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For the Weekend...

Trying and Failing to Understand the 84th BIS Annual Report: Monetarist, Deleveraging, Fiscalist, and ??? Understandings of Our Current Dilemmas: The Honest Broker for the Week of July 5, 2014

NewImageOver at Equitable Growth: I confess that I do not understand the recent BIS Annual Report. I have tried--I have tried very hard--to wrap my mind around just what the BIS position is. But I have failed.

So let me try to lay out how I see it--where I think we are, and what I think the three live macroeconomic-policy positions are:

First, where we are:

We had in the late-1990s a high-pressure full-employment low-inflation tight-fiscal equilibrium. It was, however, unsustainable: based on exaggerated beliefs not about the utility but the profitability of companies based on the high-tech computer and communications technologies of the 1990s. When expectations adjusted to the reality of profitability, the high investment part of the 1990s boom went away, and the economy fell into the minor recession of the early 2000s. READ MOAR:

We had in the mid-2000s a medium-pressure high-employment low-inflation loose-fiscal equilibrium. It was, however, unsustainable: based on exaggerated beliefs about the safety of leveraged investments in U.S. real estate. When expectations adjusted to reality, the housing bubble collapsed, the New York financial system nearly collapsed, the tolerance of private-sector savers for risky assets collapsed, the confidence of private-sector savers that money-center banks could accurately characterize the risk of the products they sold collapsed, and the economy fell into the Lesser Depression in which we are now mired.

Second, the positions:

I have, up until now, seen the debate over what policies should be now as a three-cornered debate:

  • On the fear-not hand, there was a monetarist view--call it the Janet Yellen view--that relies on interest rates low enough and expected to continue to be low enough for long enough to rebalance the economy at full employment and low inflation.

  • On the remove-obstacles hand, there was a painful-slog view--a Ken Rogoff or a Richard Koo view--which appears to hold that the problem is not that the fundamental interest rate consistent with full-employment low-inflation equilibrium had fallen, but rather that excessive leverage had broken the credit channel. We must thus wait for time, bankruptcy, rescheduling, and amortization to deleverage the economy until full employment is once again sustainable given saver tolerance for and intermediary ability to transform risk.

  • On the drum-of-creation hand, there was a fiscalist-financialist view--call it the Larry Summers-Brad DeLong view--that requires the government to issue safe debt itself (or to guarantee private debt in order to make it safe) to substitute and compensate for sharply-reduced saver risk tolerance, substantially-impaired intermediary ability to undertake risk transformation, and the resulting broken financial credit channel.

  • And the fourth flame-of-destruction hand was empty.

The Fear-Not Hand: First, the Janet Yellen view--which is also the Ben Bernanke view--is that the root problem is that the economy suffers from a global savings glut (or, if you prefer, a global investment shortfall). Thus maintaining real interest rates at what were equilibrium levels in the 1990s leads to slack output and idle capital and labor. The Wicksellian natural rate of interest has fallen. Appropriate monetary policy to balance the economy needs to recognize this fall in the natural rate. Central banks need to keep interest rates at unusually low levels as long as they do not lead to elevated inflation--until, that is, something happens to either reduce desired savings or increase desired investment. In the Janet Yellen view high asset prices and low asset yields are an equilibrium reflection of fundamental shifts that have raised the value of the future in terms of the present and thus reduced the equilibrium premium return the borrowers have to offer in order to induce savers to lend. These low interest rates lead to a redirection of economic activity in the direction of building more long-duration assets and undertaking more highly speculative long-run investments. But this is a good thing.

The Remove-Obstacles Hand: Second, we have the Rogoff-Koo view--if I understand it correctly--that holds that the monetarist approach is inadequate. We do not have a global savings glut that has lowered all interest rates and raised all asset prices via a fall in the Wicksellian natural rate of interest that the central bank ought to accommodate. We have, rather, excessive leverage, and a consequent collapse in private-sector financial risk-tolerance plus a loss of trust in the ability of financial intermediaries to be good and trustworthy agents who will take savers' money and manage it wisely. Savers will not buy-and-hold risky financial assets offered by financial intermediaries. Savers will not trust financial intermediaries to produce safe assets.

