A Conversation With Lord Adair Turner

Lord Adair Turner, is the Chairman of the Board of the Institute for New Economic Thinking (INET). Prior to joining INET, Lord Tuner was the Chairman of the United Kingdom’s Financial Services Authority, the UK’s regulator for the financial industry, in the wake of the 2008 crisis. He was head of practice for Russia and Eastern Europe at McKinsey Consulting in the early 1990s and has worked with a variety of major financial firms including Merril Lynch and Standard Charters as well as holding academic appointments at a variety of institutions including the London School of Economics. His new book Between Debt and the Devil: Money, Credit, and Fixing Global Finance addresses how the growth of private private debt has led to the global recession and what we can do about it. The Private Debt Project had a chance to interview Lord Turner in December, 2015. 

Following the 2007-08 financial crisis, much of the public anger was directed at the reckless or even criminal behavior of bankers and a lot of the reform energy was focused on too-big-to fail banks.  Yet in your book you argue the central cause of the crisis was not dishonest bankers or too-big-to-fail banks but an addiction to debt.  Would you explain what you mean?

To be sure, many bankers lent money recklessly to U.S. subprime mortgage borrowers or to Irish, Spanish, or British real estate developers.  And some acted dishonestly, manipulating the LIBOR rate or knowingly selling securities whose value they doubted to investors whose acumen they disparaged.  But important though the incompetence and dishonesty of some bankers was, it was not a fundamental driver of the crisis, any more than the misbehavior of individual financiers in 1920s America was of more than peripheral importance to the origins of the 1930s Great Depression.

As for regulatory reform, much focus has been placed on making sure that no bank is “too big to fail” and that taxpayers never again have to bail out banks as they did in autumn 2008.  That is certainly very important.  But focus on the too-big-to-fail problem also misses the vital issue.

The fundamental problem is that modern financial systems left to themselves inevitably create debt in excessive quantities, and in particular debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate.  It is that debt creation that creation which drives booms and financial busts; and it is the debt overhang left over by the boom that explains why the recovery from the 2007-08 financial crisis has been so anemic.

In the decade running up to the 2007-08 crisis, private credit grew rapidly in almost all advanced economies:  in the United States at 9% per year, in the United Kingdom at 10% per year, in Spain at 16% per year.  In most it grew faster than nominal GDP: as a result, private leverage—the ratio of private credit to GDP—significantly increased.  Total UK private-sector leverage grew from 50% in 1964 to 180% by 2007; in the United States, it grew from 53% in 1950 to 170% in 2007, with much of that increase occurring in the last decade.

Are you suggesting that financial crises are inherent in the kind of financial system that we have today?

The dangers of excessive and harmful debt creation are inherent in the nature of debt contracts.  But they are hugely magnified by the existence of banks, and by the predominance of particular categories of lending.  Read almost any economics or finance textbook, and it will describe how banks take money from savers and lend it to business borrowers, allocating money among alternative capital investment projects.  But as a description of what banks do in modern economies, this is dangerous fictitious for two reasons.  First, because banks do not intermediate already existing money, but create credit, money, and purchasing power which did not previously exist.  And second, because the vast majority of bank lending in advanced economies does not support new business investment but instead funds either increased consumption or the purchase of already existing assets, in particular real estate and the urban land on which it sits.

As a result, unless tightly constrained by public policy, banks make economies unstable.  Newly created credit increases purchasing power.  But if urban real estate is in scarce supply (which it is in many cases), the result is not new investment but asset price increases, which induce yet more credit demand and yet more credit supply.  At the core of financial stability in modern economies, I would argue, lies the intersection between the infinite capacity of banks to create new credit, money, and purchasing power, and the scarce supply of irreproducible urban land.   Self-reinforcing credit and asset price cycles of boom and bust are the inevitable result.  Such cycles are inherent in leveraged banking system.

But it is not just banks, is it?  With financial innovation, we have seen a variety of new instruments and institutions that have helped drive credit expansion.

