Speech
Embargo
1 November 2017, 6.15 pm
Credit, debt and growth
Collegium generale, University of Berne
Fritz Zurbrügg
Vice Chairman of the Governing Board*
Swiss National Bank
Berne, 1 November 2017
© Swiss National Bank, Berne 2017 (speech given in German)
Ladies and Gentlemen
Returning to one's alma mater is always a special occasion. It was 28 years ago that I
completed my doctorate here at the University of Berne. Since then, my professional career
has taken me to a variety of places, but there has always been one topic accompanying me on
the way: the topic of debt. In my first job at the Federal Finance Administration at the end of
the 1980s, I was charged with analysing the Latin American debt crisis. Then, at the end of
the 1990s, working for the International Monetary Fund (IMF) in Washington D.C., the
emphasis was on resolving the debt crisis in Asia. Back in Switzerland, my efforts went into
implementing the debt brake at federal level. And even switching to the Swiss National Bank
(SNB) in 2012 was no escape. The European debt crisis had a major impact on the Swiss
franc exchange rate and on our monetary policy. In addition, we at the SNB are very carefully
monitoring the risk to financial stability inherent in the rise of mortgage debt in Switzerland.
As you can see, the topic of the Collegium generale's lecture series has played a major role
throughout my career. I was therefore very pleased to be invited to deliver a speech today on
credit and debt. I'm deliberately using these terms in conjunction here. Because ultimately
they refer to the same thing. They describe an agreement between two parties. One party, the
creditor or lender, entrusts money or other goods to the second, the debtor or borrower, who
promises to return the money or goods at a later stage. The borrower's financial debt
represents an asset of the lender's.
And yet, although the terms refer to the same concept, the associations they generate go in
debt
opposite directions. In common speech, the word usually has a negative connotation.
Debt sounds like something to be avoided. Whereas the word credit gives rise to positive
associations. Credit opens up new possibilities and is a bedrock of growth.
The different way in which the two terms are perceived is also reflected in their etymology
(cf. slide 2). Debt comes from the Latin debitum, from the verb debere, which means to owe
something, or to have an obligation. The word thus has a moral overtone. Credit for its part
goes back to the Latin words credere, meaning to believe or to trust, and creditum, referring
to something entrusted in good faith.
So which is it? Are debt and credit - I will be using these terms to describe a single
phenomenon in the following - something positive or negative? Over the next hour, I would
like to pursue this question from an economist's perspective.
Let me save you the suspense and reveal the result of my reflections with an analogy.
Sustainable lending is like maintaining a healthy, well-balanced diet. Food is one of the pillars
of our life. In equal measure, lending is a pillar of a thriving economy. However, eating
unhealthy food or eating too much produces only a short-lived sense of gratification and is
likely to lead to health problems in the long run. These will then have to be battled with
tedious diets or even medical treatment. In the same way, unhealthy or excessive lending can
trigger crises. Far-reaching intervention by governments and central banks is then needed to
bring the ensuing turmoil under control.
Ladies and gentlemen, this is what awaits you in today's speech (cf. slide 3): First, I want to
explain why a thriving economy depends on loans just as much as we human beings depend
on food. Next, I would like to discuss why time and again, throughout history, there have
been cases of gluttony at the 'credit buffet', and why these can have far-reaching
consequences. Finally, based on current developments on the Swiss credit market, I will show
up ways in which such downsides can be kept in check without curtailing the advantages
offered by the credit system. My main focus thereby will be on what central banks can and
should do.
Why are loans useful from an economic perspective?
Lending is one of the cornerstones of a successful economy based on the division of labour.
This fact has been recognised since ancient times (cf. slide 5). As much as 5,000 years ago in
Mesopotamia, seeds for crops were made available on loan, with repayment including interest
due after harvest. Loans were also commonly used in ancient Greece and Rome.1
Lending in its present form dates back to the emergence of the 'modern' banking system in
Europe in the late Middle Ages.2 To this day, banks fulfil key functions in brokering loans.
Without them, efficient large-scale lending as we know it would not be possible.3 Most
recently, alternative methods of credit provision have emerged thanks to digitalisation - P2P
or crowd lending for example. Nevertheless, banks remain the mainstay of an effective credit
system.
