Tags: Turner | debt | crisis | leverage

Adair Turner: Cause of Financial Crisis Remains Unaddressed

By Michael Kling   |   Friday, 06 Sep 2013 08:06 AM

Five years after the peak of the financial crisis, the world has yet to address its fundamental cause — excess debt.

And that's why economic recovery has been so slow, or even nonexistent in some countries, writes Adair Turner, former chairman of the United Kingdom's Financial Services Authority, in an article for Project Syndicate. If the cause goes ignored, the crisis won't be the last, he warns.

Policymakers failed to foresee the crisis, failed to predict the extent of economic pain and failed to predict it would spread to Europe, notes Turner, a member of the U.K. Financial Policy Committee and the House of Lords.

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Why the incredible lack of foresight?

Mainly because the experts failed to understand that high — and growing — debt burdens, especially in the private sector, endangered economic stability.

Household debt in the United Kingdom rose from less that 15 percent of GDP in 1960 to more than 90 percent in 2008. In the United States, total private credit ballooned from about 70 percent of GDP to well over 200 percent in 2008.

Policymakers thought private debt had no impact on macroeconomics.

"That assumption was dangerous, because debt contracts have important implications for economic stability," Turner explains. "They are often created in excess, because in the upswing of economic cycles, risky loans look risk-free. And, once created, they introduce the rigidities of default and bankruptcy processes, with their potential for fire sales and business disruptions."

Plus, debt can cause over-investment, prompting boom and bust cycles, he adds. Good times made rising leverage seem to disappear. Just look at the Irish and Spanish property booms, he notes.

"Indeed, subprime mortgage lending delivered illusory wealth increases to Americans at a time when they were suffering from stagnant or falling real wages."

The real problem is that in the downturn, all those debts depress the economy, smothering chances of recovery. Overleveraged businesses and consumers cut investment and consumption in an effort to pay down debts. That's what caused Japan's lost decades after 1990. Rising government deficits can help offset that kind of deflation, but it just shifts leverage to the public sector.

"Private leverage levels, as much as the public-debt burden, must therefore be treated as crucial economic variables. Ignoring them before the crisis was a profound failure of economic science and policy, one for which many countries’ citizens have suffered dearly."

Policymakers and pundits have listed a many possible causes of the financial crisis. Former Treasury Secretary Hank Paulson blames government regulations. "I believe that the root cause of every financial crisis, the root cause, is flawed government policies," Paulson told The New York Times.

"I’m most concerned about the multiple regulators falling all over each other and the confusion that regulatory competition creates," he added.

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