chi'n meddiwch i'r cysyllt o'r cyfrifiadau peddwch felwad dweud, fod y fanchorau fawr yn gallu sy'n gweld yn cael ei gwirigol iddo i ddweud cyfrifiadau ar y proscieffol gyda'u aelodau yma, i wneud yn cael ei zeulu cyfaint yn credu y casiable. Ond y ddiwg arwain er mherwysaeth 19th o'r gweithio o'r economi. Mae'r awgurdad yn ymwybodaeth yma yw ddim yn fawr yn cael ei wneud o'r ddechrau ac mae'n dweud o'r iawn o'r cyflawn. Mae'n dduch ar gyfer y cyflawn ar gyfer y gwaith. Mae'n dduch ar cyflawn o'r cyflawn o'r cyflawn o'r cyflawn o'r cyflawn. ..y'r cymdeithasol ond yn ym hyffordd pethau yn gweithio'r llaw. A oedd yn y cyfrifolau cymdeithasol o'r cyfrifol yn y cyfrifol.. ..y'r cyfrifolau cyfrifol yn y pethau. Yn y cyfrifolau, ond mae'n ffordd a ffordd yw ddau cyflwyddoedd.. ..y'n ddiweddol ffynanc o'r ddeunydd. Mae'n beder yw'r cyfrifol gwiriaid gynhyrchu'r cyfrifol ac yn ymgyrch.. ..y'n beder yw'r cyfrifol.. a byddwch i gwasanaeth ymwneud y cyfnodd cyfnodd pan falle ymwneud o'r eu Llyfrgell. A ddod yn cael ei gilydd, yn y ffwrdd, yn y stryd, ac yn y ffwrdd pan yn awr, yn y Llyfrgell yn y ffwrdd yn y Llyfrgell. Dwi'n arbennig, mae'n gwneud o ffwrdd cyfnodd cyfnodd cyfnodd cyfnodd a gweithio. Ond ydych chi'n rhaid i gael gweithio'r cyfnodd. Felly, mae'n cyfarwadau i'n gwneud yn ddefnyddio 50% i 10%. Felly, mae'r cyfarwadau i'n gwneud yn ddefnyddio, mae'r cyfarwadau i India sy'n ddefnyddio 10% i GDP, dyfodol yn galludsodol penedigol sy'n gwneud yn 50%. Mae ddyn nhw'n gweithio sydd gen i ni ddau 50%, 100% yn ymlaen, 170% yn ymlaen. Felly, rydw i'n gweithio, ond yn ymlaen, And thePEs were telling us financial deepening more debt to GDP is better. For the macroeconomists, the people who study Modern Monetary Theory and the people in Central Banks, their philosophy was basically that whatever was happening in the financial system was neutral, could be ignored. Some people are really startled by that fact, but it is true. Mae'r bwysig y dystiad cyfnod o'r economi ar gyfer dynamic stocasticaeth general y Llywodraeth yn ymgyrch. Mae'n rhan i'r cyfnod ffordd o'r system cyfnod. Mae'r cyfnod ymgyrch yn ymgyrch yn ymgyrch yn yw'r peth yma, yn cyfnod ymgyrch yn ymgyrch yn ymgyrch, yn cyfnod ymgyrch, oherwydd ymgyrch ar 800 pethu, rydyn ni'n ddod ymgyrch yn y system cyfnod. A'r cyfnod, mae'r Llywodraeth, ond we assumed we could ignore much of the details of the financial system. Or, Mervyn King, the dominant New Keynesian model of monetary economics, lacks an account of financial intermediation so that money, credit and banks play no meaningful role. Again, quite a sort of startling point that because you'd have thought that it's pretty obvious that interest rates work through the financial system. But there was a philosophy developed that the financial system it was described as a veil, a sort of translucent veil through which interest rates passed to impact the real economy but were sort of unaffected by the details of what the financial system was up to. So, that was, broadly speaking, the pre-crisis orthodoxy and that is what enabled us to look at this development and say either it was of no importance, we could just ignore it, it was of no more importance to the economy than if people wanted to consume more ice cream or more cars. That's what they want to do, but it's not macroeconomically important or it was positively benign. But those points of view were, I think, based upon two mythologies. If you pick up an undergraduate textbook of economics or indeed many advanced textbooks and advanced papers in economics, they will tell you two things. One, they'll say banks take deposits of money from savers and lend it to borrowers. And secondly, they will say or they will imply that the vast majority of the money is lent to entrepreneurs' stroke businesses who allocate that money between alternative capital investment projects. So, the iconic description which we repeat again and again and we bring up generations of new economists at university on is banks take money from the household sector's deposits and they lend money to entrepreneurs' stroke businesses. The trouble is that as descriptions of what modern banking systems do, this is mythological and so mistaken as to be dangerous. It is wrong in two respects. First, banks do not simply take money and re-lend it. They create credit, money and purchasing power. That's what banks do. At the moment they lend £100 to an entrepreneur, they put £100 into that entrepreneur's account. But that could also be for a household at the moment where they lend money to somebody to buy a house, they put it alone and they put the money into their account. Now that entrepreneur or that household, then on the very next day, probably goes and spends that money to a supplier or to somebody who's selling them a house, but the money still stays within the system. The system has more credit and more money. This is absolutely central to the way that monetary economies work. It was central to the writing of Cynutavich Sel, of Friedrich Hayek, of Joseph Schumpeter, of John Maynard Keynes in his treatise on money, and it is broadly speaking an insight which to an extraordinary extent fell out of modern macroeconomics from about 1980 onwards in what I describe as the strange amnesia of modern macroeconomics. It is fundamental. If we don't understand this, we do not understand the dynamics of how modern economies work. So that's mythology number two. The second mythology, however, is most lending is not funding capital