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On time, stocks and flows:
Understanding the global macroeconomic
challenges
Claudio Borio*
Bank for International Settlements, Basel
Munich Seminar Series, Ifo Research Institute-Suedddeustche Zeitung
Munich, 15 October 2012
* Deputy Head of the Monetary and Economic Department, Director of Research and Statistics. The views
expressed are those of the author and not necessarily those of the BIS.
Introduction: questions and thesis
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Five years after the financial crisis (“Great Financial Crisis” (GFC))
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The global economy is unbalanced
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Advanced economies are struggling to return to self-sustaining growth
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A banking crisis has morphed into a sovereign crisis
Objective: provide a broad framework to think this through
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How and why did we get here? How do we get out?
Thesis:
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Predicament reflects failure of policy to adjust to shifts in tectonic plates
of global economy (“regimes”)
• Financial liberalisation, credible anti-inflation regimes, globalisation
of the real economy….
• …have led to the re-emergence of disruptive financial cycles (FCs)
Policy needs to adjust
• Ultimate risk is another major disruptive shift in the tectonic plates
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Introduction: time, stocks and flows
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Role of time
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• Economic processes that matter take much longer to unfold
• The FC – credit and asset price booms and busts – is much
longer than the business cycle
• But planning horizons have shrunk
Role of stocks and flows
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Emergence of FC has slowed down economic time relative to calendar time
Stocks have come to dominate economic dynamics
• Build up to unsustainable levels and generate stubborn overhangs
• Given “asymmetric” policies they grow over successive cycles
• Economically and politically much harder to deal with
• Risk of entrenching instability
Needed policy adjustments
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Lengthen policy horizons
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Put in place more symmetric policies
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Tackle the stock problem head-on (debt)
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Roadmap
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I – Lay out the broad canvas
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Changing character of economic fluctuations and link to regimes
• What are the stylised facts?
• How did we get here?
• What was the role of policy and horizons?
II – Policy challenges
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Legacy of the crisis through the lens of the FC
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• a balance sheet recession and an unbalanced global economy
Immediate/conjuctural policy challenge
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• How to return to self-sustaining and sustainable growth
Longer-term/structural policy challenge
• How to adjust policy framework
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I. Stylised facts: a future economic historian’s view
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Key outcomes since mid-1980s
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Inflation becomes low and stable
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But incidence of banking crises increases
Intellectual backdrop
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Talk of Great Moderation despite crises!
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“This-time-is-different” or “we-are-different” syndrome?
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Complacency shattered only by GFC
It has happened before…
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Similar economic fluctuations occurred under the gold standard
• Ushered in the Great Depression in the US in 1930s
Banking crises: all different or all alike?
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Easy to identify differences
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But similarities matter more and hold key to right policies
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• Crises tend to occur at peaks of major FCs (credit and property prices)
FCs last around 16-20 years (crises are rare)!
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I. Stylised facts: a future economic historian’s view
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…and it had been recognised before
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Link between FC and crises was well understood in 19th century
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But recognition faded in postwar period
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Contagious enthusiasm of the Great Moderation drowned it all
• Memories are short; hubris long
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Structural similarities between gold standard and post-mid1980s period
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Liberalised financial markets
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Highly integrated goods, capital and labour markets
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• Two eras of globalisation
Reasonable price stability over long horizons
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I. The GFC: role of economic regimes
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Similarities in outcomes and structural features are no coincidence: Amplitude
and length of the FC depends on regimes
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Financial liberalisation:
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• more likely that financial factors drive economic fluctuations
• Weakens financing constraints
• Makes it easier for credit to support loosely anchored perceptions
of value and risk
Credible anti-inflation monetary policy frameworks (“credibility paradox”)
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• More likely that signs of unsustainable economic expansions show up
first as build-up of financial imbalances
• Inflation becomes less sensitive to economic slack
Globalisation of real economy raises growth potential
• ↑ financial boom; ↓ inflation
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I. The GFC: role of policy
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Policy failed to adjust: it ignored the FC
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Prudential policy (PP):
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• No role for the FC and macro-economy
• too much “microprudential”; too little “macroprudential”
Monetary Policy (MP)
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Too much focus on individual institutions rather than financial system as a
whole (trees rather than wood)
Too much focus on near-term inflation stability
• Could not tighten to constrain the financial boom
Fiscal Policy (FP)
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No recognition of the hugely flattering effect of financial booms on fiscal
accounts
• Overestimate sustainable expansion
• Financial booms are revenue rich
• Financial busts present a huge bill!