That is correct.  These cycles can also be generated by the complex chains of nonbank debt origination, trading and distribution—“the shadow banking system”—which developed ahead of the 2007-08 crisis.  Indeed, as I argue in the book, the development of more complex and liquid markets in credit securities increased the dangers of volatility; and the very techniques that were supposed to control risk actually increased it.  If debt can be a form of economic pollution, a more complicated and sophisticated debt creation engine can make the pollution worse.  The net effect of the pre-crisis financial innovation was to give us the credit cycle on steroids, and the crash of 2008.

So you take issue with the view that financial innovation improved efficiency and spurred economic growth.

The strong consensus before the crisis was that the increasing intra-financial activity brought about by financial innovation had both improved capital allocation and made the financial system and economy more stable.  Not surprisingly, the financial industry itself was happy to praise the impact of its increasingly complex activities.  An article by Glenn Hubbard and Bill Dudley, which confidently concluded that financial innovation had “improved the allocation of capital and risk throughout the US economy,” was published by Goldman Sachs.  But the IMF was equally confident that credit structuring and derivatives had made the global financial system more stable.

That confidence turned out to be utterly mistaken.  There is no evidence that advanced economies have become overall more efficient as result of the post-1970 increase in financial intensity:  growth rates did not increase.  And the development of a much bigger and more innovative financial system led to the crisis of 2007-08 and to a severe recession. (p. 89)

In the book, you argue that it just not that the financial system creates at times too much credit but too much of the wrong sort of debt.

Textbook descriptions of banks usually assume that they lend money to businesses to finance new capital investment.  Explanations of why financial deepening is valuable focus almost entirely on the beneficial impact of better credit flow to businesses and entrepreneurs.  But in most modern banking systems most credit does not finance new capital investment.  Instead, it funds the purchase of assets that already exist and, above all, existing real estate.  In some ways that is inevitable, since real estate accounts for the majority of all wealth in advanced economies. Credit to finance investment in non-real estate accounts for no more than 14% of the UK total, and the same broad pattern is found across the advanced economies and increasingly in emerging ones. 

But the increasing importance of real estate and lending against it has huge implications for financial and macroeconomic instability.  Different categories of credit perform different economic functions and have different consequences.  Only when credit is used to finance useful new capital investment does it generate the additional income flows required to make the debt certainly sustainable.  Contrary to the pre-crisis orthodoxy that the quantity of credit created and its allocation between different uses should be left to free market forces, banks left to themselves will produce too much of the wrong sort of debt. 

You highlight debt related to real estate as the wrong sort of debt.  Why can lending to real estate be so problematic?

Unlike 50 years ago, most bank lending—and in the United States most lending through capital markets—now finances the purchase of real estate.  In part that reflects simply the increasing role of real estate in total wealth.  In part it reflects the valuable social role that mortgage credit plays in lubricating the exchange of homes between different people, including different generations.  But it also reflects a bias for banks to prefer to lend against the security of real estate assets. (p.71)

Seen from the perspective of individual banks, lending against real estate often seems, and sometimes actually is, lower risk and easier to manage than other categories of lending.  But lending against real estate—and in particular against existing real estate whose supply cannot be easily increased—generates self-reinforcing cycles of credit supply, credit demand, and asset prices.  Consider how an upswing occurs.  More credit produces rising real estate prices, which in turn increase both the net worth and the confidence of borrowers and lenders.  As prices rise, lenders experience only small loan losses, which increases their capital bases, which makes it possible for them to make more loans.  And low loan losses also reinforce bank management and loan officer confidence that further loans will be safe.  Meanwhile borrowers see their net worth rise, which enables them to borrow more for any given loan to value ratio (LTV), and the experience of rising prices generates expectations that further rises will continue at least in the medium term.

Throughout modern economic history real estate credit and prices move together.  In the latest upswing, from 2000 to 2007, mortgage credit in the United States increased by 134% and house prices by 90%; in Spain the increases were 254% and 120%; in Ireland, 336% and 109%.  These cycles can generate booms in new real estate investment as well as in existing real estate.