investment. Of course it might be. Sorry, I have to point at that, don't I? But I want to focus on three conceptually distinct functions of lending, which I think are important for us to understand. We can lend money either through capital markets or through banks to finance new capital investment. That could be in non-real estate, could be in commercial real estate, it could be in residential real estate, actual new construction. It could be in human capital. Some people think of student loans as loans which support human capital investment. So there are various categories of capital investment which can be funded by new loans. But loans can also finance increased consumption. They can simply say there are some people who are either patient people and impatient people or richer people and poorer people and that either the patient or the rich lend money to the impatient or the poor and it's quite important to know which of those relationships it is. And economic theory says, well, that could be good because it enables what we mean called inter-temporal shift of consumption within the lifetime income constraint. But even if that is true, it's a very different form of lending than lending money for capital investment. But we can also lend money and the crucial thing to understand about modern financial systems is this is what they primarily do, is you lend money for the purchase of existing assets. Now that could be collectibles work of art. It could be existing businesses through leverage buyout. But by far the biggest is lending money to buy real estate. That already exists. And I just want to focus your attention on the fact that you could imagine a country which had a fully stable population which for some reason was completely happy with how many houses it has which was constructing no new houses whatsoever and you could have very significant increases occurring in the amount of credit extended to buy existing houses, right? And indeed in the UK before the crisis, unlike in Spain and Ireland where there was quite a lot of new construction, that is primarily what was going on in our credit and asset price boom. It was primarily a credit and asset price boom in the purchase of existing assets. To a significant extent, modern banking systems finance a competition between ourselves for the purchase of real estate which already exists and effectively for locationally specific real estate which ultimately means for the land on which that real estate sits and I'll come back to the importance of that later. Now just to give you an idea of the figures, it's actually not easy from the figures to exactly lining up with capital investment, with purchase of existing assets and with consumption because the same lending can perform more of those functions. But on any reasonable basis, if you take UK bank lending in 2009, probably only 15% of it effectively funded new productive investment. The vast majority of it funded the purchase of existing assets or it funded consumption. Now as they say, that's not necessarily a bad thing. We may need that in our economy but it is a bit alarming that 85% of what modern banking systems do is quite different from what our economic textbooks say they do and from which what an awful lot of economic commentary says they do. This however you might think, well this is Britain, I mean we all know Britain's are completely bonkers about housing markets etc. But other sensible countries, they'll be different from this. Well, it's not true. There's a wonderful piece of work being done by three economists, Oscar Yorda, Maurice Shulleric and Alan Taylor. Alan is based at University of California Davis and what they've done is they've constructed a dataset of what the banking systems do in 17 advanced economies going back to 1870. And they are able to show how much of that lending is against real estate. And broadly speaking you can see some extraordinary ups and downs which have to do with the impact of hyperinflation and wars but sort of ignore that. Broadly speaking from about 1870 to 1950 ignoring the amazing ups and downs of wars and hyperinflation etc. we're sort of at about 35%. And then from the post-war period onwards the percent of what banking systems do which is devoted to real estate goes up and up and is now at about 60% for all banking systems across the rich developed world. And this by the way is just residential real estate. You've got commercial real estate lending on top of that. And the conclusion which Taylor Shulleric and Yorda Reach is the following. With very few exceptions the bank's primary business consisted of non-morgage lending to companies in 1928 and indeed in 1970. But by 2007 banks in most countries had turned primarily into real estate lenders. So again they make the point I'm making the intermediation of household savings for productive investment in the business sector the standard textbook description of the role of the financial sector constitutes only a minor share of the business of banking today. Now whatever our point of view on that it's good things or bad things. We need to understand it. We can't understand the way modern capitalist monetary economies work without understanding that. Why is this so important? Well the reason why it's so important is where the majority of lending is against real estate and where in particular real estate is to a degree locationally specific and in scarce supply. Everybody wants to live in the nicer part of towns if they can afford to or we're