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I. The GFC: role of horizons
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Planning horizons were too short
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Policymakers: focus on business cycle at expense of FC
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“Unfinished recessions” 1987-early 1990s and 2001-late 2000s
• Strong macro response to economic slowdown even as FC kept
building up
• Collapse a few years later resulted in bigger recessions
Private sector: extraordinarily short horizons (especially in financial markets)
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Expectations embedded in market prices are highly extrapolative
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Paradox of financial instability: risk looks lowest when it is highest!
• Taken at face value market prices and quantities provide very
misleading signals
• What looks like low risk is a signal of high risk-taking
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Vicious circle has set in between policymakers’ and market participants
horizons
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II. Legacy of the crisis: a balance sheet recession
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Typical recession in the post-war era in advanced economies
• MP tightening to fight inflation or BoP crisis
Current recession: major FC bust with low inflation
• Preceding boom much longer
• Debt and capital stock overhangs much larger
• Damage to financial sector much greater
• Policy room for manoeuvre much more limited: buffers depleted
• Japan in the early 1990s is closest equivalent
Historical evidence indicates that these busts
• Coexist with permanent output losses
• Usher in slow and long recoveries
Why? Mixture of
• Overestimation of potential output and growth during the boom
• Misallocation of resources, notably of capital
• Oppressive effect of the subsequent debt and capital stock
overhangs
• Disruptions to financial intermediation
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II. Legacy of the crisis: a balance sheet recession
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Evidence
• Still weak banks in EU and, to a lesser extent, US
• High private- and public-sector debt-to-GDP ratios and sovereign strains
• Policy interest at zero; central bank balance sheets have ballooned
But differences across countries
• If seen domestic financial booms and busts
• Strains in banks and private non-financial sectors (eg, US, UK, ES, IR)
• If banks incurred losses on financial cycles elsewhere
• Strains in banks; private sector may still be leveraging up (eg, FR, DE,
CH)
• If banks spared because not directly exposed to financial busts
• Resilient and have seen financial booms (eg, EMEs, AU, CA)
Situation particularly worrying in euro area
• Perverse feedback loop between banks’ and sovereign balance sheet
weakness
• But should not confuse symptoms with illness
• Markets are late to react….
• Some other countries have also unsustainable fiscal positions
• But bond markets seem oblivious…
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II. The immediate challenge: back to self-sustaining growth
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Immediate policy challenge
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Return to self-sustaining and sustainable growth
Challenge varies across countries
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If largely spared by the crisis
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• Contain financial booms underway and not overestimate strength of fiscal
positions
• if FC has already turned, contain the damage of the bust
If experiencing a bust following a domestic financial boom
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• Deal with twin weaknesses in banks’ and non-financial sector balance
sheets
If banks have suffered losses on exposures to financial busts elsewhere
• Deal with banks’ balance sheet weakness
Everywhere
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Restore, or avoid deterioration in, the sovereign’s creditworthiness
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II. Addressing a balance sheet recession: issues
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Key issue
• Prevent a major stock problem from becoming a major and persistent flow
problem
• Weighing down on expenditures and output
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Distinguish two phases
• Crisis management
• Priority is to prevent implosion of system
• Key: restore confidence
• If there is scope, should deploy policies aggressively
• Especially MP
• Crisis resolution
• Priority is to establish basis for self-sustained recovery
• Key: balance sheet repair
• Policies should be adjusted accordingly
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II. Addressing a balance sheet recession: PP
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Priority
• Induce thorough repair of banks’ balance sheets
• Support return to sustainable profitability
How?
