July 1, 2014 6:59 pm

Bad advice from Basel’s Jeremiah

The Bank for International Settlements’ proposals for post-crisis policy have serious flaws
Ingram Pinn illustration©Ingram Pinn

I admire the Bank for International Settlements. It takes courage to accuse its owners – the world’s main central banks – of incompetence. Yet this is what it has done, most recently in its latest annual report. It would be easy to dismiss this as the rantings of a prophet of doom. 

That would be a mistake. Whether or not one agrees with its pre-1930s view of macroeconomic policy, the BIS raises big questions. Contrariness adds value.

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.

On the first, the perspective is that of the “financial cycle”. This analysis goes back to the work of the great Swedish economist Knut Wicksell at the turn of the 20th century. The core idea is that if the rate of interest is too low, a boom driven by expanding credit and rising asset prices may ensue

One of the crucial (and correct) implications is that credit and money are endogenous: they are created by the economy. 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 Institutepainful deleveraging and extended periods of feeble growth. Such cycles, argues the BIS, “tend to play out over 15 to 20 years on average”. To give credit where it is due, the BIS gave such warnings well before the crisis hit the high-income countries from 2007.

On the second, the BIS notes that growth has picked up over the past year, with advanced economies gaining momentum, while emerging economies lose it. Nevertheless, recovery has been slow and weak in crisis-hit countries. While global growth is not far from rates seen in the 2000s, the shortfall in the path of gross domestic product persists. Meanwhile, 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. The BIS is particularly concerned about new sources of vulnerability in the latter, including foreign borrowing by non-financial corporates. Overall, concludes the BIS wryly, “it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments”. (See charts.)

It is on the third pointwhat is to be done – that the BIS turns into a prophet from the Old Testament: it demands austerity now. In countries that have experienced a financial crisis it recommends balance sheet repair and structural reformderegulation, 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”. It plays down both risks and costs of deflation, despite the huge overhang of debt that it also stresses. Even Jens Weidmann, the Bundesbank president, does not do that. Being more hawkish than the Bundesbank is quite something. Meanwhile, 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, 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 that 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 (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.

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, of Princeton and Chicago universities respectively, make much of this argument in their important book, House of Debt. Unfortunately, it is also politically difficult to make this process work.

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 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.

Copyright The Financial Times Limited 2014.

The World’s Central Banker

J. Bradford DeLong

JUN 30, 2014
Federal Reserve Washington DC

BERKELEYThe US Federal Reserve these days is broadly happy with its monetary policy. But, since mid-2007, its policy has been insufficiently expansionary. The policy most likely to succeed right now would be analogous to that implemented by the Fed in 1979 and 1933, Great Britain in 1931, and Shinzo Abe today.

Those of us who fear that the Fed’s approach has greatly deepened the US economy’s malaise and is turning America’s cyclical unemployment into permanent long-term structural non-employment have lost the domestic monetary-policy argument. But there is another policy argument that needs to be joined. The Fed is not just the US central bank; it is the world’s central bank.

America’s current exchange-rate regime is one of floating rates – or at least of rates that can float. Back in the 1950s and 1960s, economists like Milton Friedman assumed that a global regime of floating exchange rates would be one in which currency values moved slowly and gradually alongside differences in the economy’s inflation and productivity-growth rates.

In the 1970s, the economist Rudi Dornbusch (and reality) taught us that that was wrong: a floating-rate regime capitalizes expected future differences in nominal interest rates minus inflation rates into today’s exchange rate. A country that changes its monetary policy vis-à-vis the US changes its current exchange rate by a lot; and, in today’s highly globalized world, that means that it deranges its import and export sectors substantially. Because no government wants to do that, nearly all governments today follow the US in setting monetary policy, diverging from it only tentatively and cautiously.

So the US is not just one economy in a world of economies following their own monetary policies under a flexible exchange-rate regime. The US is, rather, a global hegemon: the central bank for the world, with a responsibility not just to stabilize output, employment, and inflation and ensure financial stability in the US, but also to manage the world economy in its entirety.

One area of concern is the health and stability of growth in emerging markets as they attempt to benefit from capital inflows; satisfy North Atlantic demands for open financial markets; and manage the resulting instability created by speculative hot money,” the carry trade, irrational exuberance, and overshooting. Emerging-market central-bank governors fear a US that alternates between expansionary policy that fuels huge hot-money inflows and a domestic inflationary spiral, and rapid tightening that chokes off credit and causes a domestic recession.

Then there is the main problem facing the global economy today: the crisis of Europe and the eurozone. The creation of the euro without an appropriate fiscal union meant that transfers from surplus to deficit regions would not eliminate or even cushion demand imbalances. The fact that the eurozone lacked the labor-market flexibility needed to make it an optimal currency area meant that adjustment via regional reallocation of economic activity would be glacial, while its members’ loss of control over monetary policy ruled out adjustment via nominal depreciation.

Moreover, Europe lacks the governance institutions needed to choose the easiest path to manage economic rebalancing: moderate inflation in the north, rather than grinding deflation and universal bankruptcy in the south. The European Union’s institutional design amplifies the voices of those interests pushing for policies that have now set Europe on the deflationary road, thus all but guaranteeing lost decades during which the EU will fail to deliver growth and prosperity.

We have an example from the early twentieth century of the political consequences of such a period of economic depression and stagnation. The reaction to what Karl Marx called parliamentary cretinism is the rise of movements that seek, instead, a decisive leadersomeone to tell people what to do. Such leaders soon learn that their solutions are no better than anybody else’s and decide that the best way to remain in power is by blaming all problems on foreigners. Thus they exalt the “nation” and focus their policies on zero-sum quarrels with other countries and on scapegoating deviantaliens” at home.