in a reasonably densely populated country where we're not going to just build more and more on the green belt. In that environment the extension of credit tends to produce a very strong reaction of asset prices and indeed what we get is these amazingly strong credit and asset price cycles where the amount of credit which extended increases the asset prices which then induces both in the minds of the borrowers and lenders a further acceleration of the cycle. The inner circle is on the borrower side the more that the price of real estate whether it be houses or commercial real estate goes up the more that people expect there to be future increases in real estate and therefore the more they want to borrow either to make money out of it or simply in order to not losing money out of it the classic I've got to get on the housing ladder because otherwise I'm going to lose out at motivation. And then on the outer wing increased asset prices mean that for a time nobody's defaulting on credit to real estate therefore the loan losses occurred by banks are low therefore banks feel more confident therefore they have also an increased capital base making more profit therefore they arrive at favourable assessments of credit risk therefore they're willing to lend more. These cycles are absolutely fundamental they are not part of the story of financial instability they are again and again and again the story of financial instability. We get the upswing of the cycle and then the red cycle is just the same in reverse what happens in the downswing this is the pattern before the crisis house prices going up because household debt as a percent of GDP goes up and as I say if we look at the causes of financial crisis certainly over the last 30 years it is fundamentally credit and real estate prices that is the cause of the Japanese financial crisis of 1990 the Scandinavian financial crisis of the early 1990s the Texas of the early 1980s the Massachusetts of the early 1990s and the latest. It's just the pattern repeats again and again and again I want to say one final thing however about this which is why are modern economies so real estate intensive and the story I want to tell is part of the reason why is not going to go away modern economies are going to be more real estate intensive but we have to realise that once you once the general natural tendency for that to occur is observed the system has a tendency to take it to excess let me explain what I mean first of all let me point out that the value of real estate is fundamental to modern economies many of you I'm sure have read Thomas Piketty from the beginning to the end now what is interesting about and this chart is taken from Thomas Piketty's very very fine I think capital in the 21st century is a huge contribution an amazing database he's pulled together you don't have to agree with every bit of his analysis to admire an extraordinary piece of empirical economic analysis and what Piketty of course has pointed out is this fascinating move in the ratio of wealth to national income wealth to national income used to be about 700% in the 19th century fell to sort of to 300% in the 1920s and then is going back to the sort of 5-600% that we saw in the 19th century that is a crucial part of the Piketty story what I think he has not adequately focused on and I've exchanged emails with him saying well why didn't you stress this point because it's in your own figures is that the vast majority of the increase in the wealth to income ratio is explained by this green band and this band is housing we see over the previous two centuries a collapse in the importance of agricultural land as a source of wealth but we see from the 1950s onwards a relentless increase in the importance of real estate as a percentage of wealth and indeed if you look at all the figures even for countries like Germany that we think of not having big real estate booms one finds that the majority of the increase in the wealth to income ratio which Piketty has set out is always explained by real estate and fundamentally it's not explained by the construction of real estate it's constrained, it's explained by the increase of the land value I am fortunate enough to live in a very nice house in London which is now worth something like seven times what I paid for it in the early 1990s there isn't a brick has been changed I put in a new kitchen but that's not why it's gone up seven times this somewhat small patch of land it can be no bigger than this room on which my house sits actually considerably smaller than this room has somehow gone up enormously this story of the value of urban land is fundamental to modern economies why is this going on? I think what we have is an interface between three factors the first I think we have to accept that the desire to compete with one another for the ability to live in the nicer part of town or to stay at the hotel which is closer to the beach or is closer to the skiing piece or closer to the centre of town if that's what you like doing is a high income elasticity activity that as people either in general across society or in the upper half of the income distribution or something like satiation in how much food they have or how many clothes they have they will devote an increasing proportion of their income to essentially competing with other people for the right to live in the nicer rather than less parts of town so part of it is a high income elasticity of demand which I suspect means that even in the