But a new study by the Swiss-based Bank for International Settlements (BIS) suggests that Bernanke saved the world from a crisis that was at least partly of his own making. Worse, it argues that the course he set and that his successor Janet Yellen and other central banks are following will produce another and perhaps graver crisis.
Government monetary and fiscal policymakers have lost their way, the BIS argues. So badly that they don’t just need a new direction. They need a new compass.
Drawing heavily on the past work of the head of the BIS’s Monetary and Economic Department Claudio Borio, the organization’s annual report blames policy blunders by fiscal and monetary officials in the governments of advanced economies for the Great Recession.
The prologue to the Great Recession is well known. A major financial boom developed against the backdrop of low and stable inflation, turbocharged, as so often in past such episodes, by financial innovation. Credit and property prices soared, shrugging off a shallow recession in the early 2000s and boosting economic growth once more. Spirits ran high. There was talk of a Great Moderation – a general sense that policymakers had finally tamed the business cycle and uncovered the deepest secrets of the economy (p. 10).
But the Great Moderation abruptly gave way to fears of a Great Depression, fears that sparked the monetary and fiscal improvisations of 2008 that “prevented the financial system and the economy from plunging into a tailspin” (p. 11).
Once the worst of the crisis had passed, the Fed and other government agencies failed to pivot from crisis management to crisis resolution, the BIS argues. They did not address the problems that were both the cause and effect of the bust with the bitter medicine of debt reduction and price discovery. Instead they fell back on traditional policy bromides – heavy government borrowing (deficits) and accommodative monetary policy (zero interest rates and asset purchases) – that have stunted economic recovery and threatened future crises. Having not learned from their errors, they seem determined to repeat them.
In no small measure, the causes of the post-crisis malaise are those of the crisis itself – they lie in a collective failure to get to grips with the financial cycle. Addressing this failure calls for adjustments to policy frameworks – fiscal, monetary and prudential – to ensure a more symmetrical response across booms and busts. And it calls for moving away from debt as the main engine of growth. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy maneuver will run out. (p. 8)
The BIS critique draws a sharp distinction between business cycles – which average 1 to 8 years in length – and the booms and busts associated with financial cycles, whose timeframe is longer and whose peaks and troughs are more pronounced. Governments tend to focus on the business cycle, treating recessions with bigger deficits and lower interest rates that are thought to induce economic growth and reduce joblessness.
Those policies have fallen flat in the nearly six years that have passed since the Lehman Brothers bankruptcy. “The post-crisis period,” the BIS says, “has been disappointing,” characterized by a “slow and weak recovery,” unemployment “well above pre-crisis levels,” and the grim reality that “we have not made up lost ground” (p. 8). “The longer term outlook for growth,” meanwhile, “is far from bright,” largely because of disappointing productivity growth on top of a longer-term trend decline (p.9). Government’s fixation on stimulating demand at the expense of increasing output is in part to blame for the tepid recovery.
There is some good news, the report acknowledges. Inflation remains low, fears of deflation have not materialized (though they persist in the eurozone), and “financial markets have been exuberant over the past year, at least in advanced economies, dancing mainly to the tune of central bank decisions” (p. 9).
That exuberance doesn’t square with economic reality. “It is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally” (p. 9).
Global financial markets, the report says, are levitating “under the spell of monetary policy” (p. 23). That policy continues to favor increased debt over balance sheet repair (debt reduction). Enabled by loose monetary policy, the total debt of private non-financial sectors has risen globally by 30 percent since the crisis, while the public sector debt-to-GDP ratio of G7 countries has grown by nearly 40 percent over that span (p. 9).
It is precisely this debt, along with increased property prices, that exacerbate the boom phase of the financial cycle, according to a December 2012 BIS paper, leading to bigger and more devastating busts (p.2). The effects of these busts are, as we are learning, very difficult to shake off.
To remedy this, the report argues, governments should pursue countercyclical monetary, fiscal and regulatory policies that lean against booms and reserve more accommodative policies for responding to busts.
The overall strategy for national policy frameworks should be to ensure that buffers are built up during a financial boom so that they can be drawn down in the bust. Such buffers would make the economy more resilient to a downturn. And, by acting as a kind of sea anchor, they could also dampen the boom’s intensity. Their effect would be to make policy less procyclical by rendering it more symmetrical with respect to the boom and bust phases of the financial cycle. This would avoid a progressive loss of policy room for maneuver over time (p. 19).
Instead, governments have pursued fiscal and monetary policies ill-suited both to booms and busts. Fiscal policy, the report observes:
lags furthest behind. There is little recognition of the huge flattering effect that financial booms have on the fiscal accounts: they cause potential output and growth to be overestimated, are particularly generous to the fiscal coffers, and mask the build-up of contingent liabilities needed to address the consequences of the busts…Similarly, there is scant appreciation of the limitations of an expansionary fiscal policy during a balance sheet recession; indeed, the prevailing view is that fiscal policy is more effective under such conditions.
Nor are central banks properly calibrating monetary policy. The Fed that kept interest rates too low for too long and thereby helped produce the real estate bubble has responded to the bursting of that bubble with quantitative easing and near-zero rates that have lasted more than 5-1/2 years and are projected to continue at least into 2015 and perhaps beyond. The Fed fears raising those rates, citing the risk of monetary tightening amid tepid economic growth and elevated unemployment. That decision could prove every bit as wrong-headed as the accommodative policies that helped precipitate the Great Recession, according to the BIS.
Monetary policy … has been overburdened for too long. After so many years of an exceptional monetary expansion, the risk of normalizing too slowly and too late deserves special attention (p. 20).
Those risks are real and ominous.
The risks of failing to act should not be underestimated. The global economy may be set on an unsustainable path. And at some point, the current open global trade and financial order could be seriously threatened. (p. 20)
Preserving that order requires taking politically difficult decisions.
There is little appetite for taking the long-term view. Few are ready to curb financial booms that make everyone feel illusively richer. Or to hold back on quick fixes for output slowdowns, even if such measures threaten to add fuel to unsustainable financial booms. Or to address balance sheet problems head-on during a bust when seemingly easier policies are on offer. The temptation to go for shortcuts is simply too strong, even if these shortcuts lead nowhere in the end (p. 21).
The BIS report offers this unwelcome piece of advice to economic policymakers who are, as David Byrne once sang, on the road to nowhere: get a new compass.