Asset price collapses, banking crises and recessions (Werner 2005)

Instances of asset inflation are not welfare optimal. For one thing, it cannot be considered efficient nor equitable when new claims on finite resources are created by banks and then granted to a specific group of individuals who use them purely for speculative gain, without adding to productivity or output. Moreover, the extension of speculative loans and asset-collateralizing loans creates negative externalities in the economy and thus directly affects others. If house prices are driven so high that they are beyond the reach of first-time buyers, this can affect the quality of life of entire communities. In England, many cities are unable to attract sufficient numbers of welfare workers, teachers or firemen, as they cannot afford to live in them on their salaries. High real estate prices in city centres may increase commuting times and hence shorten the time available for family or leisure.

The externalities in the banking system are also significant: as banks become overextended to borrowers who have not invested the newly created money productively, our theory of productive credit creation tells us that, in aggregate, such loans cannot be paid back (only ‘productive’ loans will be non-inflationary and only ‘productive’ loans will produce goods and services of value, thus producing income to service the loans). As a result, systemic risk increases.

Bank lending for speculative purposes CF is only viable as long as banks continue to increase such lending. It seems a reasonable assumption that banks will not continue to increase their speculative lending CF into eternity. We thus consider what happens when at some stage (perhaps again induced by a regulatory shock, such as a change in the monetary policy of the central bank) CF  falls. According to equation (5), asset prices will fall. This will then reduce collateral values and bankrupt the first group of speculative borrowers who were seeking merely capital gains. Their default will create bad debts in the banking system. This in turn will raise banks’ risk aversion and reduce the amount of credit newly extended. This further reduces asset prices (equation 5), which increases bankruptcies. The process can easily make banks so risk averse that they also reduce lending to firms for productive purposes, in which case GDP growth will also fall (equation 4). Such credit crunches have been observed in many cases, including the US.[2] This exacerbates the vicious cycle, since with less economic growth, corporate sales and profits decline. As more firms become unstable, bad debts increase further (see Figure 16.1). [emphasis added] (Werner 2005)



Richard A. Werner, New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance, (Houndmills, Basingstoke, Hampshire: Palgrave Macmillan, 2005), 229-230.


[2] For empirical evidence of the credit crunch problem in Japan see, for instance, Matsui (1996). On the US see, for instance, Gertler and Gilchrist (1994).

Werner to BBC: UK QE = FAIL

In both Japan and the UK, QE isn’t working, he says, because it doesn’t focus on “the most important part of the money supply”, which is bank lending. “UK QE has singularly failed, as bank credit is still shrinking.”

When faced with the claim used by some British banks that the demand for credit is low, Prof Werner is dismissive. “I’m quite used to this argument, because banks in Japan used it for 20 years,” he says. “The banks, of course, have become very risk-averse, as they have many non-performing assets.”

Prof Werner is also critical of the UK’s concentrated banking structure – which he argues has made the economy more vulnerable. “British banking is dominated by a small number of big banks – with just five banks controlling 90% of deposits,” he says.

Richard Werner talking to the BBC in their news item UK QE has failed, says quantitative easing inventor.

What is completely lost in that BBC article is that Werner has always emphasised that the effect of credit creation depends on the use of money. Werner cites two cases:

Case 1. The newly created purchasing power is used for transactions that are part of GDP. In this case, nominal GDP will expand: credit creation for ‘real economy transactions’ C(R) –> nominal growth can result in two outcomes

  1. Inflation without growth | Credit creation is used for consumption: more money coincides with the same amount of goods and services = consumptive credit creation
  2. Growth without inflation | Credit creation is used for productive credit creation: more money coincides with more goods and services = productive credit creation

Case 2. Newly created purchasing power is used for transactions that are not part of GDP (financial and real estate transactions). In this case, GDP is not directly affected, but asset prices must rise (i.e. asset inflation): credit creation for financial transaction C(F) –> asset markets.

  1. Asset inflation | Credit is used for financial and real estate speculation. More money circulates in the financial markets = speculative credit creation.

For a recent deck of his go here

One of the best books that few people know about let alone have read is Werner’s New Paradigm in Macroeconomics Solving the Riddle of Japanese Macroeconomic Performance

That will be covered in the future on this site as it will become more relevant that rate normalization will not be around the corner in Canada, USA or elsewhere where the debt burden for households is large, debt servicing long and the banking sector is fundamentally an extender of credit for real estate speculation, development and home buying rather than a lender for funding new startup entrepreneurial ventures that are critical to economic rejuvenation but also risky: most fail. There isn’t an immediate solution to the lack of funding for start ups but new models of peer to peer lending may be an option.