absence of any credit system would be likely to produce an increase in the wealth income ratio as it relates to real estate but it's naturally arising we're not going to avoid that modern economies are going to be real estate intensive the very same processes that keep the value of this continually collapsing as a result of technological advance which means that there's a limit to how much money however hard you try you can spend on iPads and mobile phones etc means that you devote more of your money to paradoxically the least high tech thing of all which is why I call the modern economy the high tech high touch economy the more high tech it is the more we value the things whose value does not collapse because of technological progress the trouble is that the moment we all observe that that's going to occur land becomes an investment asset because the very fact that it is likely in some way to go up faster of income makes it logical for people to say well I better get into that or I better buy two of them or I better buy three of them I better buy to let landlord and therefore it becomes an investment asset class but it is also an investment asset class which is the easiest thing for banks to lend money against because when you lend money to a business proposition you've got to sit down and do some analysis of a business proposition when you lend money against a house you can if you want lend money simply against the value of the house the collateral of the house so we have a tendency and let's remember that banks can create credit, money and purchasing power and so we end up with an inelastic supply of locationally specific land and a potentially infinite supply of credit and private money creates an instability at the centre of our financial system and of our modern economies I think this is fundamental to understand but the bit we're focusing on today is where credit and private money comes into it so that's my story of what is the core of instability but let me make two things clear why does the growth in leverage matter and how is it possible without stimulating inflation I should have mentioned earlier when I mentioned the point of view of the macroeconomists that the rising credit was neutral they basically said it's neutral as long as there isn't inflation so they observed that growth of private credit they said growth of private credit is occurring but as long as the inflation rate is only about 2% then we're in the middle of a great moderation and indeed they had a thesis that I'll come back to as to why as long as they were hitting price stability it must be the case that credit however much credit was a good thing so that's the second question I'm going to ask but first I want to be clear why is the growth in leverage matter I mean obviously it can produce the green cycle and the red cycle but why is that more than a cycle why have we ended up in this deep post crisis recession the essence is what I call, what lots of people call the debt overhang and I think the fundamental reason why we are now six years into this recession and have such low growth is the debt overhang effect let me explain what that is we ought to have understood that it was going to occur because we had a canary in the mine and the canary in the mine was Japan Japan in the 1980s had a huge credit and real estate boom some of you may remember those mythological stories of about 1988 where somebody who'd worked out that the value of the land of the imperial palace if you could only build high rise offices and hotels on it was worth more than the whole of the state of California probably an urban myth but even though that was an overstatement extraordinary value of land in urban Japan in particular Tokyo are all funded by credit and what you had was a set of private non-financial corporates PNFCs who were borrowing money the red line here, a sector financial deficit borrowing lots of money and even companies whose fundamental business electronics or cars were saying why don't I get into a bit of commercial real estate development on the side it was an absolutely crazy credit and asset price boom what happens in about 1990 is that the boom turns to busts and that the real estate prices having gone up four times fall 80% they fall back to where they were and the crucial thing is what has happened to the red line what you have is a whole load of corporates which now feel that they are over leveraged they feel oh my god I borrowed all this money against real estate the value of real estate has collapsed and because it's collapsed I'm now determined to do one thing which is to pay down my debt and I pay down my debt by not investing by converting my cash flow in an attempt to pay down my debt it's what's called what Richard Coo in a very fine book calls a balance sheet recession the corporates become focused not on decisions at the margin about innovation or new investments they get focused on their balance sheets they want to cut their investment that pushes the economy into a recession the offset however naturally arising and essential is the blue line because when the economy goes into a recession the public deficit moves from a surplus into deficit because unemployment benefits go up and taxation receipts go down and not only does that occur automatically but according to Richard Coo and others it was a good thing that happened because if it didn't happen Japan would have faced not just a decade of low growth but an absolutely massive great depression