This excessive-leverage has three results: The first result is a safe-asset shortage: an extraordinary increase in the value of assets perceived as safe--Treasury bonds--with a consequent fall in the rates of return on such assets. The second result is a risky-asset surplus: even with extremely high safe-asset values, there is no extraordinary increase in the value of assets perceived as risky: indeed, by standard metrics equity investments are high but not that high relative to current fundamentals. The third result is that entities that would normally rely on financial intermediaries' ability and willingness to grade and manage risks to give them access to capital find themselves rationed out of the market. We must thus wait for time, bankruptcy, rescheduling, and amortization to deleverage the economy until full employment is once again sustainable given saver tolerance for and intermediary ability to transform risk. And the right policy is that government should do what it can to hurry along the process of deleveraging to the extent that it can.

The Drum-of-Creation Hand: Third, the Larry Summers-Brad DeLong view agrees with Rogoff-Koo on the deficiencies of the monetarist approach, but holds that expansionary fiscal and credit policy by the government is the short-term and perhaps the medium-term solution. Like Rogoff-Koo, the root problem is different than a simple fall in the Wicksellian natural rate of interest. And like Rogoff-Koo in the Summers-DeLong view high asset prices and low asset yields for assets perceived as safe are not the best fix. But for Summers-DeLong the Yellen solution of lowering interest rates and keeping them low for the long run is only a third-best response to the breakdown of the credit channel. The first best would be fixing the credit channel: restoring the willingness of savers to accept and hold risky assets that have been vetted by financial intermediaries worthy of trust--which requires the recreation or creation of financial intermediaries worthy of trust as well. But--and here comes the difference with Rogoff-Koo--the second best would be using the government as a financial intermediary: have the government spend, borrow, and tax in the future, thus dragooning taxpayers into playing the role of the risk-bearers who have not shown up for the performance and are absent from the private market.

Why does the Summers-DeLong position see the Yellen solution only the third-best response? The fundamental underlying market failure takes the form of an inability to perform the risk transformation--to produce savers of sufficient risk tolerance that they are willing to hold the vetted assets produced by financial intermediaries that must back those assets with fundamentally-risky long-term investment projects. The Yellen solution provides businesses and financial intermediaries with an overstrong incentive to create long-duration assets: those are the things that have their value boosted most by sub-first-best interest rates. The economy thus winds up investing too much in long-duration projects and too little in risky projects.

I think that the Rogoff-Koo critique of Summers-DeLong is that expansionary fiscal and credit policies are very likely to crack the government's status as safe borrower. And if the expansion of government debt means that it also loses its status as perceived to be safe, we have not reduced but widened the disequilibrium between the (diminished) supply of safe assets from financial intermediaries (including the government) and the (enhanced) demand for safe assets from savers, and so deepened the depression.

There is another potential drawback to the Yellen solution. A well-functioning credit channel directs savers' funds to financial intermediaries that can add value: intermediaries that can properly understand, grade, classify, and manage risks--not financial intermediaries who are writing unhedged puts when they are not engaged in a full-blown Ponzi scheme. A broken credit channel levels the playing field for financial intermediaries, eliminates the advantage prudent risk-managers ought to have over put-writers and Ponzi-schemers. Lower interest rates do not fix this but rather accentuate it by raising the potential returns to successfully selling assets perceived as safe at the very high earnings multiples associated with low interest rates. It thus rewards those who can talk a good game and create the perception relative to those who can understand and calculate the reality.

The Flame-of-Destruction Hand: Now we seem to have a fourth position advocated by the BIS. It is not fear-not monetarist--it calls for raising interest rates now, rather than keeping them low to accommodate the fall in the Wicksellian natural rate of interest. It is not drum-of-creation fiscalist-guaranteeist--it fears activist expansionary fiscal policy even more than it fears monetary ease. And it is not remove-obstacles wait-for-deleveraging to bring demand for and supply of risky and safe assets back into balance--indeed, it seems hostile to any increase in the demand for risky assets that would remove or reduce the current disequilibrium.

So what is the BIS view? I am not sure. Gavyn Davies and Martin Wolf have tried to spell it out:

Gavyn Davies: Keynesian Yellen versus Wicksellian BIS: "On [the BIS] view, monetary policy has been too easy on average...

