Blame Real-Estate Lending. Then Rein It In.
Left to themselves, banks and shadow banks are bound to create too much of the wrong sort of debt and leave economies facing severe debt overhangs. That raises the question: How can we prevent excessive credit creation?
Following the 2007–2008 crisis, major reforms have sought to make the financial system more stable, ensuring better-run banks and fixing the problem of “too big to fail.” But this is insufficient; lending that looks good from a private perspective can have bad economic effects, and better risk-management tools, such as credit derivatives, can make the overall financial system more unstable.
We need to manage the quantity and allocation of credit, not just fix the banks and cap bankers' bonuses. The debt overhang that delays economic recovery and causes deflation can be driven as much by borrowers who pay off their loans as by those who default.
The fundamental problem is real estate. The homes and buildings people want to own are limited in supply, and the land on which they sit is an irreproducible asset. Credit and real-estate price cycles, as a result, have been not just part of the story of financial instability in advanced economies; they are close to the whole story. And as economies get richer, real estate and urban land will become still more important.
Rising real estate and land prices have been the predominant driver of the increase in wealth-to-income ratios that French economist Thomas Piketty has documented. Real estate and urban infrastructure investment will inevitably account for an increasing share of all capital investment as the prices of capital goods that incorporate information technology continue to fall. And residential mortgages are bound to account for a large share of lending, since they play an important role in lubricating the exchange of assets within and between generations.
But these inherent tendencies make economies less stable. Even if debt contracts and leverage were entirely absent, economies with higher wealth-to-income ratios would be less stable because consumption and investment are highly sensitive to fluctuations in asset prices. And high leverage against real estate exacerbates the danger.
To manage this, the available tools include significantly higher capital requirements for real-estate lending. They also include borrower constraints, such as maximum loan-to-value and loan-to-income ratios. Policies to address the underlying drivers of real-estate supply and demand are also crucial. I recommend tight mortgage underwriting standards and limits on the advertising of very high-interest credit.
Public policies that encourage dispersion of economic development might also be needed to reduce the importance of scarce urban land supply.
Tax policy also must be changed. Capital-gains tax regimes that exempt family homes make housing a capital asset that delivers a tax-free return. Interest expense on mortgage debt is tax deductible for owner-occupiers. And in almost all countries, mortgage interest is tax deductible for investors in rented property. In the U.K., this has helped finance a “buy-to-let” boom that has driven house prices higher.
There is a strong case for taxing either land values or the gain from their appreciation. Land-value appreciation produces wealth accumulation unrelated to the processes of innovation or capital investment that drive economic growth. Rising urban land prices are also a major contributor to wealth inequality.
Inequality is rising rapidly in both advanced and emerging economies. High-income earners tend to have a higher propensity to save; many middle- and lower-income earners borrow to maintain consumption. Credit therefore has to grow faster than GDP simply to maintain demand growth. Differential access to, and pricing of, credit can give a further twist to inequality.
At the top end of the distribution, access to well-priced credit increases opportunities for capital gain. At lower- and middle-income levels, mortgage borrowing at high loan-to-income levels can result in wealth losses in post-crisis recessions. And dependence on unsecured debt at high interest rates can generate poverty.
Does this rising inequality matter? Some people argue that in already-rich societies, where even low incomes are high compared with those in the rest of the world, it does not. Others suggest that inequality at the bottom of the income distribution matters, while the soaring incomes of the very rich do not. I am concerned about all these trends, yet for me the key issue is the danger that an unequal society will mean an increasingly credit-intensive economy, and as a result a potentially unstable one.
If we remove the credit growth but not the rising inequality, we may be left with a deflationary problem. The effect on consumer welfare would also be unfair -- not to mention politically unpopular -- if people who want credit can't get access to it. We should therefore seek to reverse or at least halt the dramatic rise in inequality.
Policies to do so must reflect the root causes. Globalization of trade and capital flows has reduced the relative position of less-skilled workers in advanced economies. Information and technology are almost certainly driving down the wages of workers and creating opportunities for rapid wealth creation by successful entrepreneurs. The growing number of financial transactions has itself played a major role in driving inequality at the top end of the income distribution.
There are also strong reasons to believe that one of the standard answers to the problem -- “let’s increase people’s skills” -- will be only partially effective in a world in which very large differences in labor costs are driven by minor differences in skill or simply by luck. Growing income divergence, moreover, can generate still greater inequalities, as wealthier people save more and enjoy superior rates of return than do poorer individuals.
It is therefore highly likely that offsetting the rise in inequality or even preventing further increases will require more redistribution of income and wealth, whether achieved through the tax and public spending system or through labor-market intervention. A basic income paid to all citizens regardless of the labor-market price for their skills and higher minimum wages have merit. Piketty argues for a globally agreed wealth tax to offset the self-reinforcing effects of rising income inequality and wealth accumulation.
Political support for such measures may well be lacking. One of the paradoxical effects of rising inequality is that it tends to reduce rather than increase support for income redistribution. But we must recognize the role of rising inequality in driving the increasing credit intensity of growth.
If we fail to tackle it, we will face not only its direct, adverse implications for social cohesion and human welfare, but its consequences for financial instability as well.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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