«There is no way Japan will ever repay its debt»

Lord Adair Turner, former head of the Financial Services Authority, recommends a debt monetisation to Japan and the Eurozone. Central banks would wipe out part of the government debt.

Mark Dittli and Alexander Trentin

Japan could show the Eurozone how to get rid of a huge debt overhang, Lord Adair Turner argues. The central banks could write-off government debt they bought or at least never claim back. In the future it has to be avoided that private and public debtors pile up too large stocks of debt. The interview was conducted during a conference of the UBS International Center of Economics in Society.

Lord Turner, many industrialized nations suffer from a large overhang of private debt which piled up before the crisis. In the aftermath of the crisis the public debt has increased. How can we make this debt go away?

We have a huge problem. The total amount of debt, private and public debt, is so large that it is very unlikely that we can grow out of it. Some say, you always can grow out of debt. They use the example of the UK which came out of the Second World War with a debt to GDP of 240%. By 1970 it was 50%. But we could only grow out of the debt, because we had 25 years in which nominal GDP grew at 8% per annum. Because of demography and productivity increases we could have real growth of 3% p.a. We had a repressed financial system with inflation of 5% but interest rates of 3 or 4%. Countries got out of debt after the Second World War either by hyperinflation, by defaulting, or by financial repression. They had levels of inflation and real growth which are unlikely to occur today. The most inflation we are going to have is 2%. And our mature economies are at the frontier of technology, so the fastest we are going to grow is 1.5 or 2% real. If you run these figures, growing out of the debt just does not work.

So how do we get out of it?

I can tell you what I think will happen in Japan and how it applies to the Eurozone. Japan should have done 15 years ago what Ben Bernanke suggested: a helicopter drop of money. The Japanese should have had a fiscal deficit paid for with central bank money on a permanent basis. They didn’t, and now public debt to GDP is 230%. But even now their best policy, I think their only policy, is to monetize their debt. The government can only repay the debt either by restructuring it, by saying that debt you thought was worth 100 is now only worth 70, or by monetization.

How would monetization work?

You replace the government bonds the central bank owns by a new form of debt which is perpetual and with zero interest. The balance sheet of the Bank of Japan would keep its size, but the government never has to pay interest or repay on this debt. It just sits on the balance sheet of the BoJ forever. It is important to realize that money is a perpetual form of government debt. If you turn government debt into a perpetual and no interest rate debt, you’ve turned it into money. And that is how you monetize.

It sounds like a silver bullet.

It can be a silver bullet. But it has its disadvantages. The US Union government during the US civil war paid a significant amount of the civil war by printing Greenbacks, paper money. This led to significant inflation, but not to so much inflation that there was a problem. It was one reason for the very rapid growth of the economy of the Union states during the civil war. At the same time the Confederacy government did the same thing, but on such an enormous scale that it produced inflation of 1000%. Monetisation will create nominal demand, to that extent it is a free lunch for governments. But crucial is the scale of it. Some people think you must be a mad inflationist, a socialist to support this. But Milton Friedman wrote in an article in 1948 that it would be logical for the government to run a small deficit each year – maybe 1% of GDP – and pay for it by pure money. He said that it would be better than to borrow money and repay.

Are there other successful monetizations?

One of the best examples from economic history where it was done successfully and on a large scale is actually Japan. Finance minister Takahashi from 1931 to 1936 used central bank financed fiscal deficits to drive the economy out of recession. It was very successful. Japan pulled out of recession faster than most countries in the 1930s.

Why is this solution then not discussed more widely today?

Regarding money-financed government deficits, we created an absolute taboo. That was done for political economy reason: We are terrified that if we do it on a small amount, we will want to do it on a bigger and bigger amount – and then it will produce hyperinflation like in Weimar or a Zimbabwe. It is like a medicine which taken in small quantities is good, but taken in large quantities is fatal. The legitimate argument of the Bundesbank point of view is: Yes, technically you could do it and it would help us to recover from the debt. But it is just too dangerous and we should not touch the medicine.