...leading to a long term upward trend in debt and risky financial investments. The financial cycle, which extends over much longer periods than the usual business cycle in output and inflation, eventually peaked in 2008. But, even now, the BIS says that the central banks are attempting to validate the long term rise in debt and leverage, instead of allowing it to correct itself. Excessive debt, it contends, is preventing the rise in capital investment needed for a healthy recovery. Financial and household balance sheets need to be repaired (ie debt needs to be reduced) before this can take place. In contrast... Yellen... admits that mistakes were made... in the regulatory sphere.... Higher interest rates, she says, would have led to much worse unemployment, without doing much to reduce leverage and dangerous financial innovation....

The BIS argues that zero interest rates and quantitative easing are becoming increasingly ineffective in boosting GDP growth... artificially inflating asset prices... blocking a necessary correction in excessive debt. Macro-prudential and regulatory policy might be helpful here, but will not be sufficient. The main risk is that the exit from these accommodative monetary policies may come too late. The Yellen view... is an outright rejection of the view that interest rates have been too low throughout previous cycles. If anything, the “secular stagnation” argument... suggest[s]... that real interest rates have been and remain too high, because the zero lower bound prevents them from falling as far as would be required to reach the equilibrium real rate. On this view, the danger is that the exit from accommodative monetary policies will come too early, not too late...


Gavyn Davies: ‘Artificially’ high asset prices: "Is it possible that the natural rate that seems appropriate for the real sector of the US economy...

...might sometimes be lower than a wider definition of the natural rate, which applies to the entire global economy, including the financial sector in the longer term?... New Keynesian models might not allow for excessive risk taking in the financial markets, because they usually do not contain a fully developed financial sector.... Borio... says that credit bubbles can develop, along with excessively high asset prices, if interest rates remain at present levels. On this view, the banking and shadow banking sectors can take on a life of their own, in the context of a long-term financial cycle driven by rising risk appetites among borrowers and lenders.

The resulting increase in credit and debt may not give any inflationary signals to the central bank. It could instead be felt in the demand for financial assets, in which case the price of assets may rise, without any immediate effect on the real economy or inflation. Or it might cause capital outflows which are then translated into credit bubbles in other countries.... In such circumstances, monetary policy faces a conflict. The real economy in the US might require lower interest rates to reach equilibrium, but this can cause excessive financial risk-taking domestically, or credit bubbles abroad....

What is the relevance of all this for the “artificiality” of asset prices? As Krugman argues, asset prices are not “artificially high” for as long as the Fed is able to set interest rates at the low levels that appear to be needed by the real sector of the US economy. The Fed’s low rates are in line with Paul’s version of the Wicksellian or natural interest rate, which (I think) he derives mainly from the near-term behaviour of the real sector of the US economy. However, asset prices could turn out to be artificially high, if the Fed’s low rates are judged against the higher Wicksellian or natural interest rate that could be applied to... the financial sectors in the long run. That might only become clear when the Fed is eventually forced to adjust rates upwards towards this broadly-defined natural rate. That, anyway, is my interpretation of the BIS concern....

It is, of course, possible that the excessive risk taking in the financial sector could be controlled by regulatory or macroprudential policy. The BIS is increasingly sceptical about the effectiveness of such controls, unless they are backed by higher interest rates. But, even if regulatory controls worked, they would presumably also bring down asset prices from their present levels.

And Martin Wolf:

Martin Wolf: Bad advice from Basel’s Jeremiah: "One can divide the BIS analysis...

...into three parts: what caused the crisis; where we are now on the way out of it; and what we should do....

The perspective is that of the “financial cycle”.... If the rate of interest is too low, a boom driven by expanding credit and rising asset prices may ensue.... When the financial cycle turns from boom to bust, crises erupt. Then follow the “balance sheet recessions” described by Richard Koo of the Nomura Research Institute--painful deleveraging and extended periods of feeble growth. Such cycles, argues the BIS, “tend to play out over 15 to 20 years on average”.... On the second, the BIS notes that growth has picked up over the past year, with advanced economies gaining momentum.... Overall indebtedness continues to rise. Crises, we are reminded, cast a long shadow. Furthermore, the policies of central banks are exerting extraordinary influence on financial markets, generating a “search for yield”, a disappearance of pricing for risk and a collapse in market volatility. This is true even though balance sheets remain so stretched. Meanwhile, credit excesses have emerged in a number of emerging economies....