So in that sense, there is also a danger of over-investment.

Yes.  Credit creation can facilitate capital investment.  But, as both Friedrich Hayek and Hyman Minsky explored, it can produce cycles of overinvestment that leave behind wasted real resources and a debt overhang problem.  And that of course is what happened in the U.S., Spanish, and Irish real estate building booms of the 2000s, as it did during earlier overinvestment booms such as the railroad booms of the nineteenth century.  By 2006 Ireland was building 90,000 homes per year in a country of just over 4 million people.  Many of the builders and developers who built those homes have subsequently gone bankrupt.  At least 20,000 homes on “ghost estates” are now being demolished, their construction an utter waste. But in the upswing of the cycle, building them and lending money to the builders appeared profitable.

These cycles of overinvestment cause two types of harm.  The first is the misallocation of real resources:  in Spain the construction sector swelled from 8% to more than 12% between the late 1990s and 2007, in Ireland the increase was from 4% to 9%, and in both the share of construction in total employment grew rapidly.  High employment was the inevitable post-crisis consequence.  The second harm is the debt overhang effect, which can suppress growth for many years as households and companies deleverage.

You note in the book that leverage has increased in most advanced industrialized economies because credit grew faster than nominal GDP.  In particular you observe that in the two decades before 2008 “credit grew at about 10-15% per year versus 5% annual growth in nominal income.” In other words, our economies have become more dependent on debt.  Why is that so?  Why does it now take more credit to produce economic growth than it did, say, in the three or four decades after World War II?

In the book, I discuss three underlying drivers of increasing credit intensity.  The first is the increasing importance of real estate in modern economies.  As I suggested earlier, real estate accounts for more than half of all wealth, for the vast majority of increases in wealth, and for the majority of lending in all advanced economies.  As I explain in the book, this is the inevitable consequence of trends in productivity, in the cost of capital goods, and in consumer preferences—that is, what people want to spend their income on.  Real estate is bound to become more important in the advanced economies:  but that has consequences for financial and economic stability that need to be carefully managed.

The second driver is increasing inequality.  Richer people tend to spend a lower proportion of their income than do middle income and poorer people.  Increasing inequality will therefore depress demand and income growth, unless the increased savings of the rich are offset by increased borrowing among middle or low income earners.  In an increasingly unequal society, rising credit and leverage become necessary to maintain economic growth but lead inevitably to eventual crises.

The third driver is global current-account imbalances unrelated to long-term investment flows and useful capital investment.  The surpluses enjoyed by some economies must inevitably be matched by the accumulation of unsustainable debt in others.

These three factors each result in a growth of debt that, contrary to the textbook assumption, does not support productive capital investment and does not therefore generate new income streams with which debt can be repaid.  As a result, they drive increases in leverage that are needed to support demand but will eventually cause severe economic harm. 

After the crisis, much of the effort to restore economic growth, especially in Europe, focused on fixing the banks under the theory that the banks were too impaired to support new lending.  In the book, you argue that fixing the banks will not fix the economy.  Why?

After the crisis, credit growth collapsed in all the affected economies.  In the United States, it fell from 8.8% per year in the decade before the crisis to -2.5% in 2009; in Spain from 17% per year before the crisis to -3% over the years 2009-2014.  Restoring robust credit growth seemed essential to drive economic recovery.  And that meant policies to fix the banks—to remove the blockages to the credit supply.

I was involved for 4 ½ years in the debates that led to those policies and I believe that they were important.  And I also believe that restricted credit growth can hold back growth.  But both Japan’s experience in the 1990s and Western experience after 2007-08 crisis show that restoring potential credit supply is insufficient to restore growth.

Many analyses of Japan in the 1990s focus on the role of a broken banking system. But as Richard Koo illustrates, by the mid-1990s that banking system was offering loans to businesses at close to zero interest rates, but corporate borrowing remained depressed. Monetary policy was effectively transmitted to cheap credit supply, but the demand was not there, because borrowers were already overleveraged.