I will now explain why growth and prosperity would be significantly lower without an
efficient credit system. To do so, I need to clarify the two basic functions of loans (cf. slide 6).
First, loans enable borrowers to have future income at their disposal now. And second, loans
allow creditors to make optimal use of their available capital.
Loans enable borrowers to have future income at their disposal now
Let me explain this in greater detail. Regarding function number one: Without loans,
expenditure at any given time is limited to one's savings and one's current income. The
possibility of taking out a loan expands this limit by adding anticipated future income to the
resources available for spending. Why can this be a good idea? The somewhat banal answer is
because making certain purchases or investments before having saved up the required amount
can have a beneficial effect. Here are a few examples to show that this holds true from the
point of view of companies, households and governments.
Let's start with the example of a start-up by a university of Berne graduate. This graduate has
come up with a brilliant idea for a new product. To develop and produce it, she needs capital.
She herself has no savings and it would take her decades to accumulate the required amount
on her own. Under these circumstances, she would probably give up on the idea. The
possibility of obtaining credit radically changes the situation. A loan enables her to realise her
idea within a short time and generate income with the sale of her product.4
The example shows how loans make it possible even for firms with little capital to make
investments that will generate income in future. In the best case scenario, such investments
also drive technological progress. Thus, loans do not only benefit the company concerned, but
also contribute to raising an entire economy's productivity, growth potential and prosperity.5
Households, too, can harness future income for present-day benefits. The obvious example is
a mortgage to buy a house. Let's take a specific case. A young family - we'll call them the
Miller family - is expecting a child and so will soon need larger living quarters. They have
found their dream house, but the money they have saved so far is not sufficient for them to
buy it. Thanks to the possibility of taking out a mortgage, the Millers can nonetheless
purchase the house of their choice and move in without further delay. The family will from
then on be using part of their income to repay the loan, thereby reaping present benefit from
their future earnings. In other words, they are putting their income to use at a time when they
derive the greatest advantage from it, and in doing so they enhance their prosperity.6
Finally, borrowing can also make perfect sense for a government. Fiscal income and
expenditure are not always in balance. During a recession, for instance, a state's income
declines, whereas expenditure increases due to the activation of various countercyclical
measures such as the provision of unemployment benefit. The result is a fiscal deficit.
Governments can cover the deficit either by temporarily raising taxes or by reducing their
spending. Neither of these measures are helpful in a recession. On the contrary, they would
merely aggravate the recession. Borrowing money enables the government to bridge
temporary gaps between income and expenditure without having to resort to higher taxation
or short-term cuts in spending.
Lending enables creditors to make optimal use of their available capital
As we have seen, borrowers can make optimal use of their income over time thanks to the
credit system. From a lender's point of view, too, providing loans generates substantial
benefit. This brings me to the second basic function of the credit system. The possibility of
lending enables available capital to be invested as profitably as possible, and enhances the
diversification of investment risk. For society as a whole, it means that accrued savings are
made widely available and thus put to better use.
Let me give you an example. An entrepreneur is faced with the question of what use to make
of his assets. There is no major purchase to be made at the moment. Neither is there a
profitable project at his own company in the pipeline. Do you remember our university
graduate with her brilliant idea for a product? The entrepreneur could lend her some of his
assets against interest and so generate a return.7 By extending a loan to the young graduate, he
is also diversifying his investments. As the proverb has it, he is not putting all his eggs in one
basket.
Overall, we can conclude that an effective credit system represents an essential basis for a
thriving economy. It allows borrowers to put their income to the best-possible use over time.
And it give lenders the opportunity to invest their accrued assets in an optimal way.
Individuals benefit from this mechanism, and so does the economy as a whole. As the
examples show, the credit system can support prosperity and economic growth and enhance
the growth potential.8
Under what circumstances is lending detrimental to an economy?
Given all the positive aspects, the possibilities and opportunities linked with the credit system
- why then the negative image associated with the notion of debt?
As mentioned at the beginning, the term 'debt' emphasises the borrower's obligation to repay
the loan in future. Each credit/debt relationship is therefore fraught with the risk that the
borrower might incur financial difficulties and be unable to repay the loan. The cartoon here
makes a tongue-in-cheek reference to this credit risk (cf. slide 8).
