By Perry Mehrling, a professor of economics at Barnard College. Originally published at his website
The 85th Annual Report of the BIS is not perhaps the obvious first choice for beach-reading on a holiday weekend, but having read through its 119 pages, the core message reminds me of nothing so much as the most memorable line of the 40-year-old summer blockbuster “Jaws”: “You’re going to need a bigger boat.”
Notwithstanding everything that has been done since the Great Financial Crisis, it is not at all safe to go back in the water. Indeed danger of financial fragility is greater now than a year ago.
The danger this time comes, interestingly, not so much from the banks but from the policymakers, who persist in using empirically discredited pre-crisis thinking as a guide to macroeconomic policy. The problem, in a nutshell, is that “a monetary policy focused on managing near-term inflation and output may do so at the cost of higher fluctuations in credit and asset prices than in the past.” (p. 75)
In the modern financially globalized economy, the connection of monetary policy to domestic inflation and output is much attenuated, while the connection to asset prices is much increased. Monetary authorities who are focused on stabilizing quarterly aggregate demand can and do easily miss the effect of their actions on building up financial imbalances in the longer run, especially so when those imbalances are building up outside their own national borders.
In this respect, the biggest danger comes from the largest policy actors, the Fed and the ECB, since the “dollar zone” accounts for nearly 60% of world GDP, and the “euro zone” much of the rest (p. 87). The major central banks are keeping domestic interest rates low in an effort to stimulate domestic output in the short run, but the consequence is to blow asset bubbles in world as a whole. The problem is “excess financial elasticity” and the current major source of the problem is policy.
Why are they doing it? The problem, suggests the Report, is with the faulty ideas on which policy makers are depending (p. 13):
“If one strips the prevailing analytical view of all its nuances and focuses on how it is shaping the policy debate, its basic logic is simple. There is an excess or shortfall of final demand for domestic production (an “output gap”) that determines domestic inflation, not least by underpinning inflation expectations. Aggregate demand policies are then used to eliminate that gap and so achieve full employment and stable inflation; fiscal policy affects spending directly, and monetary policy indirectly, through real (inflation-adjusted) interest rates. The exchange rate, if allowed to float, permits the authorities to set monetary policy freely in line with domestic needs and will, over time, also balance the current account. If each country adjusts its monetary and fiscal levers so as to close the output gap period by period, everything will be fine, domestically and globally.”
Thus the boats we are using to combat the shark of financial fragility are the macroeconomic policies (and especially the monetary policies) of individual countries, each looking for what seems best for their own domestic economy. The problem is spillover to the rest of the world, and from there spillback to the source. The main problem is not current account imbalances, but growing international financial imbalances, to which standard economic models are blind. “Another year of exceptionally expansionary monetary policy raises the question of whether existing policy frameworks are fit for their intended purpose” (p. 64).
And that’s where the bigger boat comes in. We live in a global economy, and the central problem we face is global liquidity. In times of crisis, central banks have proven ability to cooperate for the good of all. But what we need is more than that, cooperation for crisis prevention. Faulty ideas are part of the problem, and faulty mandates are the other part.
“Two factors have severely hindered monetary policy cooperation outside crises. The first has to do with diagnosis and hence the perceived need to act. As explained above, the prevailing view is that flexible exchange rates, combined with inflation-focused domestic regimes, can foster the right global outcomes. As a result, discussions on how to promote global coordination have centred on how to deal with current account imbalances, which are less amenable to monetary policy measures. Indeed, the terms “imbalance” and “current account imbalance” have been treated as synonymous. The second factor has to do with mandates and hence the incentive to act. National mandates raise the bar: actions must clearly be seen to promote the interests of one’s own country. In other words, there is no perceived need and no incentive.”
Don’t say we didn’t warn you!