In Between Debt and the Devil, Adair Turner writes (p. 61),
Textbook descriptions of banks usually assume that they lend money to businesses to finance new capital investment…But in most modern banking systems most credit does not finance new capital investment. Instead, it funds the purchase of assets that already exist and above all, existing real estate.
…Different categories of credit perform different economic functions and have different consequences. Only when credit is used to finance useful new capital investment does it generate the additional income flows required to make the debt certainly sustainable. Contrary to the pre-crisis orthodoxy that the quantity of credit created and its allocation between different uses should be left to free market forces, banks left to themselves will produce too much of the wrong sort of debt.
What is good about the book is that he invites us to examine how credit is created and where it goes. As he points out, standard macro models have totally ignored this issue.
What is bad about the book is embedded in the last sentence quoted above. We are left to assume that the huge allocation of credit toward housing was the operation of “free market forces.” I do not know about other countries, but for the United States this is totally false. The government was very much involved in channeling credit, and it channeled as much as it could toward housing finance.
Still, I think that what is good about the book makes it worth reading. I plan to say more when I have finished it.
Financing of already existing assets can certainly create value; it amounts to financing entrepreneurial activity.
Perhaps it would be more accurate to say that the availability of credit facilitates the expressions of different determinations of values or assets for different allocations.
The above reminds me of an email exchange I once had with someone who suggested that the favored capital gains rates on stocks should only go to new capital investment which companies used to build factories and such and not stock trading of existing shares. My response was in the real world, you cannot distinguish between the two and any attempt to do so will raise the cost of capital which will reduce economic growth ( example 1, Apple sells 10 million share to finance a factory, 20 million shares traded that day, how do you tell good from bad shares? If you mark them, do we need 2 separate types of shares, and do good shares become bad shares once they are sold, and how does this impact liquidity and cost of capital for Apple).
Often when someone buys something, whether a house, commercial property or a business, he buys the current value but has a “dream” that that asset can be made better (which is generally why he buys). This dream generally involves improving the asset, or cutting costs to make the business more efficient (thereby increasing productivity and making us all better off). Now each purchase of an asset involves some of the existing value, that just changes hands, and some of the “improvements”.
How is or should a banker/lender know or care? Don’t you just want him to make loans which will be repaid at the highest risk adjusted rate?
Financing existing assets doesn’t in itself, but while it can just lead to higher prices for them, it sometimes leads to investment in new ones justified by them. The vast government intervention was by China keeping its currency down. The investment in housing, like the investment of most imbalances, was just credit seeking its level. Yet this was continually touted as an economic free lunch. Then the bill arrived.
Collateralized borrowing (financing) has now become predominant.
Collateral for that function may be valued for its productive capacity (which includes transferability and variability of uses) as well as it’s “market” value, an assessment of liquidation worth.
The Sparrows Point Works of Bethlehem Steel.
The problem with banking is that the failure of a weak bank does not strengthen the others.
In theory I disagree. But in practice I suspect he is right.
I will also leverage what Arnold said. What if any old bank got 1 10th of 1% bonus to real estate debt. Why would they do anything else? The free market strawmanning has got to stop, especially in fractional reserve banking.
Trying to generalize a bit, isn’t the shadow banking system filling this gap where banks only over-invest in allegedly lower risk proven/existing assets?
And how could the political process promote anything anything than what is considered herd-like risk, making it systemically risky?
Money is fungible. It doesn’t matter which assets they finance. Doing so frees others to invest in other assets.