Similarly, in the United Kingdom we had intense discussions from 2009 to 2013 about why the banks were not lending the money made available to them through quantative easing.  But we always had strong indications that lack of demand was the more important problem.  Even when banks had already granted lending facilities to companies, actual utilization remained low:  and the Bank of England’s Credit Conditions survey repeatedly found that lack of demand for business products and services was a more important brake on business activity than the availability of credit.  Similarly, in the Euro-zone efforts were made to ensure the credit supply at low price was available, but there too credit demand was lacking because of the debt overhang effect.

Atif Mian and Amir Sufi argue indeed that the dominance of the debt overhang effect is so clear that we should shift the policy focus entirely from a “banking view,” in which restoring bank health is the key priority, to a “debt view,” which should lead, for instance, to significant personal debt forgiveness.  My judgement is that both credit supply and credit demand matter. But Mian and Sufi are right that public debate after the 2007-08 crisis was skewed too much toward the credit supply problem and that we were slow to realize the severity of the debt overhang challenge. 

It would seem that deleveraging, then, is essential to restoring economic growth.  But as you point out in the book, we have seen precious little deleveraging.

Once economies have too much debt, it seems impossible to get rid of it  All we have done since the 2007-08 crisis is to shift it around from the private to the public sector, and from advanced economies to emerging economies, such as China.  Total global debt to GDP, public and private combined, has continued to grow. (p. 12)

The shifting of debt from the private sector to public sector  was of course most evident in Japan after its crisis in the, early 1990s  Between 1990 and 2010, Japanese corporate debt fell from 139% to 103% of GDP.  Japanese companies reduced their leverage.  But Japanese government debt increased from 67% of GDP to 215% of GDP.  And the increase in government debt was an automatic consequence of corporate-sector deleveraging.  Companies cut investment, and the economy entered recession, so government deficits increased as tax revenues fell and social expenditures rose.

This pattern has been replicated in numerous countries after the 2007-08 crisis.  U.S. private debt to GDP has fallen by 12 percentage points (from 192% of GDP in 2008 to 180% of GDP in 2013 with significant household deleveraging) but public debt has increased from 72% to 103%.  Spanish private debt to GDP, having risen sharply in the years before 2008, has fallen from 215% of GDP to 187%, but public debt has increased from 39% of GDP in 2008 to 92% in 2013.  Overall, in the advanced economies, household debt is down as a percentage of GDP since 2009, corporate debt is flat, but public debt has dramatically increased.  Total debt for the real economy (that is, excluding intrafinancial system debt) has continued to increase.

You point out that a similar shift of debt has taken place among countries.

Yes, in addition to the shift from the private to the public sector, it has shifted between countries.  One of the biggest shifts has occurred as a result of China’s post-2009 credit boom, with “total social finance” up from 124% of GDP in early 2008 to 200% in 2014 and still rising.  That increase was the direct consequence of the 2007-08 crisis and thus in turn of the pre-crisis growth of advanced economy private leverage.  Faced with a severe global recession in autumn 2008, and fearful that this would produce a socially dangerous slowdown of Chinese growth, the Chinese authorities used rapid credit expansion as the only tool apparently available to maintain growth.

Even where individual countries have achieved deleveraging, their ability to do so has been crucially dependent on growing leverage in other countries.  Germany is one of the few countries where private leverage today, at 108% of GDP, is below the level of both 2007 and 2000.  But Germany’s economic growth has still been driven by unsustainable increases in debt:  it is simply that in Germany’s case the credit growth occurs in its export markets.  Before the 2007-2008 crisis, Germany’s export growth and large current-account surplus were made possible by rapid growth in private credit and demand—and the resulting current-account deficits—in the United States, the United Kingdom, and peripheral eurozone countries, such as Spain.  After the crisis Germany’s now yet larger surpluses have been underpinned by public debt increases in economies like that of the United Kingdom and the United States, and by China’s huge credit boom.