It is on the third point--what is to be done--that the BIS turns into a prophet from the Old Testament: it demands [monetary and fiscal] austerity now. In countries that have experienced a financial crisis it recommends balance sheet repair and structural reform--deregulation, improved labour flexibility and “trimming public sector bloat”. It demands fiscal retrenchment. But unlike, say, George Osborne, the UK chancellor of the exchequer, the BIS wants to see monetary stimulus withdrawn, too, emphasising the risks of “exiting too late and too gradually”.... In countries that have experienced financial booms (the report points to Brazil, China and Turkey), it recommends pre-emptive monetary tightening and imposition of macroprudential restraints. To me... this is a blend of the wise, the foolish and the doubtful.

Start with the doubtful. The BIS is right to emphasise the enormous costs of credit-driven booms. But it ignores the context in which policy makers allowed these to occur. In particular, it ignores the evidence of a global savings glut.... Similarly, it ignores the impact of adverse shifts in the distribution of income and in business behaviour on propensities to save and invest.... The BIS insists that losses in output relative to trend are inevitable.... But by the 1950s, the US had recovered fully from the gigantic losses relative to the pre-1929 trend in GDP per head caused by the biggest crisis of all: the Great Depression (see chart). Is this not because, unlike in the pusillanimous present, the US subsequently experienced the biggest fiscal stimulus ever--the second world war? I can imagine how the BIS would have warned against such fiscal irresponsibility....

The BIS is right to add to warnings over credit booms. Their joy is fleeting and the hangover agonising. This is particularly true for countries unable to borrow easily in their own currencies or without large holdings of foreign exchange reserves. Pre-emptive action is indeed required.... The BIS is right to emphasise the case for accelerating post-crisis recognition of bad debt and reconstruction of balance sheets of both borrowers and intermediaries. This process of deleveraging is nearly always too slow....

The foolish. There is indeed an important argument to be had over the right balance to strike between fiscal and monetary reactions to financial crises. I believe we have relied too much on monetary policy, which does carry with it many of the risks the BIS rightly emphasises. But the notion that the best way to handle a crisis triggered by overleveraged balance sheets is to withdraw support for demand and even embrace outright deflation seems grotesque. The result, inevitably, would be even faster rises in real indebtedness and so yet bigger waves of bankruptcy that would lead to weaker economies and so to further increases in indebtedness. The reasons for abandoning the pre-Keynesian consensus were powerful, whatever the BIS (and many others) may think. The BIS is entitled to warn. Central banks should listen to it politely. But they must reject important parts of what it advises...

Both Gavyn Davies and Martin Wolf are very smart, very thoughtful, and very good. Still, somehow, neither the BIS report nor their attempts to summarize it manage to successfully elucidate it to me.

Paul Krugman explicitly admonishes me for thinking I should try to work out what model underlies the Bank for International Settlements' 84th Annual Report. It is, he says, not so much a macroeconomic model or an analytical framework. Rather, he says, it is a mood: the rhetorical stance of austerity a outrance:

Paul Krugman: Liquidationism in the 21st Century: "The BIS position... [is] that of 1930s liquidationists like Schumpeter...

...who warned against any 'artificial stimulus' that might leave the 'work of depressions undone'. And in 2010-2011 it had an intellectually coherent--actually wrong, but coherent--story... that mass unemployment was the result of structural mismatch... [and] easy money would lead to a rapid rise in inflation.... it didn’t happen. So... it... look[ed] for new justifications for the same [policy] prescriptions... playing up the supposed damage low rates do to financial stability.... That over-indebtedness on the part of part of the private sector is exerting a persistent drag on the economy... is a reasonable story.... But the BIS... doesn’t understand that model... as if they were equivalent to... real structural problems... [which] makes a compelling case for... fiscal deficits to support demand while the private sector gets its balance sheets in order, for monetary policy to support the fiscal policy, for a rise in inflation targets both to encourage whoever isn’t debt-constrained to spend more and to erode the real value of the debt. The BIS, however, wants governments as well as households to retrench... and--in a clear sign that it isn’t being coherent--it includes a box declaring that deflation isn’t so bad, after all. Irving Fisher wept....

Are the BIS’s methods unsound? I don’t see any method at all. Instead, I see an attitude, looking for justification...