Naturally, credit risk is also inherent in the case of our university graduate's start-up. There is
a rule of thumb in the start-up scene that says only one in ten start-ups succeeds. If her
product idea fails, our University of Berne graduate will lack the funds to repay her loan and
interest.
And the Miller family's mortgage loan is not exempt from credit risk, either. Payment
difficulties could arise if, for example, a divorce or rising interest rates lead to an unexpected
hike in current expenses, or if the family's future income is reduced by unemployment or
illness.
In such cases, borrowers will of course do all they can to avoid a default and first of all try to
lower other expenses. This may mean cutting back on non-essential consumer spending or
postponing maintenance work or investments. A default, after all, has far-reaching
consequences. In the case of the start-up, it could possibly lead to insolvency. The Miller
family for their part might be forced to sell the house in an emergency sale.
When borrowers face payment difficulties or default on their loan, this also causes problems
for creditors. They will have to write off anticipated interest income and may even lose the
money lent if the loan isn't secured by collateral. And even if the loan is secured - for
instance by real estate - getting a good price for the collateral could prove difficult, depending
on the circumstances.
Credit as a burden for an entire economy
The examples show that an actual or impending default on a loan can represent a serious
burden for the party concerned or even a personal tragedy. To a certain extent, this explains
the negative connotations associated with debt. However, from a macroeconomic perspective,
default by a single borrower does not usually pose a problem.
Unless the single borrower happens to be a massively indebted state or big bank. An
impending default by such a player has a far-reaching impact on the economy as a whole, as
witnessed in the recent financial crisis.
Debt also becomes a macroeconomic problem when a large number of economic agents help
themselves too generously at the credit buffet table. Such phases of excess on the credit
market usually end with a large number of borrowers encountering payment difficulties. For
the rest of my presentation, I would like to concentrate on this type of debt crisis and on the
costs involved.
Empirical literature indicates that recessions run particularly deep when they are connected
with just such a debt crisis (cf. slide 9). Moreover, the subsequent economic recovery tends to
be sluggish. This applies all the more when the debt crisis also hits the banking sector.9
Why is this so? In a debt crisis following a credit boom, not just a few, but a large number of
households and companies face payment difficulties and have less income and assets at their
disposal. Accordingly, they need to scale down consumer spending and investments over a
relatively long period of time in order to service outstanding loans and reduce their excessive
debt burden. In addition, such an environment usually leads to greater uncertainty, which also
impacts on economic agents that are not directly confronted by payment difficulties. Under
such circumstances, they, too, tend to show less appetite for consumer spending, investments
and risk.10
Cutbacks in consumer spending and investments are even more pronounced when, at the same
time, banks are busy cleaning up their balance sheets. They then become very restrained in
their lending.11 This can even affect fundamentally profitable investments and borrowers with
a high credit rating.
All this places a burden on the economy not just during the acute phase of the crisis, but over
a prolonged period. Lower investment also results in lower growth potential. Because less
investment means less innovation, and less innovation leads to lower productivity growth.
To put it in a nutshell, and to come back to the analogy of food: When, during an upturn,
economic agents have taken excessive helpings from the credit pot, they will, in the wake of a
debt crisis, be forced on a necessary, but long and painful diet.
Why do so many economic agents take excessive risks at the same time?
Thus, the correction of excesses on the credit market leads not just to economic downturns but
also often to sustained loss of growth potential. For this reason, all economic agents should
have a strong interest in avoiding any excesses which could end in a crisis.
Nevertheless, historical evidence shows that periods of excessive risk-taking by individuals,
banks, companies or governments occur with quite alarming regularity. Why do we learn so
little from experience?
Let me say from the outset, there is no one single reason for the repeated excesses on the
credit market. A number of closely related factors all play a role. In the following, I will be
looking in more detail at three of these factors (cf. slide 10). First, a favourable
macroeconomic environment drives the supply and demand of loans. Second, the rational
reaction of individual lenders and borrowers to the favourable environment can lead to a
build-up of systemic risks. And, third, distorted expectations of economic agents also play a
role.12
To illustrate these factors, I will use the example of the Swiss housing boom of the 1980s.