To understand excessive credit creation and debt overhang, we must take a global perspective. Overall, developed country leverage, public and private, has continued to increase slowly, and total global leverage has increased significantly as emerging economy private credit has grown at a fast pace.  Attempted deleveraging has depressed economic growth, but no overall deleveraging has actually been achieved.

As you observe in the book, the United States and Britain were able to deleverage after the Second World War with rapid nominal GDP growth, low interest rates, and low but rising private leverage.  But as you also point out, deleveraging will be much more difficult under today’s circumstances.

The historical experience of the United States and the United Kingdom illustrates that public deleveraging is possible, but it also indicates how difficult simultaneous public and private deleveraging will be in today’s changed circumstances. Demographic and technological factors will not allow the real growth rates observed in many advanced economies in the 1950s and 1960s; and if 2 % inflation targets are considered sacrosanct, nominal GDP growth in many advanced economies is unlikely to exceed 4%.  In some it will be lower still:  the Bank of Japan estimates that Japan’s potential growth rate is no more than 1%.  Even if it achieves its 2% inflation target, nominal GDP will grow at only 3%.  Growing out of debt burdens will be far more difficult than in the post-war period. 

Indeed, in some countries the mathematics make it impossible. The IMF Monitor illustrates that Japan would need to turn today’s primary deficit of 6.0% (that is, its fiscal deficit before interest expense) into a surplus of 5.6% by 2020 and to maintain that surplus for an entire decade to reduce its net public debt to 80% of GDP by 2030.  This will simply not occur, and if attempted would push Japan into a deep deflationary depression in which public debt leverage, far from falling would almost certainly rise. Japanese government debt will simply not be repaid in the normal sense of the word. 

A similar situation pertains in Europe.  Italy’s public debt burden, at 132% of GDP and rising, is also now so high and the country’s potential long-term growth so low that there is no clear “austerity plus growth” path to fiscal sustainability. Across the eurozone, indeed, the “Fiscal Compact” requirement that all countries should reduce their debt stocks to a maximum of 60% of GDP through running primary budget surpluses is not credible.  To achieve this objective, Greece would have to run a primary budget surplus of 7% of GDP for more than a decade; Ireland, Italy, and Portugal 5%; and Spain 4%.  As Barry Eichengreen has pointed out, there are close to no historical examples of such large continued primary surpluses.

As you note, China’s huge credit expansion after the 2007-08 financial crisis helped other economies to stabilize their debt.  But now China faces its own debt overhang, which is depressing growth and threatening financial stability.  What do you see as the prospects for China?

China now faces two challenges faced by advanced economies—how to build a less credit-intensive economic growth model and how to manage the problems of high debt stocks created by past credit-intensive growth.

Achieving the first will, in China as elsewhere, require policy changes that go far beyond the details of the financial system.  Wage rises faster than nominal GDP are required and may occur naturally as the Chinese labor market tightens in the face of falling number of young adults.  But reduced household savings are also desirable and will only occur if the government establishes better social security and healthcare systems, reducing the need for high precautionary savings.  In the financial system itself, China, like other countries, needs strong policy tools to constrain real estate lending.  But it also needs to address land pricing and purchase rules:  the current ability of local governments to take land from peasants in return for little compensation creates huge incentives for excessive real estate development.

As for the problem of existing debt, China faces a difficult choice between three risky policies.  It could “let the market work” as companies and local governments deleverage where they can and default where they cannot. But that could produce a bigger economic downturn than the authorities are willing to accept.  The second would be to “let the credit boom run” with yet more credit extended to highly indebted companies and local governments.  But that route would delay the desirable transition to a less investment focused economy and build up bigger financial problems for the future.  The third choice would be explicitly to socialize some of the debt—writing off bad loans in the banking sector and bailing out banks, state-owned companies, and overextended local governments—financing the operation with central government debt.  With Chinese total government debt still only about 39% of GDP, the potential for such socialization is significant, but it is not limitless.  Beyond some level, concern about Chinese debt sustainability might emerge.  That problem in turn could in theory be dealt with by monetization—by printing rather than borrowing money—but at the risk, potentially, of inflation.

