Yves here. We’ve written approvingly of Claudio Borio’s work, since he (along with the BIS’ William White) warned central bankers of the dangers of synchronized housing bubble well before the crisis. The then-celebrated Alan Greenspan airily dismissed those concerns.
Another important paper by Borio, Global imbalances and the financial crisis: Link or no link? hasn’t had the impact it should have. Borio and co-author Piti Disyatat decisively debunked the saving glut theory, which former Fed chair Ben Bernanke has pushed (and sadly probably even believes) as the explanation for the crisis. That theory, conveniently enough, exculpates central bankers of blame for the financial meltdown.
The big shortcoming with that paper, is that Borio and Disyatat wrote it in a very defensive manner, which makes it hard for laypeople to read. Our Andrew Dittmer translated it from Economese into Layspeak.
By Marshall Auerback, a market analyst and commentator. Produced by the Independent Media Institute
When Claudio Borio speaks, the big bankers and investors, the economics profession, and senior policymakers listen quite carefully—even if his sentiments don’t reach the shores of the popular media. Borio, the chief economist for the Bank for International Settlements (BIS), the central bankers’ central bank, recently remarked on the fragility of the global economy, and suggested that we were on the verge of a significant relapsesimilar to the global crash experienced 10 years ago. Among the parallels he perceives: the proliferation of “collateralized loan obligations (CLOs), which are ‘close cousins’ of the infamous instruments known as collateralized debt obligations, or CDOs, and securities backed by residential mortgages,” the prevalence of which helped to crater the credit system in 2008.
Mindful as central bankers have been about the ready availability of liquidity, they have (as I have written before) omitted to “proactively… [charging] private market participants variable risk premiums commensurate with the risk of the underlying activity they are undertaking when providing credit.” Furthermore, Borio implies that the monetary and fiscal authorities expended excessive efforts toward restoring the status quo ante, instead of directing policy toward broader job creation and income generation, which would place the economy on sounder footing when the next downturn inevitably comes. Finally, the BIS’s chief economist also publicly mooted whether additional “medicine” of the kind that we used last time will be in sufficient supply to respond adequately when the next crisis emerges.
So is Dr. Borio correct in both his diagnosis and concomitant concern about the lack of readily available cures for the prevailing illness? And are there any key omissions in his analysis that could help to mitigate the inevitable relapse that he forecasts?
Borio has a good track record in terms of forecasting economic crises. As early as 2006, he was presciently warning about the risks to the economic upturn posed “by the unwinding of financial imbalances that occasionally build up over the longer expansion phases of the economy,” in marked contrast to most experts at that time, who often sounded Pollyannaish in comparison.
To be sure, there are ample grounds for Borio’s caution. He correctly observes the revival of many of the speculative instruments that created so many problems back in 2008, even as policy officials continuedto “administer… ‘powerful medicine’ to counter the effects of the crisis, with ‘unusually and persistently low interest rates.’” Paradoxically, the cure was almost as bad as the disease, given how aggressive monetary ease helped bring these instruments back from near death.
There is no question that in a world dominated by high and persistent levels of debt (particularly private debt), low interest rates helped to reduce the crushing burden for borrowers. But to extend the medical analogy, using interest rates to cure a global debt deflation is akin to using a sledgehammer during surgery, rather than a scalpel. There are diffuse outcomes for the cure. For every borrower aided by lower rates, there are savers (pensioners, et al) who have been adversely impacted by the prevailing low interest rate structure. Savers secure less income from minimal interest rates on their assets. Recall that when the government runs deficits, it is a large net payer of interest on its outstanding debt.
There are also supply-side issues: Low interest rates actually exacerbate prevailing deflationary trends, because the corresponding reduction in the cost of capital reduces the threshold to turn a profit, which in turn can induce greater supply and production. In addition, under a low interest rate environment, the cost of holding inventory is very low, which may mitigate the possibility of supply bottlenecks, but also potentially creates oversupply.
Raising or lowering interest rates to affect demand is therefore less effective than fiscal spending. Government spending directly targets demand deficiencies, and net injections of government stimulus into an economy can override the impact of interest rate manipulation.
No less an authority than former Federal Reserve Chairman Ben Bernanke has indirectly confirmed this claim. In a paper dated from 2000, then-Professor Bernanke made the claim that, in a deflationary environment (which he was discussing at that time in the context of Japan), monetary policy could be effective to the degree that it retained “fiscal components.” He fretted that as interest rates plunged close to zero in the face of rising deflationary pressures, any income derived via the interest rate channel would be dissipated. That is why he advocated having the monetary and fiscal authorities working closely in harness to ensure that deflation was beaten.