Simon Wren-Lewis has an equally difficult time finding an analytical method here. He sees the BIS position as simply evidence that it has stopped thinking like macroeconomists and started simply parroting the rhetoric of bankers who need at least a 3%-point/year spread between zero and the safe short-term nominal interest rate to feel comfortable:

Simon Wren-Lewis: Why macroeconomists, not bankers, should set interest rates: "Notice what is going on here...

...The implication is that a financial crisis only happens because interest rates are set at the wrong level. The Great Recession was all the fault of the Fed, who kept interest rates too low after the 2001 recession. The gradual deregulation of the financial sector in the decades before?--not an issue. The widespread misselling of subprime mortgages?--these things happen. All the other examples of misselling and fraud?--boys will be boys. An industry that profits from a massive implicit public subsidy?--we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s?--all the result of keeping interest rates too low.

When those putting the BIS case tell you that macroprudential controls (a.k.a. financial regulations) are ‘untested’ and ‘uncertain in their impact’, what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low. There is no evidence for that proposition, and a lot of history that says otherwise.... But of course most working in the financial sector hate regulation. They have an interest in perpetuating different stories about the Great Recession. If you spend too much time around bankers, there is a danger that you come to believe these self-serving stories...

And Noah Smith, also, thinks the argument is deeply incoherent:

Noah Smith: Should the Fed crash the economy now to prevent a crash later?: "Asset prices, by historical measures, are high across the board.... Low risk-free rates, courtesy of the Federal Reserve, are driving investors... into risk assets. To many, the implication is clear: The Fed needs to raise interest rates in order to prevent a destabilizing market crash. That isn't a good idea.... First of all, higher asset prices due to lower safe interest rates... [are] rational price appreciation, not a bubble.

OK, but what if a bubble does occur?... Bubbles form when people think they can find some greater fool to sell to. But when practically everyone is convinced that asset prices are relatively high, like now, it’s pretty obvious that there aren’t many greater fools.... [In] past bubbles... there was always a large contingent of society that thought it wasn’t a bubble at all--that 'this time, it’s different'. Who nowadays thinks that there’s some special Big New Thing?... No one I know of. Paradoxically, the one time it’s hardest to have a bubble is when everyone and their dog is unhappy about asset prices and scared that there’s a bubble....

There’s laboratory evidence for bubbles.... It’s true that when you give traders in the lab more cash, you get more and bigger bubbles. Unfortunately, it’s also the case that raising interest rates doesn’t pop the bubbles, which tend to form whenever some people don’t understand fundamentals.... Basically, the people calling for Fed Chief Janet Yellen and the Fed to raise rates are demanding that the Fed crash asset prices in order to avoid an asset price crash....

There is also the idea that the rise in asset prices is simply unnatural or artificial. But the Fed has been regulating the monetary base for many decades, and for a lot of that time there were no big bubbles. Like it or not, the Fed is a natural part of the financial ecosystem.... It seems to me that 'naturalness' is a pretty weak justification for deliberate government action to crash the value of Americans’ retirement accounts.... The Fed isn’t yet worried enough... to use the blunt hammer of rate hikes. Its cautious, middle-of-the-road policy seems very at-odds with the extremism that a lot of people in the finance industry seem to attribute to it. I say we hold off on our calls for anti-bubble rate hikes.

I am not so sure.

I do think that there is a chance that the BIPS view is a live analytical position--if only I could figure out what it was. Although I do want to say that I find the way the BIS phrases its case is not a way that I find helpful at all...

To recap the three clearly live analytical positions:

On the (1) fear-not hand, the monetarist position holds that central banks can successfully rebalance economies at full employment with low inflation by central banks' setting the short-term safe interest rates they control low enough and promising to credibly keep them low enough long enough to match Wicksellian planned investment to desired saving at full employment. The major critiques of the monetarist position are three:

  • How to manufacture sufficient credibility out of thin air--why should trying to summon the Inflation-Expectations Imp be any easier or more effective than trying to summon the Business-Confidence Fairy?

  • The zero lower bound means that the short-term safe real interest rate now is above its optimum value, and so getting the long-term safe interest rate now to its optimum value requires expected future state real interest rates below their optimum values: a reliance on monetary policy alone requires future expansionary monetary irresponsibility.