In China’s case, the chances of a successful transition without monetization are far higher than in some advanced economies.  This reflects China’s potential for further rapid growth, reducing the ratio of debt to GDP by growing the denominator.  With appropriate policies China can grow for several more decades at 5% per year or more.  In contrast, Japan’s sustainable growth rate is unlikely to exceed 1%.  Provided China can shift to a less credit-intensive growth for the future, its existing debt could still, at least at this stage, be manageable. 

Despite the difficulty most advanced economies face in deleveraging, you reject the idea that there is no escape from the debt overhang trap. 

Faced with the current malaise caused by the debt overhang, it can seem all policy levers are ineffective:  many central bankers indeed are keen to stress the limits to what they can achieve, But as I argue in the book, inadequate nominal demand is one of the very few problems to which there is always an answer.  Central banks and governments together can create nominal demand in whatever quantity they choose by creating and spending fiat money.  Doing so is considered taboo—a dangerous path toward inflationary perdition.  But there is no technical reason money finance should produce excessive inflation, and by excluding this option, we have caused unnecessary harm.  In the book, I describe why money finance of fiscal deficits is technically feasible and desirable, why it may be the only way out of our current problems, and some specific ways in which we should now use this potentially powerful tool. 

One of the ways you explore in the books is funding government directly by printing money.  This seems to be a hybrid of fiscal and monetary policy.

Printing money in its modern electronic form to finance government is a technically possible alternative to either pure fiscal or pure monetary policy.  It is indeed essentially a fusion of the two.  It entails monetary finance of an increased fiscal deficit, and it would stimulate demand more certainly and with less adverse side effects than either pure fiscal or pure monetary policy.  Compared with funded fiscal stimulus, it is bound to be more stimulative, since there is no danger of either crowding out or Ricardian equivalence effects:  as Ben Bernanke put it in 2003, if consumers and businesses received a money-financed tax cut, they would certainly spend some of their windfall gain, since “no current or future debt servicing burden has been created to imply future taxes.”

And compared with a pure monetary stimulus, it works through putting new spending power directly into the hands of a broad swath of households and businesses, rather than working through the indirect transmission mechanism of higher asset prices and induced private credit expansion.  It does not rely on regenerating potentially harmful private credit growth, nor does it commit us to maintaining ultralow interest rates for a sustained period of time.

To conclude let’s talk about how to prevent future crises and create a more stable system.  In your book, you take issue with the pre-crisis orthodoxy of financial regulation that focused on one objective (low and stable inflation) and deployed essentially one policy tool (the interest rate).  First, what is wrong with relying on interest rates to regulate credit? 

The essential problem is that when credit is used for different purposes, there is no natural rate of interest, defined by the marginal productivity of new investment, that drives borrower and lender behavior.  Both borrower demand and lender willingness to lend are instead driven by future returns, which are volatile over time and variable by sector of the economy.  And especially when return derives from the rising value of existing assets, such as real estate, expectations are endogenous and self-reinforcing.  In an advanced economy where existing real estate accounts for the majority of all assets and real estate lending the majority of all credit supply, there isn’t one natural rate of interest, but instead several different and potentially unstable expected rates of return.

Thus while the pre-crisis orthodoxy believed that one of the great merits of relying on interest rates was their neutral impact on the allocation of credit, in the face of multiple private expectations of return, that neutrality is a serious disadvantage. Interest rates could certainly have a role to play in constraining credit booms and should sometimes be set higher than pure inflation targeting would suggest is appropriate.  But we also need quantitative levers, including ones that discriminate among different categories of credit.

So what exactly do you propose in its place?

