On the BIS annual report, monetary policy and the hazards of overindebtedness
The 2014 BIS Annual Report warns again about the perils of ultra-easy monetary policy as it did in the lead-up to the Great Financial Crisis. I think the BIS could prove a Cassandra here and will explain below. Nevertheless, many refuse to heed its warnings because of the concern with the sluggishness of the real economy in developed economies and the worry about becoming the next Japan. The problem, as the BIS states, is debt. But the answer is not restrictive policy and structural reform as the BIS argues. Rather it is an acceptance of fiscal policy outcomes as mostly endogenous.
I have written many times about this in the past. So I feel it is my bread and butter. Rather than repeat myself, I suggest you read my 2009 post on the origins of the next crisis, which predicted the European Debt Crisis using a modified BIS style model of the secular impact of overindebtedness. Here I want to outline the framework I am working with because it is unique in incorporating secular debt dynamics, private sector indebtedness and endogenous fiscal policy outcomes as key components to understanding the business cycle. And then I will address how this differs from the BIS and what policy implications the differences have and why it will lead to different macroeconomic predictions.
Modern-day economic models, including the standard DSGE (dynamic stochastic general equilibrium) models used in econometrics, are basically all flow models. These models are not geared to understanding macro disequilibrium and the tipping points in terms of debt stocks that often presage crisis. In the real world, economies are rarely in equilibrium. The way this works is outlined in a May post on financial bubbles and the fingers of instability. As with markets, traditional economic simplification of economic events as independent of prior economic events is wrong. Economic actors are social beings that are influenced by the environment in which they operate. And this is especially important in terms of the availability of and demand for credit. As the economic cycle continues, fingers of instability develop as economic agents vulnerable to an economic hiccup because of overindebtedness increase.
If the fingers of instability are large enough, you reach a ‘critical state’ in which event patterns are defined more by power law probability distributions than by standard Gaussian bell curve distributions. What happens then is an economic catastrophe of unpredictable size and scope, a mini-crisis that blows over in weeks or a crisis of unheralded proportions like the one that began in 2007. The key here is that the fingers of instability come together to create financial fragility in the form of overindebtedness and eventually what Hyman Minsky calls ‘Ponzi finance’ to form a potentially catastrophic outcome that cannot be predicted in time or size but that varies in an exponential magnitude that is not consistent with a Gaussian distribution. This is the essence of secular buildups of debt and is the origins of great crises. The BIS is warning, therefore, that ultraeasy monetary policy foments the buildup of these kinds of fingers of instability that lead to crisis. And they therefore recommend that central banks tighten.
The BIS’ 84th Annual Report is here. But here are two extracts of note, which I want to use as a jumping-off point. I have underlined the most important bits:
- “Understanding the current global economic challenges requires a long-term perspective. Such a perspective should extend well beyond the time span of the output fluctuations (“business cycles”) that dominate economic thinking. As conceived and measured, these business cycles play out over no more than eight years. This is the reference time frame for most macroeconomic policy, the one that feeds policymakers’ impatience at the slow pace of economic recovery and that helps to answer questions on how quickly output might be expected to return to normal or how long it might deviate from its trend. It is the time frame in which the latest blips in industrial production, consumer and business confidence surveys or inflation numbers are scrutinised in search of clues about the economy. But this time frame is too short. Financial fluctuations (“financial cycles”) that can end in banking crises such as the recent one last much longer than business cycles. Irregular as they may be, they tend to play out over perhaps 15 to 20 years on average. After all, it takes a lot of tinder to light a big fire. Yet financial cycles can go largely undetected. They are simply too slow-moving for policymakers and observers whose attention is focused on shorter-term output fluctuations. The fallout from the financial cycle can be devastating. When financial booms turn to busts, output and employment losses may be huge and extraordinarily long-lasting. In other words, balance sheet recessions levy a much heavier toll than normal recessions. The busts reveal the resource misallocations and structural deficiencies that were temporarily masked by the booms. Thus, when policy responses fail to take a long-term perspective, they run the risk of addressing the immediate problem at the cost of creating a bigger one down the road. Debt accumulation over successive business and financial cycles becomes the decisive factor.”
- “The restoration of sustainable growth requires broad-based policies. In crisis-hit countries, there is a need to put more emphasis on balance sheet repair and structural reforms and relatively less on monetary and fiscal stimulus: the supply side is crucial. Good policy is less a question of seeking to pump up growth at all costs than of removing the obstacles that hold it back. The upturn in the global economy is a precious window of opportunity that should not be wasted. In economies that escaped the worst effects of the financial crisis and have been growing on the back of strong financial booms, there is a need to put more emphasis on curbing those booms and building strength to cope with a possible bust. Warranting special attention are new sources of financial risks, linked to the rapid growth of capital markets. In these economies also, structural reforms are too important to be put on the back burner. There is a common element in all this. In no small measure, the causes of the post-crisis malaise are those of the crisis itself – they lie in a collective failure to get to grips with the financial cycle. Addressing this failure calls for adjustments to policy frameworks – fiscal, monetary and prudential – to ensure a more symmetrical response across booms and busts. And it calls for moving away from debt as the main engine of growth. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy manoeuvre will run out.”