But Japan will do this great experiment some day in the future?

If you are in a situation like Japan you are going to do it – if you want to do it or not. There is no way that Japan will ever repay the debt. And at some stage the market will wake up to that fact. There will be an increasing number of people quoting what Japanese government debt is without the central bank debt in it.

Are there no risks?

Japan is in a very dangerous position. When through a build-up of private debt and then a build-up of public debt you end up with large amounts of money, changes in market expectations can produce highly disruptive effects. Up until now, there are still people queuing up to lend money to this highly indebted government for almost nothing. But once you allowed the debt to get so big, small changes in the calculations can be highly destabilizing.

And would people not lose trust in the Yen?

This is a problem with this large debt. If people start saying the Japanese government will eventually accept that it is money-financed, not debt-financed, it might produce more inflation than the Bank of Japan wants. A downward spiral could start: Inflation would produce a devaluation of the Yen which fuels even more inflation. This could lead to higher government bond yields, the government would have to pay higher interest on their debt which is not money-financed. But there are policies to offset the inflationary effect. When a central bank buys government debt, it creates commercial bank reserves at the central bank balance sheet. The banks currently do not borrow as much as they are allowed to do by reserve rules. To stop banks from creating more private money, you could use the reserve requirement at the central bank. This can be used as a mopping up exercise if the stimulus got too big.

Will Japan lead the way for Europe, showing how to get rid of its debt?

For the Eurozone it is much more complicated. Japan at least is one country with one central bank which is responsible to one nation. Although the consolidation of debt might break the rules thought to be good central bank practice, everybody can agree the government and central bank have a right to do it as it all belongs to the same people. But in Europe whose debt do you write off? In Japan, the worry is that after the breaking of the taboo of monetization the government might become irresponsible and do it all the time. In Europe it is even more difficult. The Germans could say that Italy is responsible for all this debt. And if it is monetized, the Italians would profit from it, but the extra inflation would hit all countries. There are technical solutions for this, for example buying debt according to the GDP of each country. Politically it is hugely more complicated regarding the incentives for the future. Where one country could say we trust ourselves to do this and not repeating it too much. But Germany could assume that Italy and Spain could in the future run up private or public debt and the process would repeat again.

So what will happen in the Eurozone?

Some time next year if the Eurozone economy gets worse, the European Investment Bank could loan a whole lot of money to investment projects, and issue a lot of bonds which the ECB just happens to buy. The danger is that if you pretend you are not doing monetization, you are not sending the message which reassure people that it is possible.

Will the weak Eurozone countries ever be able to pay back their debt?

I am not sure if Italy can repay its debt. To keep its debt still in terms of debt to GDP, given low growth and low inflation, Italy has to run permanently a primary surplus before debt servicing costs around 3 to 4% of GDP. Maybe it will keep doing that, but it is politically tough to keep to this discipline. If there is a populist wave as we saw it in Greece, the dynamics will head off in the other direction. And then the dynamics become cumulative. The moment the market believes that you cannot pay back your debt, the interest rate of the new debt goes up. Unless there is at Eurozone level some progress on the acceptance of monetization, Italy may restructure its debt or leave the Euro. Then it achieves a reduction of the debt burden by renominating into the Lira.

The central banks now try to compensate for the effects of the debt overhang by stimulating banks to generate more credit. You called it curing a hangover with a drink.

That is the problem. That’s why there will be write-off or the debt needs to be monetized. Britain managed to have after Second World War for many years interest rates below inflation. It managed to run down public debt without stimulating private debt. Total leverage, public and private, did come down during that period. But we are in a different environment now. If we simply try to grow out of it or by very loose monetary policy, in 2020 debt to GDP will be even higher: Debt was shifted from the private side to the public side and then some was shifted back to the private side. The net effect is that the total debt comes up.

Why is the US now in a better situation than Japan or the Eurozone?

