Prior to the NASDAQ crash in early 2000, American commentators were fond of describing their economy as being in a “Goldilocks” phase–with all economic indicators being “just right”.
That phrase dropped out of circulation after April 2000, but a level of complacency still ruled when that stock market crash appeared to have little impact on the real economy.
Complacency dramatically left the building today, with the release of the Bank of International Settlement’s (BIS) 77th Annual Report. The BIS turns the Goldilocks story around, and sees it not from Goldilocks’ perspective, but from that of the Bears. Just as the Bears’ domestic idyll was disturbed by Goldilocks the Home Invader, the apparently neat global financial system has been put at risk by out of control speculative lending.
It appears that Central Banks do indeed divide into three camps as they discuss the impact of this interloper. The BIS identifies three schools of thought within Central Banks. The first–whom we might call the Daddy Bear faction (since he was least affected by Goldilocks’s intrusion)–disputes the importance of the growth in debt; the second Mummy Bear faction worries about the increasing levels of credit money, seeing it as a harbinger of future inflation; and the third, Baby Bear faction, sees the seeds of a future Great Depression. In the BIS’s own words:
“A close look at how central banks behave, and how they communicate, indicates that there are different views about the appropriate role of monetary and credit (“quantitativeâ€) aggregates in the conduct of monetary policy. These views combine, to varying degrees, three conceptual perspectives on the role of such aggregates in the economy.
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- The first perspective reflects scepticism about the reliability of aggregates in helping to chart the course of economic activity and inflation, especially at short horizons. It would therefore not assign a prominent role to them in policy frameworks.
- The second stresses the central role of money as a causal driver of inflation. In particular, it emphasises the special information content that monetary aggregates can have for mediumterm trends in inflation. Thus, it would assign a prominent role to these aggregates in policy frameworks.
- The third, more recent, perspective stresses the information content that unusually rapid increases in monetary and, particularly, credit aggregates can have, especially if observed in association with a surge in asset prices and unusual spending patterns. It regards these increases as a potential sign of the build-up of financial imbalances and hence of a prospective boom-bust cycle, with implications of significant economic costs over time. Like the second perspective, this view would assign a prominent role to quantitative aggregates in policy frameworks, but primarily as indicators of medium-term risks in the form of recession, financial instability and unwelcome disinflation.” (pp. 70–71)
In a surprising development, it’s fairly obvious that the BIS itself now belongs to the Baby Bear faction (and I welcome them aboard). The BIS pioneered the regulation of credit markets through largely market-based means–the so-called Basel Accords. The fact that these mechanisms have not constrained credit creation–that they may in fact have enabled debt to grow more rapidly–has now become evident to the BIS.
As someone who has been emphasising the dangers of deregulated finance for twenty years, and largely from the wilderness of the fringes of the economics profession, it is a strange experience to suddenly find myself standing in a crowd. I could have written many segments of the BIS Report–and especially its conclusion, which I would proudly put my name to (I’ll quote it at length below).
Hopefully this significant shift by the Central Bankers Central Bank presages a realisation that debt-deflation, and not inflation, is the great economic danger we face at the beginning of the 21st Century.
B A N K F O R I N T E R N AT I O N A L S E T T L E M E N T S
77th Annual Report
1 April 2006–31 March 2007
VIII. Conclusion: prevention rather than cure?
Economics is not a science, at least not in the sense that repeated experiments always produce the same results. Thus, economic forecasts are often widely off the mark, particularly at cyclical turning points, with inadequate data, deficient models and random shocks often conspiring to produce unsatisfactory outcomes.
Even trickier is the task of assigning probabilities to the risks surrounding forecasts. Indeed, this is so difficult that it is scarcely an exaggeration to say that we face a fundamentally uncertain world – one in which probabilities cannot be calculated – rather than simply a risky one.
Economic history is a useful guide in this respect. The Great Inflation in the 1970s took most commentators and policymakers completely by surprise, as did the pace of disinflation and the subsequent economic recovery after the problem was effectively confronted.
Similarly, virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s, respectively. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a “new era†had arrived.
Similar surprises can be noted at a more micro level. Around the time of the failure of LTCM in 1998, the firm faced price shocks in various markets that were almost 10 times larger than might reasonably have been expected based on previous history. As a result, its fundamental assumptions – that it was adequately diversified, had ample liquidity and was well capitalised – all proved disastrously wrong.
Of course, many will say that our understanding of economic processes has improved thanks to this experience. Yet this is not such an easy proposition to prove. Consider, for example, the typical way in which central bank economists forecast future inflation using econometric models of how wages and prices interact.
To do this accurately, at least five questions have to be answered correctly. What is the best way to measure excess capacity in the domestic economy? What is the trend rate of growth of productivity? Are foreign influences limited to import prices alone? Are wages driven by forward-looking price expectations, or by past price developments? If expectations are important, are they influenced by the credibility of central banks or by something else, like actual or even perceived inflation? Each of these questions is currently highly contentious. And when we turn to other economic variables, the degree of disagreement about many equally fundamental issues is just as great.
Indeed, in the light of massive and ongoing structural changes, it is not hard to argue that our understanding of economic processes may even be less today than it was in the past. On the real side of the economy, a combination of technological progress and globalisation has revolutionised production. On the financial side, new players, new instruments and new attitudes have proven equally revolutionary. And on the monetary side, increasingly independent central banks have changed dramatically in terms of both how they act and how they communicate with the public.
In the midst of all this change, could anyone seriously contend that it is business as usual? (pp. 139–140).
Amen to that! As I’ve argued in previous Debtwatch Reports, business as usual can’t persist when it is based upon unsustainable trends. Now the BIS is making the same observation.
