The newly-released annual report of the Bank of International Settlements sounds as if it is unusually lively reading. Most official documents strive for an anodyne tone, while this one appears to be unusually blunt. However, while some reporters have their hands on it, the report is not yet up on the BIS website, so those of us among the great unwashed will have to wait a day or two.
In the meantime, we’ll turn to Ambrose Evans-Pritchard’s write-up at the Telegraph, and assuming his summary is faithful, the BIS author, Bil White, is a man after my own heart. There is a lot of meaty stuff in the BIS report: criticism of bubble-enabling central banks, a forecast of a burst of inflation followed by nasty deflation, and skepticism about the wisdom and viability of fiscal stimulus (explicit and implicit government obligations are already too high). The BIS also charges the regulators (the Fed appears particularly guilty) with having excessively low policy rates and being asleep at the switch as the shadow banking system grew in size and importance.
A year ago, the Bank for International Settlements startled the financial world by warning that we might soon face challenges last seen during the onset of the Great Depression. This has proved frighteningly accurate.
The venerable body, the ultimate bank of central bankers, said years of loose monetary policy had fuelled a dangerous credit bubble that would entail “much higher costs than is commonly supposed”.
In a pointed attack on the US Federal Reserve, it said central banks would not find it easy to “clean up” once property bubbles have burst.
If only we had all listened to the BIS a long time ago. Ensconced in its Swiss lair, it has fired off anathemas for years, struggling to uphold orthodoxy against the follies of modern central banking.
Bill White, the departing chief economist, has now penned his swansong, the BIS’s 78th Annual Report, released today. It is a disconcerting read for those who want to hope the global crisis is over.
“The current market turmoil is without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point,” it said.
“These fears are not groundless. The magnitude of the problems yet to be faced could be much greater than many now perceive,” it said. “It is not impossible that the unwinding of the credit bubble could, after a temporary period of higher inflation, culminate in a deflation that might be hard to manage, all the more so given the high debt levels.”
Given the constraints under which the BIS must operate, this amounts to a warning that monetary overkill by the Fed, the Bank of England, and above all the European Central Bank could prove dangerous at this juncture.
European banks have suffered worse losses on US property than American banks. Their net dollar liabilities are $900bn, mostly short-term loans that have to be rolled over, a costly business with spreads still near panic levels. Mortgage and consumer credit has “demonstrably worsened”.
The BIS cautions the ECB to handle its lending data with great care. “The statistics may understate the contraction in the supply of credit,” it said.
The death of securitisation has forced banks to bring portfolios back on to their balance sheets, while firms in need are drawing down pre-arranged credit lines. This is a far cry from a lending recovery.
Warning signs are flashing across Eastern Europe (ex-Russia) where short-term foreign debt is 120pc of reserves, mostly in euros and Swiss francs. Current account deficits are 14.6pc of GDP.
“They could find it difficult to secure foreign funding if global financing conditions were to tighten more severely,” it said. Swedish, Austrian and Italian banks have drawn on wholesale markets to lend heavily to subsidiaries across the region. This could “dry up”.
China is not immune, although the BIS has dropped last year’s comment that growth is “unstable, unbalanced, unco-ordinated and unsustainable”.
The US accounts for 20pc of China’s exports, but that does not capture the inter-links across Asia that ultimately depend on US shopping malls. “There is a risk that China’s imports overall could slow down sharply should the US economy weaken further,” it said.
Global banks – with loans of $37 trillion in 2007, or 70pc of world GDP – are still in the eye of the storm.
“Inter-bank money markets have failed to recover. Of greatest concern at the moment is that still tighter credit conditions will be imposed on non-financial borrowers.
“In a number of countries, commercial property prices are beginning to soften, traditionally bad news for lenders. These real-financial interactions are potentially both complex and dangerous,” it said.
Do not count on a fiscal rescue. “Explicit and implicit debts of governments are already so high as to raise doubts about whether all non-contractual commitments will be fully honoured.”
Dr White says the US sub-prime crisis was the “trigger”, not the cause of the disaster. This is not to exonerate the debt-brokers. “It cannot be denied that the originate-to-distribute model (CDOs, CLOs, etc) has had calamitous side-effects. Loans of increasingly poor quality have been made and then sold to the gullible and the greedy,” he said.
Nor does it exonerate the watchdogs. “How could such a huge shadow banking system emerge without provoking clear statements of official concern?”
But there have always been excesses in booms. What has made this so bad is that governments set the price of money too low, enticing the banks into self-destruction.
“The fundamental cause of today’s emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in the advanced industrial countries have been unusually low,” he said.
The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning.
They could get away with this as long as cheap goods from Asia kept a cap on inflation. It seduced them into letting asset booms get out of hand. This is where the central banks made their colossal blunder.
“Policymakers interpreted the quiescence in inflation to mean that there was no good reason to raise rates when growth accelerated, and no impediment to lowering them when growth faltered,” said the report.
After almost two decades of this experiment – more or less the Greenspan years – the game is over. Debt has reached extreme levels, and now inflation has come back to life.
The easy trade-off has metamorphosed into a vicious trade-off. This was utterly predictable, and was indeed forecast by the BIS, which plaintively suggested in this report that central banks might like to think of an “exit strategy” next time they try such ploys.
In effect, this is an indictment of rigid inflation targets (such as Britain’s), which prevent central banks from launching a pre-emptive strike against asset bubbles. In the 1990s, they should have torn up the rule-book and let inflation turn negative in light of the Asia effect.
The BIS suggests that a mix of “systemic indicators” should be used. The crucial objective is to slow credit growth and make sure that the punchbowl is taken away before the drunks run riot. “We need policy measures to lean against credit-drive excess,” it said.
If there are going to be more bail-outs on both sides of the Atlantic – as there will be – the “socialised risks” should be taken on by political systems, and not dumped on the books of central banks.
“Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off.
“To deny this through the use of gimmicks and palliatives will only make things worse in the end,” he said.
Let us all cheer Dr White off the stage.
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