"This is a superb book. A must-read for anyone interested in understanding the unhealthy relationship between debt and the modern economy."--Atif Mian, coauthor of House of Debt

"This is the most penetrating analysis of the inherent imperfections of our financial system to appear since the crash of 2008. It will and should provoke extensive debates about the policies needed to avoid future crises."--George Soros

"Adair Turner is a writer who thinks unusually deeply and is prepared to follow his answers to their logical conclusion, however unsettling. Here, he offers a set of proposals for financial reform that are radical yet practical. As the global financial crisis recedes and the danger mounts that the momentum for change will be lost, we can only hope that the world heeds Turner's clarion call."--Barry Eichengreen, University of California, Berkeley

"Turner's fresh and deep insights into our financial system come with the expertise of an insider. Between Debt and the Devil is a landmark in monetary economics, with profound implications for policy reform."--Joseph E. Stiglitz, Nobel Laureate in Economics

"A masterwork! Insightful, scholarly, and persuasive. Adair Turner has provided a convincing analysis of what has gone wrong before, and what could go wrong again, among the intertwined complexities of money, credit, and misguided theories of finance."--Paul Volcker, former chairman of the U.S. Federal Reserve and the U.S. Economic Recovery Advisory Board

"Between Debt and the Devil is a devastating critique of the banking system and a powerful intellectual challenge to conventional wisdom. A splendid book."--Robert Skidelsky, author of John Maynard Keynes, 1883-1946: Economist, Philosopher, Statesman

"Stunningly thorough yet highly readable, Between Debt and the Devil is a thoughtful and deeply researched book that covers all the policy angles on debt in advanced economies, from the problems in regulating credit binges to the challenges of dealing with their aftermath."--Kenneth S. Rogoff, coauthor of This Time Is Different: Eight Centuries of Financial Folly

"Between Debt and the Devil is a wide-ranging and highly ambitious book. Turner presents an alternative way of thinking about financial economics."--Alan D. Morrison, coauthor of Investment Banking: Institutions, Politics, and Law

"Original and powerful. In a crowded field, this book stands out."--Robert Pringle, author of The Money Trap: Escaping the Grip of Global Finance

"Turner's book augments the growing literature that lays bare the realities of boom and bust, bubble and crash, and the recurrent coordination failures that characterize financial history. Between Debt and the Devil will enrich debate among both academics and policymakers."--William H. Janeway, author of Doing Capitalism in the Innovative Economy

Between Debt And The Devil

Money, Credit, And Fixing Global Finance

PRINCETON UNIVERSITY PRESS

Contents

THE UTOPIA OF FINANCE FOR ALL

In the last thirty years, dramatic changes in financial systems around the world amounting, de facto, to a revolution have brought many ... advances. We have come closer to the utopia of finance for all.

— Raghuram Rajan and Luigi Zingales, Saving Capitalism from the Capitalists

Finance looms far larger in both advanced and emerging economies than it did 30 or 40 years ago. Few readers will need convincing of that fact. Newspapers and television programs report regularly on the huge size of global capital markets and trading activity. Financial centers such as New York, London, or Hong Kong have ballooned in importance. Huge bonuses paid to bank trading staff and management are highly contentious in many countries, but the money earned by hedge fund managers dwarfs that of mere bankers. Finance has become the destination of choice for top graduates from elite universities and business schools throughout the world. Some commentators talk about the "financialization" of our economies. It is an ugly word, but it seems to capture the reality: more finance, better paid, playing a more pervasive role in economic life.

Impressions often deceive. But in this case, sober analysis confirms what anecdote suggests. Significantly in most advanced economies but dramatically in the United States and the United Kingdom, finance has accounted for a growing share of national income. And across the world, in many different financial markets, trading activity has massively increased, its growth far outpacing that of real economic activity.

Finance has grown more rapidly than the real economy since modern capitalism first developed in the nineteenth century. Analysis by Andrew Haldane shows finance in the United Kingdom growing on average by 4.4% per year from 1856 to 2008, while the economy grew at 2.1%.

But Haldane's analysis also reveals big variations in growth over time. From 1856 to 1914, the value-added of UK financial services grew 3.5 times more rapidly than national income. The economy became more complex as industry grew at the expense of agriculture; companies issued bonds and stocks on public markets; individuals began to accumulate savings; and London became a financial center servicing global capital flows. As a result the financial industry became far more important.

From 1914 to 1970 finance grew less rapidly than total GDP, even though the economy, despite two world wars, grew faster than in the previous period: by 1970 finance accounted for a smaller share of a far bigger economy than in 1914. But from 1970 on, and in particular after 1980, the picture changed again. From 1970 to 2008 UK finance grew twice as fast as UK national income, with the outperformance becoming greater as each decade progressed.

