Central Bankers - from heroes to zeros

The Bank for International Settlements (BIS), the only institution to call the financial crisis in 2007, has weighed back into the macro economic debate in the last few days in its annual report.  The report sets out a significant criticism on the current crop of central bankers, in essence the BIS lays the blames Yellen and Co for the falling: growth, demand and employment.  The expansion of national balance sheets and negative real interest rates are now the problem not the solution. The Keynesian approach that all central bankers have followed is now coming under close scrutiny as the global economy struggles to gain economic momentum. The process of piling the "cart" with more and more debt means Central Bankers are running a huge risk as the road ahead may not be as smooth as the would like!

Let's hope there are no pot holes ahead

The BIS believed that the global economy has  lost, for good, capacity and that the ultra-loose monetary policies pursued by the central banks is responsible for this wastage.  The BIS is convinced that the long run ambivalence to debt, practiced by central banks, is the route-cause of this lost capacity; they contend that negative real interest rates and very loose credit terms have allowed governments, businesses and households to maintain very high levels of debt and that is squeezing the life out of the “productive” economy.  Obviously Janet Yellen and her gang vehemently disagree.

The counter argument is that monetary easing has saved us from a full blown banking melt down and depression and it’s hard not to agree that in the early stages of the financial crisis the huge amount of liquidity pumped into the banking systems did save us from a complete catastrophe. Central Bankers were the heroes of the hour in 2008  but what is less clear is whether continued use of these measures (the US is still printing money and real interest rates are near zero everywhere) will restore normal service.  Six years on from the financial crisis this are still pretty bad – the US is still stuttering with growth rates well below trend and in the Euro-zone things are really black – Italy is back in recession, France is close to its own triple dip and most of the PIIGS are still is the S**T.  More worryingly deflation is a reality in many developed economies and debts are sure to rise because of this.

The BIS’s main contention is that central bankers have been too busy addressing the economic (output) cycle rather than addressing the financial cycle that is really killing us. This financial cycle has a longer frequency 20-30 years but importantly requires us to face up to our debt obligations (government, corporate and private).  The BIS implores us 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.

This is now clearly the case in Europe and Japan that a single failure could up-set the whole apple cart.  The chart below show how little has been done to address indebtedness across the globe.  The issue of negative interest rates and bloated balance sheets in governments, banks, other non-financial corporations and households means this creeping malaise that has become very difficult to shake off.  The main symptoms BIS identify are:
• chronic shortfalls in aggregate demand.
• lose of skills caused by unemployed
• misallocations of credit and other resources (allocation of credit matters more than its aggregate amount - it is important that good borrowers obtain credit rather than bad ones)
• Dangerous impacts on asset prices and markets (bubbles)

Riding for a fall on a mountain of debt

Keeping their focus on the “Financial cycle” the BIS argue that there needs to be a fundamental repair of balance sheets;  in any scenario where the cost of money is zero and prices are falling there can be no dynamism.  Distressed debts weigh heavily on innovation and growth, owners of capital are unprepared to invest for the long term (who would if prices are falling) and consumers will pair back there spending.  Demand must be weak.  Importantly the BIS argue that over the long run and across the financial cycle Central banks should cease from their chosen path of borrowing in both the down and up-cycle -
“asymmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy. Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap”

The bad news is that the only way to escape the debt trap is to crystallize distressed debts and ensure and improved allocated of credit going forward.  I have been arguing for some time that negative real interest rates for an extended period can only cause great damage, and the Japanese economy over the last 20 years is ample proof of this.

It may be worth reminding ourselves that the current up-swing in the business cycle (not the financial cycle) is due to end in 2017-18 – periods of expansion typically last 6-7 years. Unless we start repairing our balance sheets, reducing debts and increasing interest rates we will have absolutely no room for manoeuvre when the next down turn comes.  Unsurprisingly the cadre of Central Bankers and Keynesian economist  (see Gavyn Davies' blog) have screamed loud in protest – but they are howling in the against a wind of change that should sweep them away.