Friday, May 30, 2014

Person (5) Memory

Human memory is an amazing facility. A small piece of meat, at the front of our brains, less than a cubic inch in size, can store more information than a super-computer.

Our memories store much of the information that we have learned throughout out our lives. We can recall facts that we learnt when we are children and much of what we have learned since. That is a huge amount of information. Unfortunately, we also store facts that are wrong.

Our memory also stores a record of many of the things that have happened to us. This is not just a list of events. Our memory stores video and audio. Sometimes it store the smells and the touches we experienced too. We can recall events from the past and relive them again, as we lived them the first time. More than that, the emotions that we experienced are stored alongside the audio and the video. They are recalled with the sounds and sights of the memory.

We have the ability to recall events from most stages of our lives. When we bring them into our minds, it is like we are experiencing them again. I can close my eyes, and see my mother when I was a child baking biscuits. I can recall the taste and the smell.
I can remember sitting in school as a five year old and making a booklet out of yellow paper to write lists of words in. We did not have a stapler, so I stitched the spine of the book with needle and cotton thread. I can remember when the small school got its first stapler, because it was such a marvellous thing.

The memory facility is neutral. It just stores stuff. It can store things that are good. It can store stuff that is evil. Christians want their memories to be filled with good stuff. We need memories of evil stuff too, for our protection, but we do not want these memories to be so vivid. For evil, the facts will usually be enough.

The memory tends to get a good press from Christians, but this is not quite right. Memories are like computer hard drives that need to be cleaned up and defragmented when they get full of junk. We reorganise our memories by recalling things. Memories we never try to recall, tend to disappear deeper in. Things or events that we recall often are kept fresh.

Vivid negative memories are dangerous, because they pop out when we do not expect it, and constrain our behaviour.
There are several ways we can restructure our memories for good.
  • Worship defrags the memory. If we constantly recall what God has done for us and give thanks, those memories seem to move to the front.

  • If we forgive people that hurt us, the memories of those hurts will retreat. It is not a case of forgive and forget, but forgive and the memory will grow dim and less dominating.

  • If we have really bad memories that keep popping out, we may need to ask the Holy Spirit to remove them. Prayer with others might help with that.

  • Some of our memories will be false. False memories can have a negative effect on our behaviour. We need to talk to people who can help us correct them. Sometimes we will need the Holy Spirit to correct our memories, by explaining what happened from God’s perspective.

  • Christians should always be willing to learn new things. We should always strive to correct wrong facts that we have put in our memories.

  • We should frequently recall the dreams that God has given to inspire and direct us.

  • We should recall the prophesies that God has spoken to us over and over again.

Thursday, May 29, 2014

Person (4) External Senses

The five external senses are well understood. We learn to enumerate them from childhood: see, hear, smell, taste, touch.

Those who want scriptures can find references for each of the five senses. There are plenty for seeing, hearing. Jesus physically touched many people and the bleeding women touched him. Smelling is less common, but Lazarus stank. There was plenty of tasting at the wedding in Cana.

The role of the external senses is to inform us what is happening in the external world. When a leaf fall off the tree, I can see it. When a door shuts, I can hear it. These senses are essential for living in the physical world. A person who is deficient in one sense is limited in some way. A person who is blind finds it much harder to move around in the physical world. A deaf person misses out on some things.

The external senses have no moral character. They are neither good or bad. However, they are neutral in what they perceive. They can perceive things that are good and things that are bad. My eyes can see violent movies. I can hear a testimony about Jesus.

Our external senses take stuff from the external world and bring it inside us, so we should be careful about how we use our senses. We can use our external senses to fill minds with good stuff and with bad stuff. Job said,
I made a covenant with my eyes
not to look lustfully at a young woman (Job 31:1).
We should be careful that our eternal senses are focussed on stuff that will edify us.

Christians should not be driven by what we perceive from the physical world with our external senses. We should be shaped by what is happening in the spiritual realms. We perceive that through our spirit. Paul said,
Since, then, you have been raised with Christ, set your hearts on things above, where Christ is, seated at the right hand of God (Col 3:1).
Christians use their five external senses to operate in the physical world, but we must fix our heart on Jesus in the spiritual realms. I have described this in greater detail in the Spiritual Realms.

Wednesday, May 28, 2014

Person (3) Mind

The mind is where everything happens. We can recall things to our minds from our memory. We can bring thoughts about the future in from our imagination. Our external senses report to our minds, so that we can perceive what is happening in the world around us.

