Evening Must-Read: Nick Rowe: Siimple Arithmetic for John Taylor's Mistaken Legislated Rule
Monday Smackdown: Chapter 11 of David Graeber's "Debt" Is Definitely in Chapter 11! Part IV

Weekend Reading: Claudio Borio (2012): The Financial Cycle and Macroeconomics: What Have We Learnt?

Claudio Borio (2012): The Financial Cycle and Macroeconomics: What Have We Learnt? "[']The financial cycle[']... denote[s] self-reinforcing interactions between perceptions of value and risk...

...attitudes towards risk and financing constraints, which translate into booms followed by busts... [that] amplify economic fluctuations and possibly lead to serious financial distress and economic dislocations.... Equity prices can be a distraction.... Interest rates, volatilities, risk premia, default rates, non-performing loans, and so on.... Combining credit and property prices appears to be the most parsimonious way to capture the core features....

The blue line traces the financial cycle obtained by combining credit and property prices and applying a statistical filter that targets frequencies between 8 and 30 years. The red line measures the business cycle in GDP obtained by applying the corresponding filter for frequencies up to 8 years.... Orange and green bars indicate peaks and troughs of the financial cycle....

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The close association of the financial cycle with financial crises helps explain another empirical regularity: recessions that coincide with the contraction phase of the financial cycle are especially severe.... It is possible to measure the build-up of risk of financial crises in real time with fairly good accuracy... [by] simultaneous positive deviations (or “gaps”) of the ratio of (private sector) credit-to-GDP and asset prices, especially property prices.... One can think of the credit gap as a rough measure of leverage in the economy, providing an indirect indication of the loss absorption capacity of the system; one can think of the property price gap as a rough measure of the likelihood and size of the subsequent price reversal, which tests that absorption capacity....

Graph 3, taken from Borio and Drehmann (2009).... Danger zones are shown as shaded areas. The graph indicates that by the mid-2000s concrete signs of the build-up of systemic risk were evident, as both the credit gap and property price gap were moving into the danger zone....

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The length and amplitude of the financial cycle... depend on... the financial regime, the monetary regime and the real-economy regime.... 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 link between financial liberalisation and credit booms is one of the best established regularities in the literature.... It is no coincidence that the only significant financial cycle ending in a financial crisis pre-1985 took place in the United Kingdom, following a phase of financial liberalisation in the early 1970s....

[In] a systematic modelling... the financial boom should 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 allows expenditures to take place and assets to be purchased. This in turn 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....

The third feature 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. Ostensibly, sustainable output and non-inflationary output need not coincide....

How best to incorporate the three key features just described into models is far from obvious.... Move away from model-consistent (“rational”) expectations.... Heterogeneous and fundamentally incomplete knowledge is a core characteristic.... State-varying risk tolerance.... Deal with true monetary economies, not with real economies treated as monetary ones.... While the generation of purchasing power acts as oil for the economic machine, it can, in the process, open the door to instability.... In all probability, this will require us to move away from the heavy focus on equilibrium concepts and methods to analyse business fluctuations and to rediscover the merits of disequilibrium analysis....

What are the policy implications?... The main adjustment is to strengthen the macroprudential, or systemic, orientation of the arrangements in place... address the procyclicality of the financial system head-on.... build up buffers in good times, as financial vulnerabilities grow, so as to be able to draw them down in bad times... capital and liquidity standards, provisioning, collateral and margining practices, and so on.... Adopt strategies that allow central banks to tighten so as to lean against the build-up of financial imbalances even if near-term inflation remains subdued.... Operationally, this calls for extending policy horizons beyond the roughly 2-year ones typical of inflation targeting regimes and for giving greater prominence to the balance of risks in the outlook....

In the case of fiscal policy, there is a need for extra prudence during economic expansions associated with financial booms. The reason is simple: financial booms do not just flatter the balance sheets and income statements of financial institutions and those to whom they lend, they also flatter the fiscal accounts.... And the sovereign inadvertently accumulates contingent liabilities, which crystallise as the boom turns to bust and balance sheet problems emerge, especially in the financial sector....

More generally... policy responses that fail to take medium-term financial cycles into account can contain recessions in the short run but at the cost of larger recessions down the road. In these cases, policymakers may focus too much on equity prices and standard business cycle measures and lose sight of the continued build-up of the financial cycle. The bust that then follows an unchecked financial boom brings about much larger economic dislocations. In other words, dealing with the immediate recession while not addressing the build-up of financial imbalances simply postpones the day of reckoning.