because remember there are basically four sectors here household, corporate, overseas and government and they have to sum to zero they can't all run surplices they have to sum to zero however there is one problem with that which is the net implication of it is that the stock of government debt goes on goes up and what we can see here is the red line is bank lending to non-financial corporates which slowly comes down as a percent of GDP as all the corporates attempt to deleverage and the blue line is that the debt of the public sector just goes up and up and up and the government debt to GDP has now reached 230% and is still rising now the deficits that the Japanese run were important to avoid a still deeper recession but there is still an issue of what are you going to do about the government debt that results and that pattern that post a recession which is created initially by private credit creation that post the recession the leverage doesn't go away it simply moves from the private to the public sector has been repeated again and again and again over the last five years so what you see here for the UK, the US and Spain is the private non-financial corporates in the households increases in leverage before the crisis some beginning of deleverage thereafter but a more than offsetting increase in public debt essentially once we have an excessive amount of debt in the system created by the private side we have a major problem we don't know how to get rid of it we simply know how to shift it around the economy we know how to shift it from the private sector to the public sector or from Germany to China China has had a huge credit explosion over the last five years so have many emerging economies but we don't know how to get rid of it if you look at the figures produced by the Office of Budget Responsibility for the next five years what they suggest is that the only way we're going to get out of this recession is to shift it all back again to the private sector so that they have a forecast which goes ah yes eventually we'll get public debt under control as a percent of GDP but at just the point where we do that household debt will turn around and go back up again and indeed you're only going to get the growth which achieves this according to the OBR if you get the increase of debt which does that so my message is the reason why the leverage matters which was my question earlier the reason why the leverage matters the private leverage is once you've got it you end up as we have been for the last six years in an extraordinarily difficult public policy space because it appears that you're blocked now we can debate whether you're really blocked or not but some people believe you're blocked in terms of fiscal stimulus because you're facing public debt increase so they don't want to run large fiscal deficits because that will still further increase the public debt so you try instead to stimulate the economy with ultra-loose monetary policy by reducing interest rates close to the zero bound by quantitative editing by funding for lending and eventually if you chuck enough at it you'll get some sort of response but the trouble with ultra-loose monetary policy is that its transmission mechanisms have major problems first they tend to create asset bubbles indeed they only really work via asset bubbles you have to increase asset prices with low interest rates which will encourage people to then spend some money second they tend to be very unequal in effect because given that they work through asset prices they give the benefit to people who already have assets and third and most ironically they can only work really by eventually restimulating the very growth of private credit which created our problems in the first place now let me be clear if I had been on the Monetary Policy Committee of the Bank of England I was on the FPC but not the Monetary Policy Committee I would have voted for ultra-loose monetary policy because I think vote de mure with nothing else available it was the best thing that we can do but ultra-loose monetary policy has significant adverse side effects we appear to be stuck we appear to be out of ammunition and unable to have a policy which produces a good effect now I happen to believe that we're never out of ammunition there are very few problems in economics to which there are definitive solutions but absolute deflation is one and intriguingly the solution to absolute deflation is a point of economic policy where Milton Friedman and John Maynard Keynes agreed completely and they said face with that environment you do what Milton Friedman called helicopter money you fill a helicopter with money and you scatter the dollar bills around or you do what John Maynard Keynes said you put pound notes in old bottles and dig them in the ground and pay people to dig them up again Slightly odd in that respect Keynes wasn't normally a puritan so you'd have expected him to go straight for the more just give the stuff out but in that respect he wanted people to do a little bit of work on route Milton Friedman was a bit more radical and the question I have raised is should we have done simply helicopter money rather than quantitative easing I would ask you to look at these two possibilities we have essentially done several hundred billions of quantitative easing with a commitment that at some stage we will reverse it we have done funding for lending we have relaxed bank and capital and liquidity standards in an attempt to get people