An important aspect of being a human is that we are conscious of our existence and our actions. That consciousness is registered in our minds. If we lose consciousness, we stop functioning fully as a person, though we might be still alive physically.

Our minds are corrupted by sin. It was created to think in a rational and logical way, but the fall means that our thinking is often twisted and distorted. We fool ourselves into thinking things that are illogical or wrong.

The Bible challenges us to renew our minds.
Do not conform to the pattern of this world, but be transformed by the renewing of your mind (Rom 12:2).
One of the best ways to reshape our minds is to fill it with the word of God.
We demolish arguments and every pretension that sets itself up against the knowledge of God, and we take captive every thought to make it obedient to Christ (2 Cor 10:5).
Listening the Holy Spirit is essential for renewing our minds. The goal is the mind of Christ.
But we have the mind of Christ (1 Cor 2:16).

Tuesday, May 27, 2014

Person (2) Body

Every person has a body. Our bodies are what make us human. They are made of muscle, bones, nerves, etc. Our bodies allow us to move around and undertake activities in the physical world.

Our bodies are weakened by sin and sickness. The body of many people wears out before they have completed their work on earth. Jesus was beaten for the healing of our bodies.
By the lacerations of his body we are healed (Is 53:6).
Through most of the history of the church, this aspect of Jesus’s suffering has been wasted.

Monday, May 26, 2014

What is Person

I have never studied psychology, but I have given a lot of thought to what makes a person tick.

Some Christians divide a person into body, soul and spirit. But we are really much more complicated than that. The scriptures presents a much more complex picture of human nature.

I will explain everything in turn.

Saturday, May 24, 2014

Healing: Insights for Christians

Today is the last day to get your free copy of the Kindle edition of my book called Healing: Insights for Christian Elders from and

Friday, May 23, 2014

Raising the House

This earthquake damaged house in Christchurch has been lifted up so a new foundation can be built. Is there are parable here?

Healing: Insights for Christians

The Kindle edition of my book called Healing: Insights for Christian Elders will be available for free on and for two days from Friday 23 May to Saturday 24 May.

Thursday, May 22, 2014

Driving a Convertible

Last weekend I converted my desk into a convertible. I can switch from sit-down to stand-up desk simply by moving my wireless keyboard.

The benefits are described in this article called standing desks sit well.

Tuesday, May 20, 2014

Christchurch Rebuild

The earthquake damaged Miller's building is being knocked down so a new bus station can be built.

Saturday, May 17, 2014

Silas Marner

I have just finished reading Silas Marner by George Eliot. It is free on Kindle. George Eliot tells a great story with some delightful characters about reaping what you sow. The honest tradesman with no expectations discovered love and peace. The indolent gentlemen found only disappointment and sadness.

Thursday, May 15, 2014

Vague Lending

If I lend you my combiner harvester, you would not record it as an asset on your balance sheet. Yet that it was banks do, when I deposit money with them for safe keeping. This gives them the right to lend the money to someone else. I think the money belongs to me and is ready for me to use whenever I want it. They have given it to someone else. If my friend gave my combine harvester to someone else to use without asking me first, I would be a bit upset. However banks do this all the time.

I would not promise my combine harvester to another person without checking when they planned to do their harvest. I would want to make sure my harvest would be done first, or that they would be completed theirs, before mine was ready. The agree would sort this stuff out, so that I was no left in a situation where I lost my harvest.

Our contracts with banks are too vague. People depositing money in a bank have different intentions.

  • Some will be transactions money left in my bank between payday and when my rent is due, or I can get to the supermarket to buy my groceries.
  • Some is money that I do not want to use for a while, because I am saving to buy a new computer in about six months time.
  • Some will be long-term savings for when I retire.
The bank does not know my intentions. We need deposits with contracts appropriate for the various purposes for which I deposit money in the bank.

Wednesday, May 14, 2014

Turner Turns (14) Warehouse Bank

Adair Turner acknowledges the problems with modern banking, but his solution is for central banks to have better prudential controls. He does not get to the heart of the problem, because he just accepts the laws that give banks the right to take immoral actions.

I have described a warehouse bank which must match the term of its loans with its deposits.

To make a loan of a particular term, the bank would have to attract equivalent deposits for the same time. This would limits its ability to create credit, because it would be limited to true intermediation.

We need honest banks.