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Graph 9... illustrates this for the United States.... [In both] the mid-1980s-early 1990s and the period 2001-2007... monetary policy eased strongly in the wake of the stock market crashes of 1987 and 2001 and the associated weakening in economic activity. At the same time, the credit-to-GDP ratio and property prices continued their ascent, soon followed by GDP, only to collapse a few years later and cause much bigger financial and economic dislocations.... From the perspective of the medium-term financial and business cycles, the slowdowns or contractions in 1987 and 2001 can thus be regarded as “unfinished recessions”.... Not all recessions are born equal.... The quintessential “balance sheet recession”... [is] particularly costly.... Arguably... [this] reflect[s]... the overestimation of both potential output and growth during the boom; the misallocation of resources, notably the capital stock but also labour, during that phase; the oppressive effect of the debt and capital overhangs during the bust; and the disruptions to financial intermediation once financial strains emerge. This suggests that the key policy challenge is to prevent a stock problem from leading to a long-lasting flow problem, weighing down on income, output and expenditures. And the goal has to be achieved in the context of limited room for policy manoeuvre: unless policy has actively leaned against the financial boom to start with, policy buffers will be very low....

In crisis resolution... the priority is balance sheet repair, so as to lay the basis for a self-sustained economic recovery. Here addressing the debt overhang is essential. And policies need to be adjusted accordingly.... Traditional rules of thumb for policy... may buy time but also make it easier to waste it... [and] store up bigger problems further down the road....

The first case, universally recognised as a good example, is how the Nordic countries addressed the balance sheet recessions they confronted in the early 1990s.... The crisis management phase was prompt and short.... They addressed balance sheet repair head-on... they enforced comprehensive loss recognition (writedowns); they recapitalised institutions subject to tough tests, including though temporary public ownership; they sorted institutions based on viability; they dealt with bad assets, including though disposal; they reduced the excess capacity in the financial system and promoted operational efficiencies, so as to lay the basis for sustainable profitability. The recovery was comparatively quick and self-sustained.

The second case... Japan.... The authorities were slow to recognise the balance sheet problems... had much more room to use expansionary monetary and fiscal policies.... Balance sheet repair was delayed for several years. The economy took much longer to recover....

If effective macroprudential frameworks were in place, capital and liquidity buffers could be drawn down to soften the blow to the financial system and the economy. But if the authorities have failed to build up buffers in good times and financial strains emerge, the challenge is to repair financial institutions’ balance sheets. A possible pitfall here is to focus exclusively on recapitalising banks with private sector money without enforcing full loss recognition.... [But] just like Caesar’s wife, not only do banks’ balance sheets have to be impeccable, they also have to be seen to be impeccable....

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....

What about monetary policy? The key pitfall here is that 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 in a balance sheet recession.... 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....

It is high time we rediscovered the role of the financial cycle in macroeconomics: Hamlet has to get its Prince back. This is essential for a better understanding of the economy and for the design of policy. This essay has taken a small step in that direction, by highlighting some of the core empirical features of the financial cycle, suggesting what might be necessary to model it, and proposing adjustments in policy to address it more effectively.


BIS 84th Annual Report:

I. In search of a new compass: The global economy has shown encouraging signs over the past year. But its malaise persists, as the legacy of the Great Financial Crisis and the forces that led up to it remain unresolved. To overcome that legacy, policy needs to go beyond its traditional focus on the business cycle. It also needs to address the longer-term build-up and run-off of macroeconomic risks that characterise the financial cycle and to shift away from debt as the main engine of growth. Restoring sustainable growth will require targeted policies in all major economies, whether or not they were hit by the crisis. Countries that were most affected need to complete the process of repairing balance sheets and implementing structural reforms. The current upturn in the global economy provides a precious window of opportunity that should not be wasted. In a number of economies that escaped the worst effects of the financial crisis, growth has been spurred by strong financial booms. Policy in those economies needs to put more emphasis on curbing the booms and building the strength to cope with a possible bust, and there, too, it cannot afford to put structural reforms on the back burner. Looking further ahead, dampening the extremes of the financial cycle calls for improvements in policy frameworks – fiscal, monetary and prudential – to ensure a more symmetrical response across booms and busts. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy manoeuvre will run out.