lending again to get the economy going the transmission mechanisms of this are through asset prices through more lending etc we could have done several tens of billions of overt money finance what I call overt money finance of increased fiscal deficits you just say I'm going to increase the fiscal deficit and this bit of the increased fiscal deficit don't worry how you're going to pay it back because this is funded with permanent central bank money and with a commitment that this will be permanent by saying even raising this question I put myself in a taboo space slightly odd taboo space because it's what Ben Bernanke said in 2003 in Japan it is what Milton Friedman said in his helicopter money article and in 1948 but it has become taboo because people say yes but at the moment you do that you can't trust the politicians they won't only do ten billion they'll do a trillion and then we'll have hyperinflation and the argument against this is fundamentally a political economy argument it's that we don't trust ourselves to do it in a small responsible amount I mean I'm going to assert that as a fact there are no technical arguments against doing this it is possible the issue is can you construct a robust enough political economy that you're confident we won't do it to excess but the question I pose is which of these will be most effective in the nominal demand and which would have the least adverse side effects I think we should at least have considered option 2 I think it is difficult to imagine the eurozone pulling out of its current problems without some variant of option 2 I think unfortunately there is almost no chance whatsoever that an option 2 variant will be pursued in the eurozone and therefore for that reason I am a pessimist on the eurozone because I think it's going to look for the next 10 to 15 years I don't like Japan in the 1990s but with the consequences of that far more adverse because a decade of low growth and deflation in a continent of many countries nationalist movements ethnic and religious diversity and minorities I think will be far more severe and dangerous than it was in a culturally and ethnically homogeneous Japan I'm going to move on very quickly my question was ok but central banks had a concept and the concept was I observed this growth of credit but it must be ok because I'm not seeing inflation right that was their concept they said ok I accept that too much credit might be a problem but if it is a problem it will show up in inflation that was the overt philosophy of inflation targeting and it goes back to a concept actually by the Swedish economist a brilliant economist Knut Vexell who wrote a book in 1904 called Interest and Prices and Knut Vexell said money credit is extended to entrepreneurs stroke businesses to finance capital investment there is a marginal productivity of capital what he called the natural rate of interest if central banks are silly enough to set a market rate of interest which is below the natural rate of interest entrepreneurs will go and do all sorts of wasteful capital investments and will have too much capital investment will have inflation but as long as they set the market rate of interest so as to achieve stable inflation whatever my rate of credit creation is will be the optimal rate of credit it will precisely produce the amount of investment that I could logically produce and essentially modern macro theory though it often doesn't recognise it it makes me down from Vexell sometimes that recognition is explicit Michael Woodford's Interest and Prices is named explicitly in homage to Knut Vexell's Interest and Prices but of course all of that is true or might be true to a degree if all of credit was extended to fund capital investment by businesses if that was the case and you created too much credit then you'd produce too much demand and there'd be inflation and then the central bank would respond to it so in that environment you could imagine that inflation targeting would be sufficient to ensure stability of the economy but when you think about the two other elements of the nature of how we can extend credit you realise that we can have very significant growth of credit and debt which produces problems without that ever showing up in a higher rate of inflation to which an inflation targeting central bank responds you might think that finance of consumption will be like finance of investment the more there is the more demand there is and then we have an inflationary impact and we respond to it in time but the reason why that may not work actually is rising inequality and I think he was wrong that as we got richer on average we would have a problem of secular stagnation he didn't actually use that for age I think it was Hanson who first used the haze but he basically said as people get richer there's a limited number of things they want to buy and so they'll stop buying so much and they'll start saving too much and we'll have secular stagnation I think as a statement about average propensities to consume is strong because in an environment where advertising encourages new demands and new desires in an environment where there are fashion things which you want because everybody else has them even though you don't need them there is not much evidence that on average over time for the whole society there is a secular tend to a rise in the savings rate which gets in the way of the balance of the economy but what is true is that cross sectionally within an economy richer