Tuesday, May 13, 2014

Turner Turns (13) Maturity Transformation

Banks have the ability to lend long and borrow short. This makes it easier for them to create credit.

They can create a new twenty-year mortgage and keep the balance sheet balanced by taking short-term deposits.

A person or business cannot do this. If the business wants to give it clients twenty-years to pay, it locks up some of its cash or stock for that length of time.

Monday, May 12, 2014

Turner Turns (12) Transferable Securities

When I create credit, I get an IOU from the borrower. It has limited value, as most people will not know the person who issued it like I do, so they will have no reason to trust them, even if I do. It will be quite difficult for me to sell it someone else, if I need my money back.

When a business creates credit, it will get some kind of security in return. It will be quite hard to exchange for money, unless the person or business granted credit is widely known and trusted. The security might be difficult to sell, if the business finds it needs cash for some reason.

Banks are different. They can sell securities to the central bank and get currency in return. This currency is legal tender, which is mandatory for settling debts. This gives the bank a big advantage when creating credit/money.

Healing: Insights for Christian Elders

The countdown special on the kindle version of my book on healing ends at midnight Pacific Standard Time.

Get Healing: Insights for Christian Elders for $US 0.99.

Saturday, May 10, 2014

Turner Turns (11) Banks Get the Money Back

Banks are different from other businesses in another way. Most of the money that they lend comes back to them. The bank deposits the money in the account of the person taking out the mortgage. It will not stay there, because the borrower will write a cheque to pay the person they are buying a house from (ignoring the solicitors for simplicity). The house seller will deposit the cheque in their bank account, most likely a different bank. The borrower’s bank will have to transfers reserves to the sellers bank to cover the cheque.

The seller might need to use some of the money to pay for goods and services. They might buy some shares or units in a superannuation fund. The money will end up in the banks of the businesses selling these things.

The big difference is that the money ends up being deposited in a bank account, somewhere. Whereas, when a business gives credit to a customer, they hand over good or services to them. They do not get anything back until the loan is due. The money does not come back to their business.

The credit created by the bank issuing the mortgage would end up in accounts at other banks. However many other loan transactions would be going on at the same time. The home buyer’s bank would most likely have some money paid into the accounts of its depositors relating to these transactions. It would receive Central Bank reserves from other banks to cover these cheques. All the transactions could cancel each other it, so the bank might need to give up any reserves at all. If this happened, the bank would have received back all the money that it has loaned out.

This difference allows a bank to create immense amount of credit, provided all other banks are doing the same.

Friday, May 09, 2014

Turner Turns (10) Banks

Banks create credit. However, the structure of a bank balance sheets means that it is not so constrained as other businesses.

Due to fractional reserve banking laws, only a small part of the bank’s assets are needed for the support of its ongoing business. They do not need to use their currency to make a loan. Reserves at the central bank cannot be lent to private individuals.

When making a loan, the bank simply records a deposit in it’s clients bank account. They record this deposit as a liability on the bank’s balance sheet. The mortgage is recorded on the other side of the balance sheet as an asset.
Banks are not constrained like other businesses. Only a small part of their assets, are needed to support their ongoing business. All they have to do is keep enough reserves of currency or at the central bank to cover potential withdraws of call deposits. Deposit insurance means that their reserves can be kept quite small.

Banks are different from businesses. They do have to give up anything when giving credit to a borrower. Banking laws give them the right to give borrowers something they do not own.

Understanding this is easier, if we think about the situation when banks began as goldsmiths storing gold. People deposited their gold with the goldsmith for safekeeping. Rather than withdrawing gold when they needed to make a payment, they would exchange the goldsmith’s receipts. These receipts acted as money. The goldsmiths realise that only a fraction of the gold was withdrawn at any one time, so they began lending some of it out in return for an interest payment.

All the gold belonged to the people who deposited the gold. The goldsmith bank did not own any the gold (although it would record on its balance sheet). When it loaned gold, it was lending gold did not own. It was cheating because it was lending something that did not belong to it.

Now that we have switched to fiat money, the same situation applies. Banks can lend out money that they do not own, just as a goldsmith bank lent out gold it did not own. The law allows banks to operate in this way. No other person or business has this right. Fractional reserve laws give banks a huge capacity to expand credit. This has been a major cause of instability in economies everywhere.

Thursday, May 08, 2014

Turner Turns (9) Creating Credit

Adair Turner explains that Banks can create credit. What he does not explain is why they are able to do it so freely. Is this legal? Is it right?