I do not propose a specific set of universally applicable rules. But I do set out a clear philosophy:  we need to constrain and influence the mix of debt that banks and shadow banks create.  That will require five sets of policies:

• Bank regulation designed not merely to make the banking system itself safe but also to constrain lending to the real economy, particularly against real estate;
• Constraints on risky non-bank credit intermediation (shadow banking), even if these are at the expense of reduced market liquidity;
• Constraints on borrowers’ access to credit;
• Measures to put sand in the wheels of harmful  short-term debt capital flows; and
• Actions to ensure that there is enough credit to fund required capital investment, for instance, through the creation of banks with a dedicated focus on specific lending categories. 

One of your more controversial ideas is to constrain lending by imposing very high capital requirements, much higher than those agreed in the Basel III negotiations.  And you go even further by suggesting quantitative reserve requirements.  Why in your opinion are these measures necessary?

Capital requirements limit the quantity of loans and other assets that banks can hold as a multiple of their equity or other capital.  Post-crisis reforms have increased the absolute minimum equity requirement from 2% of “risk-weighted assets” to 4.5%, and the effective regulatory requirement for major banks is much higher still, in the 7-10% range.  But Anat Admati and M.F. Hellwig in their book, The Bankers’ New Clothes, argue for far higher requirements.  Banks should, they believe, hold equity capital equal to 20-25% of the gross unweighted value of their assets, increasing effective requirements by some four or five times.  I agree but not necessarily for the same reasons they give.

The central argument of my book is that we must constrain private credit growth, and I believe much higher capital requirements are essential for that purpose.  In an ideal world, bank equity requirements would be much higher than agreed on in Basel III negotiations, and 20-25% is a reasonable target.  The question, of course, is how to transition to much higher ratios without exacerbating the deflationary impact of deleveraging.

But you propose going beyond higher capital requirements?

Much stronger capital requirements are essential but will not be sufficient.  The argument that higher capital requirements will not constrain credit is overstated but it does capture an important truth:  capital requirements do not place an absolute constraint on credit growth, since bank equity can grow whether central bank/regulators want it to or not.  Other policy levers are also needed.

One option is quantitative reserve requirements, which define the minimum reserves that commercial banks must hold at the central bank and therefore constrain the maximum quantity of bank loans (or total assets) that banks can extend.  Imposing them would constrain maximum bank loan growth more directly and more certainly than would equity requirements, since central banks themselves determine the quantity of reserves available.  Central banks can moreover choose whether to pay interest or at what rate.  If they pay below-market interest rates, they essentially impose a tax on credit intermediation.

I also propose a number of policy measures to constrain lending and borrowing and to influence the types of lending and for what purposes.

How in sum does your reform agenda differ from the pre-crisis orthodoxy?

My reform agenda represents a dramatic rejection of the pre-crisis orthodoxy.  Some elements of it—such as the importance of counter-cyclical capital requirements—are already accepted by most central banks and financial regulators.  But others go far beyond the post-crisis consensus in two ways:  first in focusing on the level of leverage as well as the pace of credit growth, and second in arguing that we must influence the allocation of capital among alternative uses.

These elements will be criticized as dangerously interventionist, replacing the allocative wisdom of the market with imperfect public policy judgements.  But free markets in credit creation can be chronically unwise and unstable.  That was why such economists as Henry Simons, in every other respect an extreme free marketer, believed that banks should be abolished.  I do not go that far.  But we need to recognize that free markets do not ensure a socially optimal quantity of private credit creation or its efficient allocation.  We should not intervene in the allocation of credit to specific individuals or businesses; but we must constrain the overall quantity of credit and lean against the free market’s potentially harmful bias toward the “speculative” finance of existing assets.

The program will also be criticized because it means “less credit to fuel economic growth.”  And there will indeed be less credit.  But as I discuss in the book, that does not mean less growth, since a large proportion of credit is not essential to economic growth; does not produce a proportionate increase in nominal demand; and leads to crisis, post-crisis debt overhang, and recession. Our explicit objective should be a less intensive economy.