The U.S. experience, illustrated in Figure 1.1, was similar. Between 1850 and the crash of 1929, finance's share of national income grew from 2% to 6%, with a particularly strong increase throughout the 1920s. That share collapsed in the 1930s and even in 1970 stood at a significantly lower 4%. From 1970 to 2008 it more than doubled. In 2007 finance played a bigger role in advanced economies, as measured by share of GDP, than ever before.

The growth of finance from the 1970s on, and the acceleration of that growth over the subsequent decades, would be an important issue for economic research even if we had not suffered the financial crisis of 2007–2008. Finance, after all, is not a consumer product or service, valued in itself, like a car or a restaurant meal or clothing. No one gets up in the morning and says "I feel like enjoying some financial services today." Finance is a necessary function to enable the production of the goods and services we actually enjoy. And it makes up a large enough proportion of the economy that the cost efficiency with which the financial industry performs these functions has a significant impact on people's living standard. Even if there had been no crisis, it would be worth asking whether we are getting value for money.

But it is the financial crisis of 2007–2008 that makes it not merely interesting but vital to ask searching questions about the economic impact of this huge increase in financial intensity. For the crisis and its aftermath have been an economic catastrophe, a setback to the success of the market economy system only previously matched by the two world wars and the Great Depression of the 1930s.

We cannot therefore avoid the questions: Which aspects of this growing financial intensity were beneficial and which harmful? Which led to the crisis, and how radically must we now reform to prevent a repeat?

Increasing Real Economy Borrowing ... and Saving

The first step is to identify which specific financial activities contributed most to finance's remarkable growth. Research by Robin Greenwood and David Scharfstein shows that two factors dominated.

First, finance made much more money out of providing credit to the economy, and in particular credit to households. Second, asset management activities and profits grew dramatically; that growth reflected increased fees flowing to a wide range of financial institutions such as securities firms, mutual funds, hedge funds, and venture capitalists. But it also entailed the extensive trading, market-making, and funding activities that form inputs to the asset management process.

Other aspects of finance also grew, but less dramatically. Insurance for instance grew slowly as a percentage of GDP but without the sharp acceleration in growth that marked debt and asset management–related activities.

Greenwood and Scharfstein's findings reflect a startling and important fact — that the role of debt in the U.S. economy, and in most other advanced economies, grew dramatically. Finance made lots more money from providing credit, because households and companies borrowed much more. In 1945 total private sector debt — household and business combined — was about 50% of U.S. GDP; by 2007 it had reached 160%. In the United Kingdom in 1964, total household debt stood at 15% of GDP; by 2007 it was 95%. In Spain total private debt was 80% in 1980 and 230% by 2007.5 Figure 1.2 shows the picture for all advanced economies combined. The private sector became dramatically more leveraged: households — and in some countries, businesses — owed much more debt relative to their income.

Increasing borrowing also helps explain rising asset management revenues. For every debt in an economy, every financial liability, there has to be some matching asset. Sometimes that match may be easy to see: a corporate bond owed by a business can be an asset owned by a pension fund. Sometimes the match is indirect and more difficult to discern: a mortgage debt indirectly funded, through multiple intermediate steps, by investors in money market mutual funds.

But overall the growth of debt liabilities as a percentage of GDP had to be matched by increases in fixed income assets, by money or bonds of some sort. In the United Kingdom household bank deposits grew from 40% to 75% of GDP between 1964 and 2007; in the United States money market funds grew from zero in 1980 to $3.1 trillion in 2007.7 Institutional holdings of bank debt and of non-bank credit securities also dramatically increased, indirectly or directly funding increased borrowing.

Fixed-income financial assets thus inevitably grew as a percentage of GDP, rising in the United States from 137% in 1970 to 265% in 2012. So too did financial assets in an equity form. Total U.S. equity market value rose from 58% of GDP in 1989 to 142% in 2007. There were many more assets to manage, so the business of managing assets grew.

Part of the reason finance grew is therefore simply that the real economy — households and businesses — owed more financial liabilities and owned more financial assets. To assess the impact of increasing financial intensity, we must therefore assess whether this increased use of financial services by the real economy was beneficial.

In most other sectors of the economy we wouldn't even ask such a question. If people choose to spend more of their increasing income on a particular service — more restaurant meals or travel — we usually trust that they have used their income in the way best suited to increase their welfare. But financial services are different, because their provision and consumption can have important effects on overall economic growth and stability.

Seen from the asset side, increased financial consumption might appear clearly beneficial: people holding more financial assets sounds like a good thing. But the dramatic increase in private sector leverage had important and harmful effects. Indeed, a central argument of this book is that the high level of private debt built up before the crisis is the most fundamental reason the 2007–2008 crisis wrought such economic harm. But the dramatic acceleration of finance's growth that occurred after the 1970s was not just the result of greater use of financial services by real economy households and businesses. Equally striking is that for each unit of financial services consumption by the real economy, the financial system itself did far more, and more complex, activities.

