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.