  • If (as I believe) the root problem is not a global savings month or investment shortfall but an absence of risk tolerance and a broken credit channel, expansionary policy that reduces all rather than just risky interest rates distorts the economy by incentivizing the creation of too-many long-duration assets. Fourth, very low long-term real interest rates amplify principal-agent problems because debtors no longer have to show their creditors the money via substantial positive cash flows.

On the (2) drum-of-creation hand, the balance-sheet-fiscalist position holds that the key problem is a broken credit channel and a lack of private-sector risk tolerance: savers no longer trust financial intermediaries to do the risk transformation and so to properly back financial assets of the degree of safety savers want to hold with appropriately-managed claims on the income from risky capital, and savers do not have the risk-tolerance to hold the financial assets that they do trust financial intermediaries to create. The solution is therefore to use the government to mobilize the risk-bearing capacity of the taxpayers, and to either guarantee loans in order to create the safe assets that savers want to hold or simply to create the safe assets savers want to hold directly: borrow money and buy stuff. The first critique is that we do not have great confidence that the government will get good-enough value either from its direct expenditures or from its loan guarantees. The second critique is the balance-sheet-austerian position.

On the (3) remove-obstacles hand, the balance-sheet-austerian position is that the problem is indeed a shortage of risk-tolerance and a credit channel that cannot fund enough risky investment projects to attain full employment, but that that is not the root problem: the root problem is excessive leverage. The solution is thus a painful-slog: we must wait for time, bankruptcy, rescheduling, and amortization to deleverage the economy until full employment is once again sustainable given saver tolerance for and intermediary ability to transform risk. The right policy is that government should do what little it can to hurry along the process of deleveraging, to the extent that it can. And this process can certainly be assisted by monetary expansion a outrance and (somewhat) higher inflation.

What this process cannot be assisted by, on the balance-sheet-austerian view, is fiscal expansion. Why not? Because expansionary fiscal and credit policies are very likely to crack the government's status as safe borrower. If expanded government debt means that the government also loses its status as a creator of safe assets, then we have not reduced but widened the gap between the (diminished) supply of safe assets from financial intermediaries (including the government) and the (enhanced) demand for safe assets from savers. We have thus worsened the problem by greatly amplifying the amount of deleveraging necessary, and so deepened and lengthened the depression.

If we want to put them in a table depending on whether they judge monetary and fiscal expansion now to be helpful, neutral, or harmful, it looks like this:

20140714 Live Macroeconomic Positions Shiva Nataraja numbers

The question is whether there is a fourth live analytical position--a coherent argument that both monetary and fiscal expansion are, here and now, bad, and whether as the BIS argues budget deficits need to be further slashed and interest rates raised RIGHT NOW!!:

20140714 Live Macroeconomic Positions Shiva Nataraja numbers

I think the balance-sheet-fiscalist position is more correct. Not that more monetary expansion is unhelpful, mind you, just that it is not first-best and is likely to be insufficient. But it could work. And we should try it. And not that deleveraging is unhelpful, mind you, just that it is not first-best. Put me down as saying: (5) try everything. (And, parenthetically, note that there are four boxes left unfilled: I know of absolutely nobody even trying to take position (6)--both fiscal policy and monetary policy right now are practically perfect in every way--or position (7)--expansionary fiscal policy is good and expansionary monetary policy bad. And positions (8) and (9) that either monetary or fiscal expansion bad but the other neutral seem to slide rapidly into the BIS view...)

20140714 Live Macroeconomic Positions Shiva Nataraja numbers

Why am I not in either the monetarist or the balance-sheet-austerian boxes? Because I buy the four critiques of the monetarist position, and I think that here and now the chances that additional fiscal expansion will crack the reserve-currency issuing governments' status as safe borrowers are very low, and that we will have plenty of advance warning should that process of the cracking of safe-asset-issuer status even begin.

So let us now try to dig into the mind of the BIS...

