What makes sovereign debt sustainable, and for how long can this situation continue?
Adair Turner, the former Chairman of the British Financial Services Authority, has written a book about the risks and unpredictability of financial markets which has many provocative insights. It also has a frustrating blind spot about how government actions can and do contribute to financial crises.
Turner clearly addresses the failure of governments to understand what was going on as the crises of the 2000’s approached, including his notable mea culpa discussed below. But there is no discussion anywhere of the culpability of government actions which greatly contributed to inflating the bubble of housing debt and pumping up leverage on the road to the U.S. housing finance collapse.
The fateful history of Fannie Mae and Freddie Mac is not discussed, even though Turner rightly emphasizes how dangerous leveraged real estate is as a key source of financial fragility. Fannie and Freddie, with $5 trillion in real estate risk, do not rate an entry in the index.
The problems of student debt make it into a footnote in chapter six, where its rapid growth in the United States is observed, along with the judgment that “much of it will prove unpayable,” but it is not mentioned that this is another government loan program.
The role of government deposit insurance in distorting credit markets, so notable in the U.S. savings and loan collapse of the 1980s, is not considered. That instructive collapse gets one passing sentence.
The Federal Reserve, along with other central banks, created the Great Inflation of the 1970s that led to the disastrous financial crises of the 1980’s. Seeking a house price boom and a “wealth effect” in the 2000’s, the Federal Reserve promoted what turned out to be a house price bubble. Turner provides no proposals about how to control the obvious dangers of central banks, although he does point out their mistake in thinking that they had created a so-called “Great Moderation.” That turned out to have been instead a Great Overleveraging.
There can be no doubt of Turner’s high intelligence, as his double first in history and economics at Cambridge and his stellar career, leading to his becoming Lord Turner, attest. But as an old banking boss of mine memorably observed, “it is easier to be brilliant than right.”
This universal principle applies as well to leading central bankers, regulators, and government officials of all kinds as it does to private actors. The bankers “that made big mistakes,” Turner correctly says, “did not consciously seek to take risks, get paid, and get out: they honestly but wrongly believed that they were serving their shareholders’ interests.” So also for the authors of mistaken government actions: they didn’t intend to make mistakes, but wrongly believed they were serving the public interest.
When former Congressman Barney Frank, for example, the “Frank” of the bureaucracy-loving Dodd-Frank Act, said before the crisis said that he wanted to “load the dice” with Fannie and Freddie, he never intended for the dice to come up snake eyes, but they did. Throughout the book, Turner displays the tendency to assume the consequences of government action to be knowable and benign, rather than unknowable and often perverse.
Debt and the Devil opens with the remarkable confession of government ignorance shown in the following excerpts. As he became Chairman of the Financial Services Authority in 2008, Turner relates:
“I had no idea we were on the verge of disaster.”
“Nor did almost everyone in the central banks, regulators, or finance ministries, nor in financial markets or major economics departments.”
“Neither official commentators nor financial markets anticipated how deep and long lasting would be the post-crisis recession.”
“Almost nobody foresaw that interest rates in major advanced countries would stay close to zero for at least 6 [now it’s 8] years.”
“Almost no one predicted that the Eurozone would suffer a severe crisis.” (That crisis featured defaults on government debt.)
“I held no official policy role before the crisis. But if I had, I would have made the same errors.”
If governments, their regulators, and their central banks cannot understand what is happening and the real risks are, then it is easy to see why their actions may be unsuccessful and indeed generate perverse results. So we have to amend some of Turner’s conclusions, to make his partial insights more complete.
“Central banks and regulators alone cannot make the financial system and economies stable,” he says. True, but we must add: but they can make financial systems and economies unstable by monetary and credit distortions.
We are “faced with a free market bias toward real estate lending” needs additionally: and an even bigger government bias and government promotion of real estate lending.
Turner quotes Charles Kindleberger approvingly: “The central question is whether central banks can contain the instability of credit and slow speculation.” This needs a matching observation: The central question is whether central banks can hype the instability of credit and accelerate speculation. They can.
“Banking systems left to themselves are bound to create too much of the wrong sort of debt” needs amendment: Banking systems pushed by governments to expand risky loans to favored political constituencies are bound to create too much of the wrong sort of debt, which will lead to large losses. This will be cheered by the government until it is condemned.
“At the core of financial instability in advanced economies lies the interaction between the potentially limitless supply of bank credit and the highly inelastic supply of real estate.” Insightful, but incomplete. Here is the complete thought: At the core of financial instability lies the interaction between the potentially limitless supply of the punchbowl of central bank credit, bank credit, government guarantees of real estate credit, and the inelastic supply of real estate.
“Private credit creation is inherently unstable.” Here the full thought needs to be: Private and government credit creation is inherently unstable. Indeed, Turner supplies a good example of the latter: Japanese government debt has become so large relative to the Japanese economy that it “will simply not be repaid in the normal sense of the word.”
According to Turner, what is to be done? He supplies a deus ex machina: “We.” So he asserts that “We need to manage the quantity and influence the allocation of credit,” and “We must influence the allocation of credit among alternate uses,” and “We must therefore deliberately manage and constrain lending against real estate assets.” Who is this “We”? Lord Turner and his friends? There is no “We” who know how credit should be allocated.
In an overall view, Turner concludes that “All complex systems are potentially unstable,” and that is true. But it must be understood that the complex system of finance includes inside itself all the governments, central banks, regulators and politicians, as well as all the private financial actors. Everybody is inside the system; nobody is outside the system, let alone above the system, looking down with ethereal perspective and the ability to manage everything. In particular, there is no “We” outside the complex system. “We,” whoever they may be, are inside the complex system with its inherent uncertainty and instability, along with everybody else.
An earlier version of this article incorrectly quoted Mr. Frank; this has been corrected.