Bank’s policy proposals have serious flaws

The Bank for International Settlements has accused the world’s main central banks of incompetence

Wed, Jul 2, 2014, 01:01

To me, then, 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 shown in low pre-crisis long-term real interest rates and huge net flows of capital from countries with good investment opportunities to countries with far worse ones.

Similarly, it ignores the impact of adverse shifts in the distribution of income and in business behaviour on propensities to save and invest.

Again, the BIS insists that losses in output relative to trend are inevitable. There is no doubt most crises end up with huge long-term losses. 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. 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.

Turn, now, to the wise. First, 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.

Second, 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. Professors Atif Mian and Amir Sufi make much of this argument in their important book, House of Debt. Unfortunately, it is politically difficult to make this process work.

Grotesque notion

Finally, consider 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 carries 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 would be even faster rises in real indebtedness and yet bigger waves of bankruptcy that would lead to weaker economies and further increases in indebtedness. The reasons for abandoning the pre-Keynesian consensus were powerful, whatever the BIS (and 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. – (Copyright The Financial Times Limited 2014)

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