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July 1, 2014 6:59 pm
I admire the Bank for International Settlements. It takes courage to accuse its owners – the world’s main central banks – of incompetence. Yet this is what it has done, most recently in its latest annual report. It would be easy to dismiss this as the rantings of a prophet of doom. That would be a mistake. Whether or not one agrees with its pre-1930s view of macroeconomic policy, the BIS raises big questions. Contrariness adds value.
One can divide the BIS analysis into three parts: what caused the crisis; where we are now on the way out of it; and what we should do.
On the first, the perspective is that of the “financial cycle”. This analysis goes back to the work of the great Swedish economist Knut Wicksell at the turn of the 20th century. The core idea is that if the rate of interest is too low, a boom driven by expanding credit and rising asset prices may ensue. One of the crucial (and correct) implications is that credit and money are endogenous: they are created by the economy. When the financial cycle turns from boom to bust, crises erupt. Then follow the “balance sheet recessions” described by Richard Koo of the Nomura Research Institute – painful deleveraging and extended periods of feeble growth. Such cycles, argues the BIS, “tend to play out over 15 to 20 years on average”. To give credit where it is due, the BIS gave such warnings well before the crisis hit the high-income countries from 2007.
On the second, the BIS notes that growth has picked up over the past year, with advanced economies gaining momentum, while emerging economies lose it. Nevertheless, recovery has been slow and weak in crisis-hit countries. While global growth is not far from rates seen in the 2000s, the shortfall in the path of gross domestic product persists. Meanwhile, overall indebtedness continues to rise. Crises, we are reminded, cast a long shadow.
Furthermore, the policies of central banks are exerting extraordinary influence on financial markets, generating a “search for yield”, a disappearance of pricing for risk and a collapse in market volatility. This is true even though balance sheets remain so stretched. Meanwhile, credit excesses have emerged in a number of emerging economies. The BIS is particularly concerned about new sources of vulnerability in the latter, including foreign borrowing by non-financial corporates. Overall, concludes the BIS wryly, “it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments”. (See charts.)
It is on the third point – what is to be done – that the BIS turns into a prophet from the Old Testament: it demands austerity now. In countries that have experienced a financial crisis it recommends balance sheet repair and structural reform – deregulation, improved labour flexibility and “trimming public sector bloat”. It demands fiscal retrenchment. But unlike, say, George Osborne, the UK chancellor of the exchequer, the BIS wants to see monetary stimulus withdrawn, too, emphasising the risks of “exiting too late and too gradually”. It plays down both risks and costs of deflation, despite the huge overhang of debt that it also stresses. Even Jens Weidmann, the Bundesbank president, does not do that. Being more hawkish than the Bundesbank is quite something. Meanwhile, in countries that have experienced financial booms (the report points to Brazil, China and Turkey), it recommends pre-emptive monetary tightening and imposition of macroprudential restraints.
To me, then, this is a blend of the wise, the foolish and the doubtful.
Start with the doubtful. The BIS is right to emphasise the enormous costs of credit-driven booms. But it ignores the context in which policy makers allowed these to occur. In particular, it ignores the evidence of a global savings glut shown in low pre-crisis long-term real interest rates and huge net flows of capital from countries with good investment opportunities to countries with far worse ones. Similarly, it ignores the impact of adverse shifts in the distribution of income and in business behaviour on propensities to save and invest.
Again, the BIS insists that losses in output relative to trend are inevitable. There is no doubt that most crises end up with huge long-term losses. But, by the 1950s, the US had recovered fully from the gigantic losses relative to the pre-1929 trend in GDP per head caused by the biggest crisis of all: the Great Depression (see chart). Is this not because, unlike in the pusillanimous present, the US subsequently experienced the biggest fiscal stimulus ever – the second world war? I can imagine how the BIS would have warned against such fiscal irresponsibility.
Turn, now, to the wise. First, the BIS is right to add to warnings over credit booms. Their joy is fleeting and the hangover agonising. This is particularly true for countries unable to borrow easily in their own currencies or without large holdings of foreign exchange reserves. Pre-emptive action is indeed required. Second, the BIS is right to emphasise the case for accelerating post-crisis recognition of bad debt and reconstruction of balance sheets of both borrowers and intermediaries. This process of deleveraging is nearly always too slow. Professors Atif Mian and Amir Sufi, of Princeton and Chicago universities respectively, make much of this argument in their important book, House of Debt. Unfortunately, it is also politically difficult to make this process work.
Finally, consider the foolish. There is indeed an important argument to be had over the right balance to strike between fiscal and monetary reactions to financial crises.
I believe we have relied too much on monetary policy, which does carry with it many of the risks the BIS rightly emphasises. But the notion that the best way to handle a crisis triggered by overleveraged balance sheets is to withdraw support for demand and even embrace outright deflation seems grotesque. The result, inevitably, would be even faster rises in real indebtedness and so yet bigger waves of bankruptcy that would lead to weaker economies and so to further increases in indebtedness. The reasons for abandoning the pre-Keynesian consensus were powerful, whatever the BIS (and many others) may think. The BIS is entitled to warn. Central banks should listen to it politely. But they must reject important parts of what it advises.
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