This is not in Europe’s interest, and it is not in America’s interest to have to deal with such a Europe. A democratic, prosperous, and stable Europe implies a much better and safer world for the US.

Here is where the Fed comes in. By shifting its monetary-policy regime to target 4% annual inflation – or 6% annual nominal GDP growth – the US would set in motion rapid rebalancing in the eurozone. Rather than see the 30% euro appreciation that would follow from the ECB’s current monetary policy, German exporters would scream for measures to prevent America’scompetitive devaluation,” finally bringing about moderate inflation in the north rather than the current grinding depression in the south.

A world in which the US has a proven record of honoring the trust that is required of it to play the role of global economic hegemon is a much better world for the US than one in which it is not trusted. Simply put, the US must manage the global economy for the collective common good, or else confront a world in which global macroeconomic management results from race-to-the-bottom national policy struggles.

America’s medium- and long-term political, security, and, yes, economic interests require the Fed to recognize that its policy mission is not to focus narrowly on attempting to achieve and maintain internal balance. Rather, it is to embrace and fulfill its role as the world’s central bank, by balancing aggregate demand and potential supply for the global economy as a whole.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.

Last updated: June 30, 2014 7:13 pm

Revisionist powers are driving the world’s crises

China is likely to emerge the challenger to the US-dominated global system

Ingram Pinn illustration©Ingram Pinn

The headlines are dominated by regional crises – in Ukraine, in Iraq and in the South China Sea. But is there a common thread that ties together these apparently unconnected events?

One global theory is advanced by Walter Russell Mead, a professor at Bard College, in a recent piece for Foreign Affairs, entitledThe Return of Geopolitics”. Prof Mead’s piece, together with a rejoinder by Professor John Ikenberry of Princeton University, offers a way of thinking through current patterns in world politics.

The shape of the world order that emerged after the collapse of the Soviet Union is fairly easy to define. Its key characteristics included a globalised economic system, functioning multilateral institutions and – most important of all – an unchallenged role for the US as the most powerful player.

The debate is about whether that system is now under threat. Prof Mead asserts that “China, Russia and Iran never bought into the geopolitical settlement that followed the Cold War and they are making increasingly forceful attempts to overturn it”. The crisis in Ukraine, which was taking shape as Prof Mead wrote his article, provides a vivid illustration of his thesis. Russia’s anger with the post-1991 settlement has led it formally to annex Crimea. China’s increasingly assertive territorial claims and Iran’s obvious dissatisfaction with the regional order in the Middle East form the other pillars of the argument. Prof Mead calls these three countriesrevisionist powers” and argues that while “they haven’t overturned the post-Cold War settlement . . . they have converted an uncontested status quo into a contested one.”

Prof Ikenberry responds that “Mead’s alarmism is based on a colossal misreading of modern power realities”. As far as he is concerned, “China and Russia are not full-scale revisionist powers, but part-time spoilers at best”. 

The US, he points out, has “military partnerships with over sixty countries, whereas Russia counts eight formal allies and China has just one (North Korea)”. All told, the “military capabilities aggregated within this US-led alliance system outweigh anything that China or Russia might generate for decades to come”.

America is also the beneficiary of favourable geography because it is “the only great power not surrounded by other great powers”. The US also promotes ideas with global appeal, while Russia and Chinahave no appealing brand”.

Above all, however, Prof Ikenberry believes that the so-called revisionist powers” are not really revisionists at all. They will not challenge the American-led world order because, ultimately, they benefit from it. He argues that “Although they resent that the United States stands at the top of the current geopolitical system, they embrace the underlying logic of that framework, and with good reason. Openness gives them access to trade, investment, and technology from other societies.” 

What is more, Russia and China are big powers with vetoes at the UN. Their interests are protected by the current system because – “they are geopolitical insiders”.

So which of these two analyses is more convincing? I should declare an interest. Back in 2010, I published a book called Zero-Sum World that predicted increasing geopolitical competition between the west and the governments in Beijing and Moscow. It always seemed likely to me that a relative decline in American power would provoke challenges to the US-led world order. So, naturally, I am sympathetic to Prof Mead’s arguments that current political developments do indeed demonstrate the failure of the west’s efforts to “shift international relations away from zero-sum issues toward win-win ones”.

That said, the debate is hardly settled. The rise in tensions in Ukraine and in the seas around China seem to fit the zero-sum thesis neatly. But neither Russia nor China has yet made a definitive break with the US-dominated global system. Indeed, if Russia fails to escalate the Ukrainian crisis, it could yet be argued that the Putin governmentfaced with sanctionsdecided that the costs of a full-scale confrontation with the west were too high.

Iran more obviously matches the profile of an outsider, revisionist power. On the other hand the Iranian regime, impoverished by sanctions, seems to be trying to break its way back into the international system, by seeking a deal over its nuclear programme.

Over the long run, China is surely the most important potential challenger. Unlike Russia it is a rising power and, by some measures, now the world’s largest economy.

Beijing has not yet attempted anything as reckless as the seizure of Crimea. And China adopts a lower profile on global issues outside its region than Russia does. But a pattern of more assertive Chinese behaviour in disputes with its neighbours, including some American allies, is now obvious.

Whether China is truly seeking to remake the global order or simply to become more assertive, within the current framework, is a debate for the seminar room. What does seem clear is that China’s traditional emphasis on economic growth is now increasingly accompanied by more nationalistic postures on political and security issues. That, in turn, is leading to an increase in tensions with China’s neighbours and with the US.

You can call that the “return of geopolitics”, or you can call it the rise of a “zero-sum world”. But whatever the terminology, it looks like a dangerous trend that is gathering momentum.

Copyright The Financial Times Limited 2014.