Banks are not unique in being able create credit. Any individual can create credit too. If I supply you with goods or services and say that you can pay me in a year’s time, I have create credit. However, I can only give away stuff that I do not need for the next year, so there is a serious limit on how much credit I can create. I have to give some goods or services that I have produced or bought in exchange for an IOU from the borrower. Unless I am rich in resources, I will not be able to give much credit.

Businesses can create credit, too. If it supplies goods or services to person or another business, and agrees that no payment is required until a year later. This credit becomes money, because the person can use the money he would have paid to the business to buy something else.

However, a business has the same constraint on the amount of credit that it can create, as a person. It has to supply some goods or services to the borrower in exchange for the security it receives from the borrower. Creating credit will reduce it stock of goods or supply of cash in the bank. It can only lend stuff that it does not need for the ongoing operation of its business. The amount of credit created will be small, because most of its resources will be needed to keep the business operating.

A businesses balance sheet looks like this.

The business needs its capital equipment and building for ongoing production. Therefore, unless the business is willing to borrow the money it lends, it has to turn some of its cash at the bank or stocks of inventory into loans to debtors. This significantly limits the amount of credit it can give.

Wednesday, May 07, 2014

Turner Turns (8) Flawed Arguments for Credit Creation

Most economists assume that private credit creation by banks is the best way to ensure sufficient aggregate demand. Several reasons have been put forward to justify the need for credit creation. They are flawed but we need to understand them.

  1. Shortage of Savings
    One possible reason for credit creation might be a shortage of saving constraining capital investment. If people do not save enough, then economic growth could be slowed. Lack of savings is a seriously problem in many economies, but credit creation is not a solution.

    At the level of real activity, investment must be matched by savings. When an economy produces capital goods, there has to be forgone consumption as less consumer goods are being produced. If Robin Crusoe devotes time to making a net, he will have less time for fishing. He will have to consume less for a while, so he can build up a supply of fish to eat while he spends time making the net.

    In a complex economy, decisions about investment and saving are made by different people, so intentions about saving and investment could get out of line. Business might produce more capital goods than savers are willing to fund. If that happens, there will be a surplus of investment goods and a shortage of consumption goods.

    Creating credit might seem like a solution, but it is not. It actually makes the situation worse, because central banks adjust interest rates to encourage the banks to create credit. When the central bank controls interest rates, the price information that savers and entrepreneurs need to make good decision are distorted. It is better to let the interest rate adjust naturally until savings and investment comes into line. Quick money schemes have an appeal, but there is no escape from the need for saving.

  2. Lack of Nominal Demand
    The most common argument in favour of credit creation is that nominal demand is sometime insufficient to produce economic growth. Central banks believe they can increase growth by increasing the supply of money. This argument is flawed, because the demand does not cause production of goods and services. Rather production creates demand for the goods and services. This is summarised by Says Law, which says that supply of goods and services creates it own demand. In a barter economy, if I have produce something for exchange, that creates a demand for something that someone else has produced.

    In a complex economy, the wages and salaries and profits earned through the production process create the demand for the goods and services produced.

    Say claimed that production is the source of demand. One’s ability to demand goods and services from others derives from the income produced by one’s own acts of production. Wealth is created by production not by consumption. My ability to demand food, clothing, and shelter derives from the productivity of my labor or my nonlabor assets. The higher or lower that productivity is, the higher or lower is my power to demand other goods and services (Says Law).
    What can happen is that entrepreneurs make the wrong types of goods and services. They might produce to many cabbages when people are wanting more pumpkins. These problems are easily solved. Prices will adjust and businesses will adjust their production to clear the market. Credit creations just exacerbates the problem by making it seem as if there is demand for the things that people did not really want. This rewards the entrepreneurs who made bad decisions, which is like to make the situation worse in the future.

  3. Short Term Liquidity
    A common argument for allowing banks to engage in credit creation that liquidity is needed for markets to function.

    You cannot buy what I have produced, until you have sold what you have produced. However, Jack cannot buy what you have produced until I buy what he has to sell. Trade appears to be stymied.

    This is an old problem, but people have always found a problem to solve it buy offering credit to each other. All it takes to get trade moving is for someone to say to someone they trust, you can pay me when you have sold what you have produced. People do this all the time. Societies have found various ways to make sure trade take place, without the need for banks to create credit.