Interestingly, analogous developments can be found in the lead-up to virtually every debt
crisis.13
Economic upturn, low interest rates and rising asset prices
Initially then, the macroeconomic environment plays a major role. Increased lending is often
associated with an economic upturn.14 A key variable here is the interest rate level: If current
and anticipated rates are comparably low, loans tend to be taken out for projects which would
not be profitable or not be financed at higher rates. Furthermore, lenders in such an
environment often take higher risks in order to achieve return and growth targets despite the
low interest rates.
Other key drivers for the increase in credit are movements in prices of assets such as shares
and real estate. Rising prices for these assets and growing credit volume often go hand in hand
and are mutually reinforcing. This applies to the real estate market in particular, since real
estate is almost always part-financed by loans.
Two mechanisms are at work here: First, rising asset prices produce 'wealth effects' in
households. Households become richer and thus more creditworthy. This has a positive
impact on household demand for loans. At the same time, rising asset prices translate into
higher-value collateral for households to use. This enables them to borrow larger amounts,
which in turn leads to a further increase in asset prices.
Second, credit risk from the lender's perspective falls with rising asset prices. During such
periods, banks therefore tend to offer more loans and at more favourable rates.
Developments in Switzerland in the 1980s illustrate these aspects clearly. From 1983, the
Swiss economy recorded dynamic growth over several years. This upturn was temporarily
challenged by the slump on the global stock markets in autumn 1987.15 Global central banks,
including the SNB, reacted with a significant loosening of monetary policy that had a rapid
stabilising effect. The economic upturn in Switzerland gained further momentum over the
following quarters. The overall macroeconomic environment was therefore favourable. Real
estate prices in this environment rose at an increasing pace between 1985 and 1990. The
volume of outstanding mortgage loans also climbed sharply.
Systemic risks
Back to the theory and to the second factor for excesses on the credit market. The previously
described reactions of individual lenders or individual banks to the favourable environment
contribute to the build-up of systemic risks (cf. slide 11). This means that from the
individual's perspective, the expansion in credit demand and supply in a favourable
environment may well make perfect sense. But, even if all parties behave rationally from their
own point of view, there is still the risk that overall an excessive level of debt will build up
that is unsustainable in the long term. Why is this? Individual lenders fail to take into account
that their behaviour has an impact on the ability of other market participants to bear debt. This
applies, for example, when investors are increasingly exposed to the same risks and invest in
the same markets.
For instance, let us assume that a large number of companies or households simultaneously
take out loans to purchase real estate. This situation creates systemic risk because a negative
surprise on the real estate market can lead to many of these investors incurring losses at the
same time, forcing them to sell off their assets so that they can continue meeting their loan
commitments. This can generate a self-reinforcing spiral of falling real estate prices, more
borrowers who can no longer service their debts, and thus greater pressure to sell.
Distorted expectations
Moreover, the behaviour of economic agents during a credit boom is not always entirely
rational. This brings us to the third factor that can contribute to excesses on the credit market
- distorted expectations (cf. slide 12). A glance at the history of financial crises shows: The
longer an economic upturn persists, and the higher asset prices rise at the same time, the more
over-optimistic economic agents are about future growth. At the same time, the more they
underestimate the risks they are taking in purchasing assets or in taking out or granting loans
for this purpose. Alan Greenspan and Robert Shiller coined the phrase 'irrational exuberance'
to describe situations when investors, in their enthusiasm, ignore the investment risks.16
What creates these distorted expectations?
Research in economic history and behavioural economics provides some explanations. The
self-reinforcing dynamics between economic upturn, low interest rates, the rise in asset prices,
and credit growth can induce market participants to feel justified in their optimism and their
expectations of price developments. Government representatives, too, are often infected by
this optimism. Who can predict the future? Perhaps there has indeed been a structural change
in the economy. In other words: During an upturn, everyone finds ostensibly good reasons
why a rise in asset prices and credit volume makes perfect sense and is fundamentally
justified - despite historical experience to the contrary.17
The feeling that this time really is different is something that I experienced at first hand
myself, when I lived and worked in Washington DC from 1998 to 2006. Local real estate
prices during this period recorded average annual growth rates of some 15%. During our stay
there, we kept asking ourselves as a family - should we rent or buy? Our answer was always
the same: Rent, because these annual price increases cannot be sustainable. However, this
argument became ever weaker with each new year of sharp price rises. Towards the end of
our stay, we too were almost ready to switch camps to the adherents of fundamentally new
economic principles in which real estate prices go in only one direction - up. But, as you all
know, in 2006 the massive price correction set in after all.