• Enforce full loss recognition (eg, writedowns)
• Recapitalise financial institutions (subject to tough tests), possibly via
temporary public ownership
• Dispose of bad assets
• Sort institutions according to their viability
• Promote removal of excess capacity in financial sector
Good example: Nordics; bad example: Japan
Benefits
• Restore confidence in banking system
• Unblock interbank markets and relieve pressure on central banks
• Restore incentives for proper credit allocation and avoid wrong risk-taking
• given debt overhang, reducing debt burden is necessary to set the
basis for a self-sustaining recovery
• Allocation of credit is more important than overall amount
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II. Addressing a balance sheet recession: FP
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Priority
• Create scope to use sovereign’s balance sheet to support repair of private
sector balance sheet
• Banks: capital injections subject to strict conditionality
• Non-financial sector: eg, households (including via debt relief)
• Find room even if sovereign strains (eg, Nordic countries)
• In euro area can get (conditional) help from rest
• And keep medium-term horizon
• Contractionary impact of cuts dissipates over time
This contrasts sharply with typical prescription
• Increase spending/cut taxes (pump priming)
• Deemed to be more effective during slumps (larger multiplier)
Typical prescription ignores specificity of a balance sheet recession
• It assumes people want to spend and can’t because they cannot borrow
• But more likely they wish to cut excessive debt burden!
• If so, rather than jump-starting the economy, untargeted pump-priming
risks being a bridge to nowhere
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II. Addressing a balance sheet recession: MP
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Priority
• Recognise its limitations and avoid overburdening it
• True of both interest rate and balance-sheet policy (eg, large scale asset
purchases, unconditional liquidity support)
Why?
• Likely to be less effective
• Over-indebted sectors do not wish to borrow
• Impaired financial sector numbs impact on expenditures
• As push harder on gas pedal, get little traction and exacerbate side-effects
Possible side effects: MP gains time but makes it easier to waste it
• Mask underling balance-sheet weaknesses/delay loss recognition
• Numb incentives to reduce excess supply in financial sector and encourage
“wrong” risk-taking
• Undermine earnings capacity of financial sector
• Atrophy financial markets as central bank takes over intermediation
• Raise political economy concerns
• Especially balance-sheet policy (quasi-fiscal nature)
Over time a dangerous “expectations gap” can develop
• Undermining the central bank’s credibility
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II. Addressing a balance sheet recession: evidence
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Recent preliminary empirical evidence
• Financial bust/balance-sheet recessions are indeed different
• MP and FP are less effective
• Debt reduction (deleveraging) helps recovery
Approach
• 24 countries since mid-1960s; 73 recessions; 29 financial crises
• Distinguish recessions (downturns) without and with financial crises
• Control for various factors (severity downturn, etc)
Findings
• In normal recessions, the more accommodative MP is in the downturn, the
stronger is the subsequent recovery
• but this relationship is no longer apparent if a financial crisis occurs
• The same applies to fiscal policy
• The faster the deleveraging in the downturn with a financial crisis, the
stronger the subsequent recovery
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II. The longer-term challenge: adjusting policy frameworks
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Priority
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Adjust policy frameworks to fully reflect nature of FC
• Lengthen policy horizon
• Shift focus from period-to-period flows to stocks
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How?
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Build-up buffers during financial booms so as to draw them down during busts
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• Makes economy more resilient to bust
• Can contain the boom (acting as a dragging anchor)
• ie, makes policy less procyclical
PP: strengthen the systemic (macroprudential) orientation
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MP: tighten when financial imbalances build up even if near-term inflation is
under control
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FP: extra-prudence during financial booms
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II. The longer-term challenge: progress and risks
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Uneven progress post-crisis
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PP is furthest ahead
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• Basel III (countercyclical capital buffer) and macroprudential frameworks
MP has shifted somewhat
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• Recognition that monetary stability does not guarantee financial stability
• Shift towards adopting “lean option”
• But MP limitations during busts remain very controversial
FP is furthest behind
• Little recognition of flattering effect of booms and FP limitations in busts
Major risk: new and more insidious form of “time inconsistency”
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Policy remains asymmetric and generates bias over time
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Erodes economy’s defences, exhausts ammunition, entrenches instability
Evidence
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Banks’ capital and liquidity buffers were too low; now opposition to rebuild them
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Actual and looming sovereign crises
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MP is testing its outer limits (interest rates and balance sheets)
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II. The longer-term challenge: global dimension and risks
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The global dimension of national MPs
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Both pre- and post-crisis very accommodative conditions in core advanced
economies have spread to the rest of the world
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• Partly via resistance to exchange rate appreciation
In turn feeding back onto core economies’ long-term bond yields
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• Via accumulation of foreign exchange reserves
One reason why long-term rates have reached historical lows
Risk that globally MP has been too easy for too long
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Policy rates look very low compared with traditional benchmarks
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Signs of the build-up of financial imbalances in several EMEs
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Risk that some EMEs will face a financial bust before advanced economies recover
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Risk of return to disruptive competitive devaluations of interwar years (currency wars)
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Risk of an epoch-defining new shift in the tectonic plates?