The US has run very large public deficits. Together with a loose monetary policy, the US was able to grow at a nominal growth rate of 3%. Deleveraging went by the denominator not the numerator of the debt ratio. It looks like the US will manage to bring down the debt ratio by increasing the nominal GDP. It all depends on the attainable growth rate. In the US it might be still 2 to 3%. The problem of Japan is that the attainable growth rate might be more like 0.5 or 1%. Because even if Japan achieves 1.5% productivity growth, it still has a declining workforce.

How would you judge if the debt level of an economy is too high?

There needs to be a unified theory of the total debt in economy, private and public debt. If you have too much private debt it may migrate over to the public side. But how much is too much? It differs by country. It partly differs in relation to the sustainable growth rate. The lower your long-term sustainable growth rate, the more you need to contain the total level of debt within the economy. There is a level of debt beyond which either where you have to accept that it will grow forever or your attempt to bring it down will suppress the economy.

And the government would need to react to rising private debt?

When Spain and Ireland allowed their private debt to GDP to go that high, they should have made sure that the public debt to GDP is at zero. Because if the bubble pops, the debt comes back to the public side and at that stage a lot of leeway is needed to increase public debt without hitting sustainability limits. One of the missing things in economics is how to look at the public and private debt together.

A tool for slowing the credit cycle are higher equity requirements for banks. How large should they be in your opinion?

Around 20% against unweighted assets. I am with Anat Admati and Martin Hellwig on that issue. In an ideal world, we would never have allowed banks to have such a high leverage as they have. International banks would have now an equity ratio around 10% of their risk weighted assets, including a capital buffer. But they can write a mortgage and say they are so safe that it’s risk-weight is only 10%. That means the banks can write a mortgage book which is financed 99% with debt and 1% with common equity. This is where we still are, despite all the efforts of myself, Philipp Hildebrand, and the Americans – we were the three hawks in the Financial Stability Board when discussing Basel III rules. The Germans, the French, and the Japanese were the doves.

Your description of a credit cycle of increasing debt until the bubbles deflate reminds of descriptions by the Austrian school of economics. Do you agree with this school?

Friedrich Hayek gives a brilliant explanation of how the upswing of the credit cycle works and how it is self-reinforcing. When you have got a problem, Hayek’s answer on this is based on an German concept of debt as Schuld, guilt. You need to purge and to liquidate, to purge the rottenness out of the system. It would be absolutely horrible, but it would be the fault of the involved parties. I don’t agree with the Hayekian answer, we need a more humane answer. But my concept of how to avoid that too much debt is created in the first place is very Hayekian.

But the Austrian concept to take short-term pain, the purge, to get long-term gains still gets a lot of sympathy in German-speaking Europe.

That was tried by Chancellor Heinrich Brüning in the early 30s. And it didn’t end too well, with deflation, mass unemployment and the rise of Hitler. This point of view gets still a lot of attention in German economics, law and politics. It is very important for people like me to engage with that German point of view. I completely understand and respect that if there is not a rule to face the consequence of too much debt, people will do it again. There needs to be solution how to get out of the mess we are in, without sending signals that there are in future no constraints because the debt will be monetized later. But I tell my German friends: I know you are fixated with the lessons of Weimars hyperinflation, but should you not be fixated with the lessons of Brüning as well? In 1928, four years after the hyperinflation, Hitler and the NSDAP got 2% in the Reichstag elections. In 1932, he got around 30% of the vote. Germany had 10% deflation then. Hitler’s great election breakthrough came by deflation. There is a bias in German collective memory to focus on the danger of hyperinflation and to understate the danger of deflation.

Lawrence Summers put out the thesis that we are in an environment of secular stagnation and that we might need credit bubbles to create new growth.

If we can only create growth by credit bubbles which every few year end in disaster, wouldn’t it be better every year to have an agreed government deficit of 1% to 2% of GDP which is simply money-financed? That is the logical consequence if you believe there is a long-term secular stagnation problem.