II. Global financial markets under the spell of monetary policy: Financial markets have been acutely sensitive to monetary policy, both actual and anticipated. Throughout the year, accommodative monetary conditions kept volatility low and fostered a search for yield. High valuations on equities, narrow credit spreads, low volatility and abundant corporate bond issuance all signalled a strong appetite for risk on the part of investors. At times during the past year, emerging market economies proved vulnerable to shifting global conditions; those economies with stronger fundamentals fared better, but they were not completely insulated from bouts of market turbulence. By mid-2014, investors again exhibited strong risk-taking in their search for yield: most emerging market economies stabilised, global equity markets reached new highs and credit spreads continued to narrow. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.

III. Growth and inflation: drivers and prospects: World economic growth has picked up, with advanced economies providing most of the uplift, while global inflation has remained subdued. Despite the current upswing, growth in advanced economies remains below pre-crisis averages. The slow growth in advanced economies is no surprise: the bust after a prolonged financial boom typically coincides with a balance sheet recession, the recovery from which is much weaker than in a normal business cycle. That weakness reflects a number of factors: supply side distortions and resource misallocations, large debt and capital stock overhangs, damage to the financial sector and limited policy room for manoeuvre. Investment in advanced economies in relation to output is being held down mostly by the correction of previous financial excesses and long-run structural forces. Meanwhile, growth in emerging market economies, which has generally been strong since the crisis, faces headwinds. The current weakness of inflation in advanced economies reflects not only slow domestic growth and a low utilisation of domestic resources, but also the influence of global factors. Over the longer term, raising productivity holds the key to more robust and sustainable growth.

IV. Debt and the financial cycle: domestic and global: Financial cycles encapsulate the self-reinforcing interactions between perceptions of value and risk, risk-taking and financing constraints, which translate into financial booms and busts. Financial cycles tend to last longer than traditional business cycles. Countries are currently at very different stages of the financial cycle. In the economies most affected by the 2007–09 financial crisis, households and firms have begun to reduce their debt relative to income, but the ratio remains high in many cases. In contrast, a number of the economies less affected by the crisis find themselves in the late stages of strong financial booms, making them vulnerable to a balance sheet recession and, in some cases, serious financial distress. At the same time, the growth of new funding sources has changed the character of risks. In this second phase of global liquidity, corporations in emerging market economies are raising much of their funding from international markets and thus are facing the risk that their funding may evaporate at the first sign of trouble. More generally, countries could at some point find themselves in a debt trap: seeking to stimulate the economy through low interest rates encourages even more debt, ultimately adding to the problem it is meant to solve.

V. Monetary policy struggles to normalise: Monetary policy has remained very accommodative while facing a number of tough challenges. First, in the major advanced economies, central banks struggled with an unusually sluggish recovery and signs of diminished monetary policy effectiveness. Second, emerging market economies and small open advanced economies contended with bouts of market turbulence and with monetary policy spillovers from the major advanced economies. National authorities in the latter have further scope to take into account the external effects of their actions and the corresponding feedback on their own jurisdictions. Third, a number of central banks struggled with how best to address unexpected disinflation. The policy response needs to carefully consider the nature and persistence of the forces at work as well as policy’s diminished effectiveness and side effects. Finally, looking forward, the issue of how best to calibrate the timing and pace of policy normalisation looms large. Navigating the transition is likely to be complex and bumpy, regardless of communication efforts. And the risk of normalising too late and too gradually should not be underestimated.

VI. The financial system at a crossroads: The financial sector has gained some strength since the crisis. Banks have rebuilt capital (mainly through retained earnings) and many have shifted their business models towards traditional banking. However, despite an improvement in aggregate profitability, many banks face lingering balance sheet weaknesses from direct exposure to overindebted borrowers, the drag of debt overhang on economic recovery and the risk of a slowdown in those countries that are at late stages of financial booms. In the current financial landscape, market-based financial intermediation has expanded, notably because banks face a higher cost of funding than some of their corporate clients. In particular, asset management companies have grown rapidly over the past few years and are now a major source of credit. Their larger role, together with high size concentration in the sector, may influence market dynamics and hence the cost and availability of funding for firms and households.

Claudio Borio (2012): The Financial Cycle and Macroeconomics: What Have We Learnt?

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