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Return to financial and trade protectionism
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Return to inflationary historical phase
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Conclusion
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A cyclist is struggling on…
• Strong start, but now pedals harder to avoid falling over, on verge of exhaustion
• Has overestimated strength
• Has treated a long-distance race as a series of ever-shortening sprints
• The horizon has been too short
The world economy is not unlike that sportsman…
• Globalisation and suppression of inflation gave it new wings
• But overestimated strength, as FC made it feel stronger than it really was
• Every time the cycle turned, they would try harder
• Close to exhaustion
• Stocks of debt kept growing, the room for manoeuvre kept shrinking
• The horizon has been too short
Maybe it is time to change course
• Stop postponing adjustment to an ever more elusive better day
• Stop calling for illusory MP fixes for balance sheet and structural problems
• Which is worse: belief in confidence fairy or in free-lunch fairy?
It will not be easy, and will require a long-term view
• At stake is the legacy of the current generation to the next
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References (to BIS work only)
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Bech, M, L Gambacorta and E Kharroubi (2012): “Monetary policy in a downturn: are financial crises special?”, BIS Working Papers, no
388, September.
Borio, C (2009): : “The financial crisis of 2007-?: macroeconomic origins and policy lessons”, in proceedings of a G20 Workshop on The
Global Economy – Cause of the crisis: Key Lessons http://www.g20.org/Documents/g20_workshop_causes_of_the_crisis.pdf
——— (2011): “Central banking post-crisis: what compass for unchartered waters?”, in C Jones and R Pringle (eds) The future of central
banking, London: Central Banking Publications. Also available as (updated) BIS Working Papers, no 353, October.
——— (2012): “The financial cycle and macroeconomics: what have we learnt?”, keynote lecture at the Macroeconomic Modelling
Workshop, “Monetary policy after the crisis”, National Bank of Poland, Warsaw, 13-14 September; forthcoming as a BIS Working Paper.
Borio, C and P Disyatat (2010): “Unconventional monetary policies: an appraisal”, The Manchester School, Vol. 78, Issue s1, pp. 53-89,
September. Also available as BIS Working Papers, no 292, 2009, November.
——— (2011):”Global imbalances and the financial crisis: link or no link?”. BIS Working Papers no 346, May.
Borio, C, P Disyatat and M Juselius (2012): “Rethinking potential output: embedding information about the financial cycle”, BIS Working
Papers, forthcoming.
Borio, C and M Drehmann (2009): “Assessing the risk of banking crises – revisited”, BIS Quarterly Review, March, pp 29–46.
Borio, C. and P. Lowe (2002). Asset prices, financial and monetary stability: exploring the nexus. BIS Working Papers, No. 114.
——— (2004): “Securing sustainable price stability. Should credit come back from the wilderness?” BIS Working Papers, No 157.
Borio, C, B Vale and G von Peter (2010): “Resolving the financial crisis: Are we heeding the lessons from the Nordics?”, Moneda y
Crédito, 230, pp 7-47. Also available as BIS Working Papers, no 311, July.
Borio, C and H Zhu (2011): Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?”, Journal of
Financial Stability, December. Also available as BIS Working papers, no 268, December 2008.
Caruana, J (2012): “Central banking in a balance sheet recession”, Panel remarks at the at the Board of Governors of the Federal
Reserve System 2012 conference on "Central banking: before, during and after the crisis", Washington, 23-24 March
Drehmann, M, C Borio and K Tsatsaronis (2011): “Characterising the financial cycle: don’t lose sight of the medium term!”, BIS Working
Papers, forthcoming.
Hannoun, H (2012): “Monetary policy in the crisis: testing the limits of monetary policy”, Speech by Hervé Hannoun, Deputy General
Manager of the BIS, at the 47th SEACEN Governors' Conference, Seoul, Korea, 13-14 February 2012.
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