One way to capture that increased complexity is shown in Figure 1.3, which sets out the scale of debt liabilities in the U.S. financial system. It illustrates the gradual growth of corporate leverage and the more significant growth of household leverage. But the most striking feature of Figure 1.3 is the growth of intrafinancial system assets — of debt and other contracts between different financial institutions. Financial institutions did much more business with one another than they had done before 1970.

Look at the typical bank balance sheet in the 1960s, and apart from government bond holdings and cash, it was dominated by loans to and deposits from households and businesses. In the United Kingdom in 1964 loans to the real economy plus government bonds and reserves at the Bank of England accounted for more than 90% of aggregate bank balance sheets. By 2008 much more than half the balance sheets of many of the biggest banks in the world — such as JP Morgan, Citibank, Deutsche Bank, Barclays, RBS, or Société Générale — were accounted for by contractual links, whether in loan / deposit or in financial derivative form, between these and other banks, and between them and other financial institutions, such as money market funds, institutional investors, or hedge funds.

That reflected in part a dramatic increase in trading activity. Financial institutions buy and sell financial instruments back and forth between each other to a far greater extent than they did 40 years ago, and financial trading has grown dramatically relative to underlying real economic flows. The value of oil futures trading has gone from less than 10% of physical oil production and consumption in 1984 to more than 10 times that of production and consumption now. Global foreign exchange trading is now around 73 times global trade in goods and services. Trading in derivatives played a minimal role in the financial system of 1980, but it now dwarfs the size of the real economy; from zero in 1980, the total notional value of outstanding interest rate derivative contracts had soared by 2007 to more than $400 trillion, about nine times the value of global GDP.

This growth of trading activity was spread across numerous different asset classes and contract types. But one of the most important changes was increased trading of credit securities, a key element in the phenomena we label "securitization" and "shadow banking."

Tradable credit securities, bonds that represent a debt claim against some counterparty, have existed for as long as bank loans: government and corporate bonds were extensively issued and somewhat less extensively traded in 1950, when finance accounted for just 2% of U.S. GDP. But from the 1970s, the scale of credit security creation soared, above all in the United States, but with consequences across all advanced economies and major financial centers. The credit intermediation system that connected end borrowers with end savers was transformed.

The new system was built on the innovations of credit securitization, credit structuring, and credit derivatives. Securitization enabled loans to homeowners, car buyers, students, or businesses to be pooled into composite credit securities and sold to end investors rather than held to maturity on bank balance sheets; it extended bond-based finance from governments and major corporations to a wider set of borrowers. Credit structuring divided up the risk and return inherent in a portfolio of loans and allowed the creation of different tranches of credit securities — from low-risk low-return "super senior" claims to high-risk mezzanine or equity. It gave us the alphabet soup of collateralized loan obligations (CLOs), collateralized debt obligations (CDOs), and even CDO-squareds. CDOs did not even exist in 1995; in 2006 $560 billion of new CDOs were issued. Credit default swaps (CDS) were invented to allow banks to hedge credit risk, but they also enabled banks and other investors or dealers to seek profit from position taking: their value grew from zero in 1990 to almost $60 trillion by 2007.

Together these innovations enabled credit exposures originated by banks (or nonbanks) in one country to be distributed to end investors across the world. Mortgage lending to British homeowners could be turned into securities and funded indirectly by U.S. money market funds. Subprime mortgage loans to U.S. low-income households could be financed by German Landesbanks seeking higher return without, it was hoped, more risk.

But the common description of this system as one of "origination and distribution" fails to do justice to its complexity. In fact credit securities and the credit derivatives that referred to them could be traded back and forth numerous times between multiple institutions. And the same credit security could pass from borrower to ultimate investor through multiple intermediate steps. An investor in an apparently low-risk and instantly available money market fund could indirectly finance 30-year mortgages, with the finance passing through contracts in the asset-backed commercial paper (ABCP) market, via structured investment vehicles (SIVs) or Conduits, or through the repo market and hedge funds.

The sheer complexity of the securitized credit and shadow banking system on the eve of the crisis is mind boggling. The Federal Reserve Bank of New York attempted to capture all of its possible paths and interconnections on a single map. It printed the results on a poster 3 feet × 4 feet in size and recommended that anyone attempting to understand the system should do the same: anything smaller and it becomes difficult to read the labels.

The overall impact was as Figure 1.3 illustrates. For each unit of real economy borrowing or saving, the financial system itself did more, and more complex, activities.

Therefore, in addition to assessing the impact of increasing real economic leverage, we need to assess the consequences — positive or negative — of this increasing complexity in the financial system itself. Although there may have been some positive effects, Chapter 6 argues that the net impact was severely negative. Increased complexity made the financial system inherently less stable, and it facilitated excessive credit extension and leverage in the real economy. As a result it both made the crisis more likely and the consequences more severe.

More Finance, Higher Pay

The financial system thus became both bigger and more complex. It also paid much better. Even in 2012, 4 years after the crisis, more than 2,500 bankers in London were earning more than £1 million per year.