Which raises the question that Borio doesn’t really answer directly: If central banks continue to wean their respective economies off low interest rates, is it inevitable that the economy will suffer a relapse? Surely, government spending and taxation decisions (which are among the first policy levers used to deal with recessions) could offset this impact, because they more directly affect demand and, if deployed aggressively enough, can offset any negative impact derived as central banks raise rates. This would imply that Claudio Borio’s implicit concerns about the withdrawal of the “low interest rate medicine” would in and of themselves overstate the problem with said interest rates rise (as they are today).
The more germane consideration that goes to the heart of Borio’s concerns (i.e., that we have run out of policy space) is how best to address a future economic relapse. Being a central banker, it is understandable that Borio places emphasis on monetary policy. But is fiscal policy subject to the same kinds of limits? Have governments have run out of fiscal policy options as a result of the measures undertaken in 2008 and the corresponding rise in public debt levels (as much private debt was “socialized”—i.e., taken on the balance sheets of governments to pay for bailouts and the like)?
Again, let us refer back to Ben Bernanke. In a now famous 2002 speech before the National Economists Club,he argued the following:
Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero. … The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.
This statement has often been misinterpreted as implying that deficits don’t matter, and Bernanke himself was often savaged for his advocacy of “helicopter money.” But his NEC speech simply states the obvious: namely that in the absence of some sort of external constraint (whether a gold standard, or borrowing in a foreign currency), a government with a free-floating fiat currency always has the financialcapacity to spend. However, it does face real resourceconstraints, which can render its activities inflationary—for example, if, as Professor Randy Wray has argued, “the economy runs up against a full employment constraint, but government stubbornly keeps spending more.” Although, as Wray notes, “The last time the US approached such a situation was in the over-full employment economy of WWII. Rather than bidding for resources against the private sector, the government adopted price controls, rationing, and patriotic savings. In that way, it kept inflation low, ran the budget deficit up to 25% of GDP, and stuffed banks and households full of safe sovereign debt.”
The point is that any policy limits that would impede our ability to respond to Borio’s feared economic relapse are largely political in nature. A necessary foundation of economic stabilization policy means that policymakers must be ready, willing and able to employ policy buffers that are large enough to do the job, and not simply operate with some preconceived notion of “financial sustainability.” At the same time, can policymakers undertake aggressive fiscal measures without re-igniting yet another bubble in the most puffed-up dimension of the economy— the figure-eight of CLOs/CDOs issued, sold and traded and the corresponding insurance products sold against them? And can they find a way to slowly let that air out of the bag without creating a full-blown discontinuity?
Beyond that, a genuinely effective policy is one that not only boosts spending if and when the economy collapses, but also expediently improves the income and employment condition of those at the very bottom of the income distribution. Historically, this hasn’t been done well. As Professor Pavlina Tcherneva has illustrated, “Only during the 1950-53 expansion did the bottom 90% capture all of the average income growth in the economy. Since then, the top 10% of households have been capturing greater and greater share of the income growth and, in the first two expansions of the 21st century, they have captured all of the income growth.”
Tcherneva’s analysis explains why the fiscal initiatives undertaken by Bush, Obama and Trump administrations, respectively, have been comparatively muted in terms of impacting the broadest swaths of the U.S. economy. Aside from the obvious morality question, growing inequality generally causes an economy to work at less than optimal efficiency, which makes sense intuitively in that it becomes increasingly difficult to grow an economy rapidly if the bulk of the gains are increasingly funneled to a smaller and smaller number of people (especially if they have the highest savings propensities).
In addition to the inefficiencies brought about by growing inequality, fiscal policy has tended to be biased toward “trickle-down economics” in which the benefits of government spending/taxation decisions “trickle down” to the population as a means of stimulating employment and income gains, as opposed to focusing directly on programs that cover “labor gaps” through direct employment programs such as the Job Guarantee(JG). The virtue of the JG, as the economist Hyman Minsky argued, is that “instead of the demand for low wage workers trickling down from the demand for the high wage workers, [policy orientation] should result in increments of demand for present high wage workers ‘bubbling up’ from the demand for low wage workers.” This can be better achieved via the JG, than, say, tax cuts.
Above all else, we need to avoid monetary machinations and central bank overreach, which simply move to restore the economy to an unsustainable status quo ante. Policymakers must also embrace fiscal initiatives that reorient policy away from demand-side trickle-down measures and toward a bottom-up approach that is based on employment and reducing inequality. Absent these considerations, Claudio Borio’s concerns will be validated: The economy’s recovery will be uneven, and the convalescence, such that it is, will be lengthy, intermittent, and maintaining many of the same pathologies that our economy displays today.