Trying And Failing To Understand The 84th BIS Annual Report

by: Brad DeLong

Over 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.

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.