Borrow till you choke.

Photographer: Kevin Frayer/Getty Images

Think of Debt as Pollution

Clive Crook is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was chief Washington commentator for the Financial Times, a correspondent and editor for the Economist and a senior editor at the Atlantic. He previously served as an official in the British finance ministry and the Government Economic Service.
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There are so many works on the global financial crisis by now that it's getting harder to justify any more, but Adair Turner's new book, "Between Debt and the Devil," is definitely worth your time. (Bloomberg View recently published two excerpts.)

Last week I praised John Kay's "Other People's Money." Turner takes a different approach, and the two complement each other very well. Kay, in effect, stands entirely outside the current system -- asking the reader to think about the basic purposes of finance and what kind of arrangements might best meet those demands. Turner's method is more straightforward: He describes the current system and what's wrong with it.

That's been done, to be sure, but the book develops a strong and persuasive central theme. The problem, Turner says, isn't so much with them -- with the banks and other financial firms, that is. It's with us, and our addiction to a certain kind of debt.

The book's main argument turns on the distinction between debt that's used mainly to finance new business investment, and debt that's used mainly to buy existing assets, especially real estate. The first, you might say, is about financing economic growth; the second is at least partly about bidding up prices. Pre-crash financial orthodoxy said the mix of credit between those different uses could safely be left to lenders and borrowers to decide for themselves. That was wrong, Turner argues.

Borrowing to buy a house, for instance, looks pretty safe from both sides of the transaction. Banks get a claim on the property, so their exposure to default is capped; and borrowers have an ownership stake they'd otherwise lack, so their mortgage repayment serves as a form of saving. What could be more prudent? Yet this appearance of safety is an illusion: "Lending against real estate -- and in particular against existing real estate whose supply cannot easily be increased -- generates self-reinforcing cycles of credit supply, credit demand, and asset prices."  

These cycles, moreover, are inevitably unstable. Between 2000 and 2007, Turner points out, mortgage credit in the U.S. more than doubled; house prices soared as well. In Spain and Ireland, mortgage lending grew much faster even that that, and house prices surged accordingly.

The point is, as the cycle gains momentum, rising prices fail to check the demand for borrowing. On the contrary, they add to it -- until the cycle swings into reverse and everything unravels. The crash levels the asset valuations but leaves the debts that caused them standing. Deflation, if it gets a grip, actually adds to the real burden of the debts. That makes a strong recovery very hard to engineer.

Many factors, in this telling, contribute to the sequence. For instance, banks over-lend partly because of the protections and subsidies they enjoy, and people and firms over-borrow because debt enjoys tax privileges. At the very least, Turner argues, debt should be treated neutrally for tax purposes. But it would make more sense, he says, to tax it as a kind of pollution.

More generally, the book argues that it's necessary to deliberately manage the credit cycle. Conventional monetary policy isn't enough. You need so-called macro-prudential regulation as well -- such as varying the maximum permitted loan-to-value ratio for housing loans according to where you stand in the cycle.

The book discusses many such post-crash innovations. If anything, in fact, it discusses too many.

The main fault of "Between Debt and the Devil" is that it covers so much ground. It discusses just about every domestic and international factor that plausibly contributed to the crash, and just about every feasible domestic and international policy response. To keep the book at manageable length, Turner keeps all this discussion brief. He name-checks author after author, and mentions study after study on issue after issue -- showing excellent taste and thorough familiarity with the material. The book always serves as a superb guide to the available reading, but it doesn't succeed every time in explaining the issues adequately.

Still I recommend it highly. Turner brings an unusual combination of credentials. As a former chairman of the U.K.'s Financial Services Authority, he's a paid-up member of the economic-policy establishment; he's also a genuinely radical thinker, and unafraid to say what he thinks. On some issues, notably in calling for "direct monetary financing" of government deficits (so-called helicopter money), he's struck out on his own and put big, bold ideas on to the policy agenda. More power to him.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Clive Crook at ccrook5@bloomberg.net

To contact the editor responsible for this story:
Christopher Flavelle at cflavelle@bloomberg.net