  4. Seasonal Finance.
    A common argument for increased money supply is that it is needed to finance seasonal production. This is an illusion. If I sow wheat in the ground, I will not reap a harvest until six months later. If I do not have any spare grain, then I have to get some grain from another person to avoid starving. That grain will not be available for someone else to consume. This shows that season activities, where production take a long time to be complete, has to be supported by real saving. Creating credit to for seasonal finance will distort supply and demand.

Not Needed
The accepted wisdom that credit creation is needed to foster economic growth is flawed. Credit creation, whether by banks or governments, is theft. It allows the people who get the created credit to buy something that really belongs to someone else. While economists are stuck with the idea that growth in nominal demand must be funded by credit creation, they will continue to create problems for their economy. The GFC is the most recent example.

Tuesday, May 06, 2014

Turner Turns (7) Moral Flaw

My turn now.

The basic flaw in Adair Turner's talk is his assumption that a gradually increasing supply of money is needed to ensure that economic growth is not constrained. Turner says that a problem with metallic money is that it does not grow fast enough. The implication is that as the economy grows, prices and wages have to slowly decline. He says that this was the situation during much of the nineteenth century. This statement is a bit odd, because this was a time of rapid economic growth arising from the industrial revolution.

Turner says that most economists believe that it is difficult to get downward flexibility and that it is more sensible to run an economy with nominal GDP growth of 4-5% price inflation of 2-2½ and real GDP growth of 2-2½. Monetary growth is needed to ensure GDP growth is not constrained.

There is a moral flaw to this argument. Monetary inflation robs savers of their wealth. Over twenty years, the purchasing power of savings is halved, if inflation averages 3% per year. That is painful, if you are living on your savings, as many people do. Over the last few decades, inflation has been much greater than 3%, so the loss have been even greater. This is theft, so it is morally wrong.

The argument that prices are sticky downward is wrong. Every time we go shopping, we see specials and offers of discounts. Clearly, retailers are quite happy lowering prices. Prices of electronic goods have declined continuously over the last few decades, without any disruption of the market.

Wages are sticky downward, but that does not matter. If all prices are declining slowly, and nominal wages are unchanged, then real wages are increasing. This is what should be happening in a vibrant economy. Improvements in productivity due to technological advances should allow business to reduce their prices. So over time, prices should be declining slowly. This increases the real value of wages, without any need for industrial pressure. This is the true trickle down.

Gradual inflation robs workers of this technology dividend. If prices are rising slowly, real wages will decline, unless employees can persuade employers to pay more. This is hard, because the truth is that wages are sticky upwards too. Under inflation the benefits of technology are captured by the richer people whose income comes from capital gains, which benefit from price inflation.

Contrary to Turner and other economists, an economy with gradually falling prices would be better for wage earners and people on fixed incomes. They would share in the benefits of technology and improvements in productivity without having to use industrial muscle of political power.

Gradual inflation encourages people to go into debt. If prices were slowly falling, people would thing twice about going into debt, because the real value of their debt would gradually increase over time. The inflationists have taken away one of the best protections against excessive data.

Monday, May 05, 2014

Turner Turns (6) Inequality

Like everyone these days, Adair Turner is concerned is about inequality.

Within any society, richer people have a higher propensity to save. If there is a dramatic increase in inequality, there can be a situation where intended savings are not matched by investment decision. This would normally create a deflationary impetus, except that rich put their money in the bank, and they lent it out subprime mortgages to people trying to make up for deficiencies of income.

Inequality will have to be eliminated to prevent this problem.
His concern about inequality comes from a Keynsian dislike of saving. I am concerned about inequality too, but saving is not the problem. Saving is essential for supporting capital formation. Without capital funded by real saving an economy cannot grow. If savers want to save more than entrepreneurs want to invest, interest rates will fall (provided central banks are not meddling) and more capital projects will be viable and the excess savings will be absorbed. So excess saving is not a serious problem. While poverty is a problem, it is foolish to say that there is too much saving.

Sunday, May 04, 2014

Turner Turns (5) De-leveraging

Adair Turner explains that during the upswing, debt contracts fool us.

The mode of the frequency distribution of returns is getting all your money back. People start to believe that the mode is the entire distribution of possible returns. Prior to the GFC, banks lent money where there was not a reasonable expectation of return. Risks of default were neglected. Subprime lending is the worst example.