people have a higher marginal propensity to save and a lower marginal propensity to consume than poorer people so if we have a very significant increase in inequality and if we did not have consumption credit we could end up with a situation where we would have an inadequacy of demand because richer people would be trying to save stuff and they'd be trying to save stuff above and beyond the investment needs of the economy the system might then balance however because essentially rich people save it and it gets lent to middle income and poorer people and I think part of what is going on is that we have had an increase in credit which we have because of inequality we have needed simply in order to have adequate demand rather than excess demand and there is a very fine explanation of that by Ragu Rajan now the central bank governor of India in his book Fault Lines who argues that you have to understand the explosion of subprime credit in the USA as being essentially part of a response to rising inequality within a political culture where it is unacceptable to say I'm going to deal with rising inequality with redistribution or minimum wages and so as he says it the response was let them eat credit and there was an explosion of credit to lower income people I think it's more important that when we have credit which is finances existing asset prices then is no direct stimulus to nominal demand you could imagine in the environment where I suggested earlier that environment of a country which was building no new houses because it had stable population and had all those houses at once you could have a large credit creation which increased credit, money balances and asset pricing assumption and investment and therefore nothing for an inflation targeting central bank to respond to now you might actually indirectly stimulate demand via what are called wealth effects but they would not be certainly and directly proportional to the increase in credit therefore when you have credit against existing assets you can have very big increases in credit which when they produce the crisis then produce a debt overhang produces us in a very difficult environment and you can have that without that ever in advance sending inflationary signals to which an inflation targeting central bank responds what this implies in the work of Richard Werner which I shall get to is that we need to recognize that credit performs very different functions in our society in our economies what Richard has done is point out the very big increase in credit in 1980s Japan which did not produce a big increase in Japanese nominal GDP and in Japanese inflation and he said you shouldn't have expected it to because there were two different correlations going on one is this one which is a fairly good correlation it's not precise because you'll see the scale on the two sides between the more credit is extended to real estate the more that the value of a commercial real estate and commercial land goes up and the more credit is extended to things that you might think of were GDP transactions new consumption or investment the more nominal GDP goes up you have two correlations not one what that suggests in monetary theory is that contrary to the basis belief that all that matters in low and stable inflation contrary to that aggregates do matter balance sheet figures do matter but for a completely different reason from what monetarists suggest we need to move away from inflation targeting to an idea that monetary aggregates matter but not because of money supply concerns but because of what Richard has called the disaggregated oops why isn't this working hit that the quantity theory of disaggregated credit it's not the case that what matters here is an increase in the money stock because it has a relationship of prices times income this is nominal GDP instead we have to think of two relationships where the increase of credit extended against real estate will have that should really be a sort of approximately equal sign it will have some relationship to the increase of the price of real estate and the increase of non real estate credit to finance GDP transactions will have some relationship with nominal GDP which of course means that the amount of money stock which will have to be the increase in the credit if we define money to be the whole of the liability side of the bank is bound to be higher than nominal GDP which means a fall in the velocity of circulation of money I mean broadly speaking the story of monetary theory in the 1980s and 90s is that back in the 1970s when people were struggling with inflation they developed an idea that the money supply matters and that the velocity of circulation of money would be relatively stable so you had to control the money supply to control inflation and the moment they started doing that the velocity of circulation started falling and after about 10 or 15 years of the velocity of circulation falling they said well something wrong with theory and they gravitated to the idea that they should just do inflation targeting and fundamentally gravitated to the idea that we didn't have to pay attention to monetary aggregates at all I believe we do have to pay attention to monetary aggregates but for a completely different reason from that which was in monetarism it is not because money is a forward indicator of inflation it's because excessive private credit creation is a forward indicator of crisis debt overhang post crisis depression and deflation now what