The place to start is with Claudio Borio (2012): The Financial Cycle and Macroeconomics: What Have We Learnt?, for the BIS report is an implementation of that paper's theoretical framework. The paper summarizes its section on monetary policy during the post-balance-sheet-recession recovery thus:

What about monetary policy?... Extraordinarily aggressive and prolonged monetary policy easing can buy time but may actually delay, rather than promote, adjustment.... Monetary policy is likely to be less effective in stimulating aggregate demand.... There are at least four possible side-effects of extraordinarily accommodative and prolonged monetary easing. First, it can mask underlying balance sheet weakness.... Second, it can numb incentives to reduce excess capacity in the financial sector and even encourage betting-for-resurrection behaviour.... Third, over time, it can undermine the earnings capacity of financial intermediaries. Extraordinarily low short-term interest rates and a flat term structure, associated with commitments to keep policy rates low and with bond purchases, compress banks’ interest margins. And low long-term rates sap the strength of insurance companies and pension funds, in turn possibly weakening the balance sheets of non-financial corporations, households and the sovereign.... Finally, it can atrophy markets and mask market signals, as central banks take over larger portions of financial intermediation.... Over time, political economy considerations may add to the side-effects... [the] central bank’s autonomy and, eventually, credibility may come under threat....

The first point made is the standard critique of the monetary-policy-is-enough view: In a balance-sheet recession and especially at the zero lower bound, expansionary monetary policy has only limited traction. It must reduce expected future short-term safe interest rates by credibly promising future monetary policies that seem incredible. And beyond that it can only have traction on long-term real interest rates by summoning the Inflation-Expectations Imp. This is, of course, a very standard argument these days. It says that the benefits of expansionary monetary policy in a balance-sheet recession at or near the zero lower bound are low.

More problematic are the next five points: costs of expansionary monetary policy as it:

  1. masks underlying balance sheet weakness.
  2. numbs incentives to reduce excess financial-sector capacity and encourages betting-for-resurrection.
  3. undermines the earnings capacity of financial intermediaries by compressing banks’ interest margins and sapping the strength of insurance companies and pension funds.
  4. atrophying markets and masking market signals, as central banks take over larger portions of financial intermediation.
  5. political economy considerations as the central bank’s autonomy and credibility come under threat.

It does not seem to me that (5) should be a consideration: it is the business of central banks to choose the right technocratic policy and to fight for the technocratic autonomy to do so. Economists do such central banks no good service when they curb their advice as to what is the technocratic first-best and so rob central banks of the ammunition that they need in their contest with political masters.

It also does not seem to me that (4) should be a consideration. We are in this mess in large part because the--deregulated--financial market could not produce the right price signals and had opened up markets in types of debt that really should not have existed, no? That the process of repairing the damage requires a somewhat larger public-sector role until the damage is fixed is regrettable, but not a reason not to do the job.

And it does not seem to me that (3) should be a consideration either. Organizations like pension funds and insurance companies have assets with a short and liabilities with a long duration. When circumstances have made the Wicksellian natural long-run safe real rate of interest very low, they are weak. Their strength has been sapped. The question is whether they should be given a special government subsidy by having the government keep the interest rate above its full-employment "natural" Wicksellian level. The answer, save for those who are stakeholders, lobbyists, or agents of influence of financial intermediaries, is no.

Thus we are left with (1) and (2): that the necessary process of deleveraging to fix the root problem underlying the balance-sheet recession would be slowed by monetary ease. And this, too, seems to me to be wrong. In an environment with substantial nominal liabilities, (moderate) inflation is an important tool for speeding deleveraging. And so here I side with Rogoff against Borio--monetary ease is a useful crutch, not a handicap, until normal is reattained.

But Borio is looking beyond the normal to the post-mid-cycle phase of the expansion:

Financial liberalisation weakens financing constraints, supporting the full self-reinforcing interplay between perceptions of value and risk, risk attitudes and funding conditions. A monetary policy regime narrowly focused on controlling near-term inflation removes the need to tighten policy when financial booms take hold.... Major positive supply side developments... provide plenty of fuel for financial booms.... Credit and asset price booms reinforce each other, as collateral values and leverage increase.... The financial boom...[does] not just precede the bust but cause it... sows the seeds of the subsequent bust, as a result of the vulnerabilities that build up.... The presence of debt and capital stock overhangs.... The weakening of financing constraints... leads to misallocation of resources, notably capital but also labour, typically masked by the veneer of a seemingly robust economy.... Too much capital in overgrown sectors holds back the recovery. And a heterogeneous labour pool adds to the adjustment costs. Financial crises are largely a symptom of the underlying stock problems and, in turn, tend to exacerbate them....

