Adair Turner: The Clearest Explanation of the Cause of Financial Crisis

Adair Turner, the chairman of the UK’s Financial Services Authority, member of the BoE’s Financial Policy Committee,  set out the fundamental cause of the financial crisis in his speech to the South African Reserve Bank on Friday 2nd Nov 2012:

“The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money.”

This is something what we’ve been saying for over two years: that if we allow banks to create money effectively out of nothing, in the way that we’re doing at the moment, then sooner or later we’re going to end up with a financial crisis, debt crisis and the situation that we find ourselves in today.

But this, coming from a chairman of FSA, is the clearest explanation of what is going wrong with our current economic system that has ever come from one of the people who are in charge of regulating the system.

“…the existence of banks as we know them today – fractional reserve banks – exacerbates these risks because banks can create credit and private money, and unless controlled, will tend to create sub-optimally large or sub-optimally unstable quantities of both credit and private money.

Lord Turner further describes the negative impacts of fractional reserve banking:

“The impact of fractional reserve banks is thus to make the financial system and the overall economy inherently more vulnerable to instability, creating risks which have to be balanced against the economic advantages which can arise from the risk pooling and maturity transformation which banks perform.”

“Banks which can create credit and money to finance asset price booms are thus inherently dangerous institutions.“

He then gives a clear description of what banks actually really do:

The banking system can thus create credit and create spending power  – a reality not well captured by many apparently common sense descriptions of the functions which banks perform.  Banks it is often said take deposits from savers (for instance households) and lend it to borrowers (for instance businesses).  But in fact they don’t just allocate pre-existing savings; collectively they create both credit and the deposit money which appears to finance that credit.Thus banks can create credit and private money.  

He also references to the work of Prof Richard Werner, who is a member of Positive Money’s Board of Advisors, and with whom Positive Money has made a joint submission to the Independent Commission on Banking that recommended the implementation of full-reserve banking for the UK.

“Werner is one among few modern economists who have focused on describing and thinking through the implications of the fundamentals of bank money creation, in the same fashion as did earlier economists such as Irving Fisher or Henry Simons.”

Adair Turner then goes on to look into the early Full Reserve Banking proposals (Chicago Plan):

The answer the early Chicago’s theorists gave us was ‘very radical’– so radical indeed as effectively to abolish leveraged maturity transforming, fractional reserve banks.

Thus in the Chicago Plan and other variants of 100% money banks (Exhibit 24) no private money is created since no private credit is extended, but instead all money in circulation derives from public debt or money issuance.

Essentially this would mean that banks which provided money services would face a 100% liquid assets requirement: while any institutions which made loans would face a 100% capital requirement, and could hold no deposits a set of prudential requirements which certainly makes Basel 3 look a pretty weak package.

He also comments on the recent IMF working paper “Chicago Plan Revisited”:

But extreme though it is, there are modern economists who believe that the Chicago Plan is a feasible model for real world policy. Indeed in an IMF working paper published in august this year, entitled ‘The Chicago Plan Revisited’ Jaromir Benes and Michael Kumhof have argued that a transition to a 100% money banking system is both desirable and possible, and that it could and should be accompanied by a dramatic write-down of existing household debts, removing in one fell swoop the vulnerability to financial and macroeconomic instability created by high levels of household leverage.

Although Adair Turner is not convinced that we could or should move away from fractional reserve banks, he thinks “we should take their ideas – rooted as they are in theoretical clarity about the origins of financial instability – as a spur to radicalism in our response to the financial crisis.”

 “If we really have constructed an economic system in which adequate nominal demand growth is only attainable with a continual upward creep in the level of debt to GDP, we have created a dangerous system and should seek to identify less risky ways ensure that demand is adequate.”

Read the full speech here.