As an example of the build-up of systemic risks and the excessive optimism of economic
agents, I can again also refer back to the Swiss real estate boom in the second half of the
1980s (cf. slide 13). Strong growth and income prospects and favourable conditions in the
mortgage market boosted demand for property. Real estate was increasingly purchased for
investment purposes since it promised high returns through value appreciation. The higher
demand in turn led to further rises in real estate prices. Accordingly, the value of collateral
and thus owners' assets continued to grow, as expected. Against this background, banks for
their part were more optimistic about credit risks as the number of loan defaults remained low
thanks to rising property prices and favourable credit conditions. As both credit volume and
real estate prices rose higher, economic agents felt vindicated in their optimism.
But if such a period of excessive optimism is followed by a downturn, the impact on these
highly indebted agents is huge. The trend on the real estate market in Switzerland reversed in
1989 (cf. slide 14). Systemic risks materialised and considerable losses were registered. As
investments were largely debt-financed, there was a flurry of loan defaults. Ultimately this led
to banks in Switzerland having to write off more than 40 billion francs.18 To cut a long story
short, the Swiss economy slid into recession at the beginning of the 1990s, unemployment
rose sharply to 5% and the economy subsequently recovered only very slowly (cf. slide 15).
Ladies and gentlemen, having shown you in the first part of my speech that loans are an
essential basis for economic growth, I have now explained how excessive lending can
seriously damage the economy. I have also outlined how a combination of rational behaviour
and distorted expectations of borrowers and lenders can lead to harmful excesses in the credit
market.
What role do central banks play in the credit cycle?
But, you might say, the behaviour of borrowers and lenders, whether rational or based on
distorted expectations, ultimately depends on interest rates. Only if interest rates are low, can
such a dynamic develop. Interest rates in turn are strongly influenced by central banks.
In the last part of my speech I would like to address this argument, and discuss the question
that has come back into focus since the financial crisis: What role do central banks play in the
event of excesses and crises on the credit market?
The fundamental task of central banks like the SNB is to ensure price stability, while taking
due account of economic developments (cf. slide 17). The main instrument they use for this
are key or reference interest rates. If, for example, the inflation rate threatens to fall too low,
key rates are lowered. This has a positive impact on price development via various channels.19
One of these is loans: An interest rate cut reduces borrowing costs and creates incentives for
expanding the credit supply. This encourages investments and consumer expenditure and
ultimately has a positive effect on price development, too. With their interest rate decisions,
central banks therefore consciously influence lending practice. If, for price stability reasons,
interest rates have to be kept low for a prolonged period, it is possible that over time there
may be undesirable excesses in certain segments of the credit market. This poses a risk for
financial stability.
When using the interest rate tool in such a situation, central banks can face a conflict of
interest between the objectives of price stability and financial stability. On the one hand, they
have to keep interest rates at an appropriate level in order to guarantee price stability. On the
other hand, they have to closely monitor the impact of this policy on the credit cycle and
financial stability. In the case of the SNB, contributing to the stability of the financial system
is part of its statutory mandate.
Let me explain this point using the current situation in Switzerland.
Internationally, interest rates have followed a downward trend for many years and are
currently at low levels.20 In the case of Switzerland, this development caused the interest rate
differential against other countries to narrow. Along with occasionally strong capital inflows
during the financial crisis, this fall in the interest rate differential has led to substantial Swiss
franc appreciation and a highly valued Swiss franc (cf. slide 18).
In order to ensure price stability in Switzerland and to create appropriate monetary policy
conditions in this environment, the SNB has had to keep interest rates low for several years
now (cf. slide 19). A higher interest rate level domestically would result in further
appreciation of the Swiss franc. This would cause a slowdown of economic growth and put
the prices of goods and services under pressure. If this downward pressure on prices were to
continue for a prolonged period, price stability would be jeopardised. The low reference rate
maintained by the SNB is therefore necessary from a monetary policy perspective in the
context of the low interest rate environment worldwide and the strong Swiss franc.