[Thus there is a] distinction between potential output as non-inflationary output and as sustainable output.... Current thinking... identifies potential output with what can be produced without leading to inflationary pressures.... Inflation is generally seen as the variable that conveys information about the difference between actual and potential output.... And yet, as the previous analysis indicates, it is quite possible for inflation to remain stable while output is on an unsustainable path, owing to the build-up of financial imbalances and the distortions they mask in the real economy.... Sustainable output and non-inflationary output need not coincide...

These are interesting claims: that output can be too high and "too much" labor can be employed without generating accelerating inflation because the only thing that creates the demand for the excess labor is the unrealistic expectations of savers and investors, and when savers' and investors' expectations return to normal they are unwilling to pay the excess workers the real wages that are required to get them to work. I do not think these are likely to be true because I do not believe that our current low levels of employment for 25-54 year olds in either the United States or the Eurozone qualify as in any sense equilibrium levels. Prime-age employment in the United States is now 4%-points below its mid-2000s peak. Prime-age employment in the Eurozone is also 4%-points below its mid-2000s peak--and is 2%-points below its level as of three years ago:

Graph Employment Rate Aged 25 54 All Persons for the Euro Area© FRED St Louis Fed

To the extent that this argument has bite, it seems to me to be a claim not that employment is "too high" during the--non-inflationary--boom, but rather that bad macroprudential regulation has meant that the full-employment level of aggregate demand is attained in an improper way that creates vulnerabilities. The policy response called for is thus not an easier monetary policy--not higher interest rates--but rather better and stricter macroprudential regulation. There seems to me at least to be an analytical error here. To reiterate:

Paul Krugman: Liquidationism in the 21st Century: "Throughout the annual report...

...balance-sheet problems are treated as if they were... real structural problems... a good reason to accept a protracted period of high unemployment as somehow natural, and to reject artificial stimulus that might alleviate the pain. That, however--as Irving Fisher could have told them!--is not at all the correct implication to draw from a balance-sheet view. On the contrary, what balance-sheet models tell us is that left to itself, the process of deleveraging produces huge, unnecessary costs: debtors are forced to cut back, but creditors have no comparable incentive to spend more, so there is a persistent shortfall of demand that leads to great pain and waste. Moreover, the depressed state of the economy can cripple the process of deleveraging itself...

The curious thing, however, is that, once we recognize that right now fiscal space is definitely not scarce for credit-worthy sovereigns who print reserve currencies, Borio (2012) appears to call for more aggressive policy both on the deleveraging and on the fiscal fronts:

Fiscal policy.... The challenge here is to use the typically scarce fiscal space effectively, so as to avoid the risk of a sovereign crisis.... If agents are overindebted, they may naturally give priority to the repayment of debt and not spend the additional income: in the extreme, the marginal propensity to consume would be zero. Moreover, if the banking system is not working smoothly in the background, it can actually dampen the second-round effects of the fiscal multiplier.... Importantly, the available empirical evidence that finds higher fiscal multipliers when the economy is weak does not condition on the type of recession (eg, IMF (2010)). And some preliminary new research that controls for such differences actually finds that fiscal policy is less effective than in normal recessions.... The objective would be to use the public sector balance sheet to support repair and strengthen the private sector’s balance sheet... [both] financial institutions... [and] households, including possibly through various forms of debt relief.... Importantly, this is not a passive strategy, but a very active one. It inevitably substitutes public sector debt for private sector debt. And it requires a forceful approach, in order to address the conflicts of interests between borrowers and lenders, between managers, shareholders and debt holders, and so on....

Whence then comes the BIS's calls for further fiscal austerity? It remains a mystery to me. But on financial deleveraging it seems to me that Borio has hit the nail on the head.

So how to sum up?

It seems to me that one way to make sense of this is to conclude that the BIS has not made the argument it really wants to make. What it really wants to argue for is (a) aggressive government promotion of deleveraging and recapitalization to solve the balance-sheet recession and (b) fiscal expansion by credit-worthy sovereigns that print reserve currencies. And, I think, it also wants to argue that effective macroprudential policies are impossible because of banking-sector capture of the regulators. And thus its arguments for monetary tightness are, I think, a counsel of despair: since the macroprudential tools cannot be used to manage and limit risk, higher interest rates once we pass the mid-cycle point are the only game in town.

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