To sum up what the BIS is saying here, I would make three points.
First, the BIS believes that the stock of debt that can build up across cycles and create financial fragility that goes undetected by policy makers because policy makers are short-term focused on business cycle dynamics, thus missing the debt dynamics. This is what I also noted at the outset of this piece. The way this short-termism has been practiced for the past three decades is what I call the asset-based economic model. It works by decreasing interest rates and lowering debt service costs such that asset prices are boosted and larger levels of debt can be secured against those assets to promote growth. This debt-fuelled growth model is highly effective from a cyclical perspective. The problem, however, is that you reach a critical state when the accumulation of debt and the misallocation of resources is so large that you have a big crisis and the whole house of cards comes tumbling down.
Second, because policy makers miss these debt stock cues, they allow a problem to build up that is much more acute in nature than the cyclical blips that they are trying to address. We saw this particularly in Ireland and Spain, where public debt levels were low pre-crisis but exploded post-crisis due to a move from public surplus to deficit and large scale bailouts to backstop a failed financial system. The same increase in public indebtedness occurred almost everywhere, and I would note that in the US and the UK, it took government from under Maastricht Treaty debt to GDP levels below 60% to well over 100%. So we are talking about public debt increasing by one-half of GDP in the case of the US and the UK, or 100% of GDP in the case of Ireland and Spain. That is an order of magnitude greater than the cost of a garden variety cyclical downturn that policy makers attempt to prevent with extraordinary policy measures.
Third, the BIS believes that demand-side stimulus is just a panacea without supply-side fixes. The buildup of debt has left the economy awash in excess supply and the economy must utilize the cyclical upturn to address that excess or it will be allowing the problem to build across cycles, fomenting another devastating crisis. I wrote on the importance of supply side problems in January of last year. The important take away regarding becoming the next Japan – which is what everyone is trying to avoid – is that in the absence of supply side efforts, stimulus is a socialisation of losses – a gearing up of the public balance sheet as a means of maintaining demand and gearing down private balance sheets. Eventually, you end up where Japan is, in a policy cul-de-sac with government debt to GDP at 230%.
Where I differ from the BIS is on the debt dynamics of fiscal policy. Take a look at this chart from Stephanie Kelton via the St. Louis Fed (click on links to view chart if reading via email):
— Edward Harrison (@edwardnh) June 23, 2014
What Stephanie is pointing out here is that deficits are mostly endogenous. They are the result of an ex-post accounting identity. When the economy is weak, the fiscal balance is more negative because spending on automatic stabilizers and stimulus increases while tax receipts decline. When the economy is strong, we see just the opposite. Spending on automatic stabilizers declines and tax receipts increase. The chart above shows in graphical form that this is almost a straight line relationship.
Deficits are mostly a function of the inputs i.e. of the private sector’s desire to net save net of investment and the government’s already legislated spending decisions. Those inputs are pre-determined. Trying to make deficits exogenous by making the deficit itself a policy variable creates reflexivity that ends in disaster when private debt levels are high. This is why austerity has been an abject failure. This is why the fiscal multiplier has been much larger than one. The deficit is not a goal. Making it a goal of policy brings uncertainty and pro-cyclicality into the business cycle. It increases private sector debt stress, reduces private spending, reduces tax receipts and increases spending on automatic stabilizers.
I am not concerned about the deficit levels of governments in sovereign currency areas. They do not face a solvency constraint. Moreover, the deficits automatically correct across the business cycle. Policy makers should allow the deficit to be large enough at cycle troughs to bring the economy quicker to full employment. And then they can concentrate on the supply side to reduce excess capacity.
By definition, this policy prescription is at odds with the prevailing paradigm, which is geared toward fiscal restraint and monetary ease. The BIS is saying we should have both fiscal and monetary restraint or at least have monetary policy be neutral. I am saying that we should have both a fiscally and monetarily neutral stance. Let the adjustment process play out on both the demand and the supply side. And then adjust fiscal policy only to deal with secular increases in public debt across the business cycle that cannot be addressed by minimizing loss socialization.
If you look at most countries, including Germany I might add, much of the increase in debt was due to loss socialization from financial distress with the rest coming from countercyclical fiscal deficits. If you limit ultraeasy monetary policy, financial fragility will lessen. And even if there is some residual fragility, policy should be geared toward reducing excess capacity and reducing loss socialization, while countercyclical fiscal policy acts as a safety net. I don’t hear anyone in policy circles making this plea. Therefore, I believe we are headed for another round of crisis when this cycle turns down. As I wrote recently on how economics has failed us, it is not that economics has failed us at all. The economic insights are there for all to see. The willingness to take action is not.