At the same time, the persistently low interest rate environment presents risks to financial
stability. This applies first and foremost to the real estate and mortgage markets. Like global
interest rates, mortgage rates in Switzerland have been on a downward trend for some 25
years. Consequently, significant imbalances have built up on the real estate and mortgage
markets.
This is evident when we look at the developments in both markets since 2000 (cf. slide 20).
On an inflation-adjusted basis, prices for single-family houses have risen by more than 50%
overall. The volume of outstanding mortgages has almost doubled over the same period.
These strong rises on their own do not prove the build-up of imbalances - the increases can be
partly explained by fundamentals such as solid population growth. Since 2000, this has
amounted to approximately 18%. A growing population produces a demand for more housing.
As land for building development is limited, this puts upward pressure on real estate prices.
At the same time, demand for mortgage loans grows.21
However, momentum on the mortgage and real estate markets has been considerably stronger
in recent years than can be explained by such fundamental developments. The ratio between
the volume of outstanding mortgage loans and nominal gross domestic product (GDP) since
2000 has risen from 110% to some 145% (cf. slide 21). Lending has thus grown significantly
faster than income in recent years. At the same time, we can observe increasing risk appetite
among banks in their lending business. This is because banks' income from interest rate
differential business is suffering due to the low interest rates. By taking higher risks - in
particular in mortgage lending - banks are able to counter this decline in income in the short
term. Yet, this exacerbates their susceptibility to negative developments on the real estate and
mortgage markets or to an unexpected sharp interest rate rise.
Given the potentially far-reaching negative effects of a debt crisis as outlined in the second
part of this speech, it is clear why the SNB has been carefully monitoring these developments
for some time and pointing out the associated risks.
Should central banks use interest rates to curb excesses on the credit market?
But what should central banks do to counter excesses on the credit market? Should they raise
interest rates, even if this would not be appropriate from the perspective of price stability and
economic activity (cf. slide 22)?
There are three reasons for not doing so.
First, we have the rule postulated by Tinbergen in the 1950s (cf. slide 23), which states that
for each economic policy target there needs to be a separate policy instrument.22 This reduces
potential conflicts of interest when using instruments and contributes to the efficient
achievement of each individual target. The Tinbergen rule is also justified in our case. If
central banks were to use the interest rate tool for the purposes of financial stability, they
might have to accept departures from the objective of price stability. Such an approach,
though, would call into question the credibility of the central bank's avowed pursuit of price
stability. In the long term this would have a negative impact on trust in the central bank and
limit its ability to ensure the goal of price stability.
Second, the crucial question is how effectively interest rate rises actually influence
overheating in the credit market. I have already explained how the interest rate environment
affects the behaviour of economic agents in the credit market. Higher interest rates, then,
should have a dampening effect on credit growth. Yet various analyses indicate that it often
takes a very sharp interest rate rise to significantly counteract excesses in the credit market.
However, this would have an unwanted and severe dampening effect on the economy and lead
to an undesirable deviation from the optimal course of inflation.23
Third, and connected with this, it is important to remember that interest rate rises affect the
whole economy. Meanwhile, excesses often occur only in certain segments of the credit
market.
For these reasons it seems more expedient to curb excesses in the credit market primarily with
instruments other than the interest rate tool. Of course, this presupposes that effective
alternative instruments are available.24
Macroprudential instruments
The focus here is on macroprudential instruments (cf. slide 24). This term describes
instruments which are aimed at avoiding the build-up of systemic stability risks and are
intended to make the financial system as a whole more robust to negative shocks.
Macroprudential instruments have become more common since the global financial crisis.25
The application of macroprudential measures in Switzerland is currently particularly
important in view of the significant imbalances in the credit and real estate markets.
The emphasis in Switzerland is placed on the sectoral countercyclical capital buffer (CCyB)
and on guidelines that address credit demand (cf. slide 25).
The sectoral CCyB obliges banks to hold more equity capital when imbalances build up on
the mortgage market. The aim is twofold: First, banks with more equity are better equipped to
absorb losses that can arise as a result of excessive lending growth. Second, costs for
mortgage lending rise, counteracting the build-up of imbalances in this segment.
The buffer is called countercyclical because capital requirements increase when the mortgage
market is on the