does that mean for the way we have to run our economies in the future? I've suggested something about the problems of how the hell do we get out of the debt overhang we're in and suggested the taboo option of overt money finance but suppose we got out of it what should we do for the future and what does that imply for the policies that we should have had in place back in 1980 to stop us getting into this mess it implies that we cannot have just one objective and one instrument low and stable inflation I personally think is important I think it's better to run economies with roughly 2 or somewhere in a 1-3% range of inflation than with 10 or 15% but it's absolutely not sufficient what we know from the crisis is that we can have credit and asset price cycles and rising leverage can produce macroeconomic instability and major harm without that ever producing an increase in inflation to which an inflation targeting central bank was also inflation targeting is not sufficient I also however believe that the interest rate tool is not sufficient some people in particular the economists around the bank for international settlement Bill Borio and Bill White say absolutely right with that but they still fundamentally think we should run the economy simply by pulling the interest rate they say what should have happened in 2000 and 2005 is the Federal Reserve and the Bank of England should have observed the growth of credit and asset prices and should have increased the interest rate by more than seemed sensible given the inflation rate at that time so they say not one objective but still one instrument slightly oversimplifying but that's broadly speaking I think the difficulty with that is what I call the diversion the heterogeneity of interest rate elasticity across the economy what I mean by that is once you get a credit and asset price boom going on in real estate once commercial real estate developers and house owners or potential house owners have convinced themselves that for the next 2 or 3 or 4 years house prices are likely to go up by 10 or 15% per annum varying the interest rate the policy Bank of England interest rate from 5 to 5.5 to 6 is not going to slow those guys down and varying it from 5 to 10 is going to really cause harm in the rest of the economy long before it slows down the real estate boom and we've seen that in Sweden over the last 2 years from about 2011 onwards the Riksbank observing a credit and asset price boom emerging in Sweden in Stockholm in particular was trying to slow that down with interest rate rises which were going against the trend of ultra loose monetary policy throughout the world it didn't manage to slow down the real estate boom but it did manage to slow down the Swedish economy which now has rising unemployment and is heading towards deflation so we cannot do this by the interest rate alone what we need is a variety of other policy tools and objectives we need to constrain the pace of growth and the level of private sector leverage but we also need to have a point of view about the balance between different sectors and while not in my opinion demonising lending against real estate because I think it has a role within an economy we have to realise that left to itself financial systems have a skew towards more lending against real estate than is socially optimal we have a social externality effect where the risks that that creates for the economy are not ones which the private sector will internalise we therefore need tools such as much higher bank capital requirements much higher counter cyclical capital requirements increasing the capital risk weights for real estate lending above what are called internal advanced IRB internal risk weighting the levels which private banks will sort out for themselves we need to constrain borrowers through loan to income ratios and we need to consider whether if banks left to themselves are always going to migrate towards real estate lending because that's the easiest thing to do do we need to set up banks who only have a licence to do what are textbooks say they do because I would read the point the textbooks that say that what banks do is lend money to a capital to businesses to do capital investment but that's not what they do now just one final point what positive money is essentially about is being much more radical than I dare to be because what I'm saying is there's this thing called fractional reserve banking and I'm saying which is the idea that we allow banks to create credit and private money and they can create credit and private money because they only need to hold as base money a fraction of their liabilities I am clearly arguing that we have allowed that fraction to be far too low that we should not have allowed it to be 5% it ought to be 15% or 20% the positive money people are the people who take it to its logical extreme and say why not 100% why do you allow this private credit and money creation at all I'm along that spectrum but I'm not that radical and we can talk subsequently about how the radical we can be the net effect is this isn't going to go away central bankers believe that having stumbled in to the realization that they have to have a point of view in order to stimulate the economy as to whether lending is more important for one sector or another is not just a temporary response to an extreme crisis it is going to have to be a central part of our philosophy of central banking and of credit and monetary policy looking forward thank you