In the downswing, debt contracts exacerbate the problem. Irving Fisher’s article covered three problems.
  1. Bankruptcy and Default
    Debt contracts do not respond to downturns in the economy, because they are non-state contingent. Adjustments occur in a jumpy fashion through bankruptcy and default. Real estate fire sales occur. Bankruptcy and default were missing from the DSGE models used by central banks.

  2. Roll-over needs and Impaired Lending Capacity
    An equity contract goes on forever. It may decrease in value, but it does not have to be repaid. Debt contracts have a specific term and have to be rolled over. If banks stop lending, there is a problem.

  3. Debt Overhang
    People feel shocked at their level of leverage and try to repay debt. Companies stop investing. Households stop consuming. These effects exacerbate the economic downturn.

The debt overhang is the reason why we have had such a slow and weak recovery from the GFC.

We do not know how to get rid of leverage in an economy. We just know how to shift it around, mostly from the private sector to the public sector. Excessive private debt is shifted from the private sector to the public sector or from one country to another. The rise of Chinese debt is the natural consequence of de-leveraging in the west, which was driving a deflation in china. We do not know how to get rid of leverage.

The accepted wisdom does not produce the optimal quantity of credit. The reason is that there is not one natural rate on interest. Natural interest rates are heterogeneous through time, and across sectors and categories of lending. In a real estate boom, shifting the interest rate from 5% to 5½% will do nothing. Increasing the interest rate to 10% will wreck the real economy long before the boom is slowed. There is heterogeneous interest rate elasticity of response.
This last paragraph explains why orthodox monetary policy does not work in New Zealand. When low interest rate cause a housing boom, the Reserve Bank of NZ pushes up interest rates. The carry trade responds by bringing funds to New Zealand to get the higher rates. This strengthens the NZ dollar, which creates problem for the export sector. This policy hurts the export sector long before it cools the housing market.

Saturday, May 03, 2014

Turner Turns (4) Credit Misallocation

Adair Turner explains that during the last couple of decades, too much credit was produced due to problems with credit allocation.

Economic textbooks say that banks lend the savings of households to businesses to fund new capital projects. Banks choose between alternative projects to find the most productive. This view is misleading. In the UK, only 15 percent of bank credit goes to fund new capital projects.

  1. Bank credit is lent to households to fund increased consumption.

    • Some may be logical optimisers rebalancing consumption over a lifecycle within a budget constraint. That is sensible.

    • Some may be impatient people trying to spend money now that they cannot afford to repay. Often these are the poorer people.

  2. Most bank credit goes to purchase existing assets, often real estate. When the growth in credit goes into residential real estate, the only thing that can give is prices. The increase in price validates the decisions of borrowers and lenders. The net worth of the borrower is increased. This increases their incentive and ability to borrow more. Credit against real estate is a cause of economic instability.

    The iron law of banking is that every 15 years somewhere in the world, a commercial banking system goes mad lending to real estate. This builds up a problem when the cycle changes from growth to decline.

The GFC demonstrated that a society can produce too much credit. To much leverage is dangerous.

Friday, May 02, 2014

Turner Turns (3) Pre-crisis Orthodoxy

Turner describes the orthodox approach by central banks prior to the Global Financial Crisis (GFC)

  • On their monetary theory side, low and stable inflation was considered to be desirable and sufficient as an objective. Low inflation indicates an economy in balance, so by definition, the right amount of credit would be created. Central banks did not have to pay attention to where the credit was going. The only concern was whether enough credit would be produced.
  • On the financial theory side, debt contracts were considered to be essential Free markets will produce an optimal balance between supply and demand.
This orthodoxy was seriously exposed by the GFC. The crisis came about through too much of the wrong sort of debt. Both sides of the orthodoxy were wrong.

We actually have a system that can produce too much credit, if left to itself.

Thursday, May 01, 2014

Turner Turns (2) Debt Contracts

Adair Turner explains that banks create ongoing debt contracts.

Economists have argued that an all-equity economy would be more smoothly operating. However, human beings cannot deal with the resulting uncertainty. They want apparent certainty, especially in wage and debt contracts. They prefer fixed flows of revenue to partnership shares in business projects.

A debt contract is non-state contingent. Payments are not contingent on a future state of the world or on the success of a particular business project. This is good for capitalisation, because it overcomes the problem of costly state verification, the difficulty of working out both ex ante and ex post whether a business project is profitable or not. Asymmetric information makes lenders powerless compared to the borrower.