A radical reform of the euro area

04 March 2015

On 26 February 2015, Adair Lord Turner of Ecchinswell, Senior Fellow at the Center for Financial Studies (CFS) and at the Institute for New Economic Thinking, was guest at the CFS Colloquium series. He made the point that the financial crisis and the slow post-crisis recovery were first of all due to excessive private credit creation. Further, he argued that radical reforms were needed within the euro zone because deficiencies in rules and responsibilities are still present.

Excessive credit growth leads to crises

According to Turner, the dilemma is that credits need to grow faster than nominal GDP in order to stimulate economic growth. Excessive credit growth however produces financial instability and leads to crises. Turner argued that governments face four options when trying to reduce their debt overhang: 1) debt write-off, default or restructuring; 2) debt erosion via inflation or monetization; 3) sustained slow growth and low deflation; or 4) stimulating yet more credit.

How to stimulate nominal demand growth?

Turner explained that, if an inflation target of 2% is still considered desirable in the future, we will need a nominal demand growth of around 4% per annum. To stimulate nominal demand growth, governments have three possibilities. The first is to create credit and money – with the downside risk of more instability in the financial system. Second, governments could increase their funded fiscal deficits, but then fiscal consolidation or monetization would be necessary in the future, Turner said. The third option is to run money financed fiscal deficits. In this case, the central bank issues new money which is distributed to the private sector (helicopter money) and, thus, directly enters the income stream. According to Turner, this option is the most effective because it will always stimulate nominal demand. However, he warned that there is a political risk that this option is used too excessively and will create hyperinflation.

Stricter rules for the euro area

Further, Turner called for implementing new rules to better control private credit creation in the euro area. These rules should not only ensure stability of the financial sector but also constrain the growth rate of private debt and the level of private sector leverage. For example, he demands far stronger bank capital and liquidity requirements than required under Basel III. Also, in Turner’s view, new rules to govern public deficits are needed in the euro zone. Market discipline had proved to be inefficient to control government debt, so that political rules are needed to prevent excessive debt accumulation.

Finally, Turner criticized that a large amount of debt within the euro area is held at the sub-sovereign level and that nationally focused banks often hold large undiversified portfolios of sub-sovereign government debt. In case of a national debt crisis, this could create risks in the financial market. Therefore, Turner pleads for prohibiting banks to hold government debt of their own country. In general, he thinks that most debt should be issued at the federal level and that banks should be able to hold federal level debt from the euro area as a risk-free asset.

  • Turner's presentation is available for download here