Is the whole theory of secular stagnation a hoax?
The Bank for International Settlements says the entire strategy of stimulus by global central banks is based on a false premise
By Ambrose Evans-Pritchard
Credit bubbles are corrosive. They gobble up resources on the upswing, diverting workers into low-productivity sectors and building booms. In Spain the construction share of GDP reached 16pc at the height of the "burbuja" in 2007, when teenagers abandoned school en masse to earn instant money erecting ghost towns.
Parasitical wastage creeps in. "Financial institutions' high demand for skilled labour may crowd out more productive sectors," said the paper, acidly.
The bubbles leave a long toxic legacy after the bust hits. This takes eight years or so to clear.
"The occurrence of a crisis greatly amplifies the impact of previous misallocations," said the paper, racily titled "Labour reallocation and productivity dynamics: financial causes, real consequences".
Crippled economies have to make the switch back to healthier sectors against the headwinds of a credit crunch and a broken financial system, and typically amid austerity cuts in public investment.
The BIS has long argued that a key reason why the US recovered more quickly than others is because it tackled the bad debts of the banking system early, forcing lenders to raise capital.
This averted a long credit squeeze. It cleared the way for Schumpeterian creative destruction.
The Europeans dallied, prisoners of their bank lobbies. They let lenders meet tougher rules by slashing credit rather than raising capital. Europe's unemployed have paid a high price for this policy failure.
Claudio Borio, the paper's lead author and the BIS's chief economist, said the "hysteresis" effect of lost productivity is 0.7pc of GDP each year. The cumulative damage from the boom-bust saga over the past decade is 6pc.
This more or less accounts for the phenomenon of "secular stagnation", the term invented by Alvin Hansen in 1938 and revived by former US Treasury Secretary Larry Summers. Loosely, it describes an inter-war Keynesian world of deficient investment and demand.
The theory of the global savings glut propagated by former Fed chief Ben Bernanke falls away, and so does the Fed's central alibi. It can longer be cited as the canonical justification for negative real rates. The alleged surfeit of capital in the world proves a mirage. So does the output gap.
If the BIS hypothesis is correct, there is no lack of global demand. The world faces a supply-side problem, impervious to monetary stimulus. The entire strategy of global central banks is based on a false premise.
There is little dispute that credit did run amok before the Lehman crisis. The Anglosphere was swept by infectious folly. Credit to households and firms in the US jumped from 157pc to 212pc of GDP over the decade leading up to 2008, and from 167pc to 248pc in the UK (OECD data).
The eurozone was just as bad, with parallel effects for countries that had to import the European Central Bank's loose money through currency pegs. Private debt in Denmark rose from 208pc to 275pc. Spain won the prize, rising from 137pc to 274pc. These were staggering jumps in such a short period, as some of us kept warning at the time, protesting vainly until we were blue in the face.
China has since replicated the Spanish property fiasco almost exactly, with the salient difference that the Communist Party's state-owned banking system will not allow a financial collapse. The trauma will manifest itself "a la japonnaise". It will be a slow loss of dynamism, a medscape of companies kept on life support, although interestingly the first state-owned shipbuilder - Wuzhou Ship - has just been allowed to go bankrupt.
The BIS lodestar is the "natural" rate of interest, coined by the Swedish economist Knut Wicksell. If real rates are held too low, they throw the monetary system out of kilter and play havoc over time.
Modern central banks think they have a warning gauge. When policy is loose, inflation picks up. This ignores irrefutable evidence that credit booms and asset prices can gather pace even if headline inflation is well-behaved, or even in deflation, and the consequences are dire.
Mr Borio swats aside the standard Fed objection that it is impossible to discern a bubble, asking whether it is really possible to discern the output gap or the "NAIRU" point of full employment, yet the Fed acts on these indicators.
He accused central banks of an "asymmetric" bias for the last quarter century. They let asset booms run their course, but throw the kitchen sink at each downturn. The result is ever-rising debt ratios, making it ever harder to right the ship again. "This can contribute to a kind of 'debt trap'. Over time, policy runs out of ammunition," he said.
This is well understood. More contentious is the BIS claim that low rates themselves become "self-validating" and pull the monetary regime downwards over time - "easing begets easing".
Personally, I struggle with these concepts. It could equally be said that the chief cause of surging debt ratios in Italy, Spain, France, Portugal, Finland and most of the eurozone from 2011 to 2014 was sheer policy error, the deflationary hammer blow of fiscal austerity and tight money at the same time. It led to a rising debt burden on a base of stagnant nominal GDP. The "denominator effect" automatically sent debt ratios spiralling upwards.
Nor is it clear exactly how, why or when the central banks first entered into their Faustian Pact.
The implict BIS argument is that they should have let benign deflation run its course in the 1990s after the opening up of China and Eastern Europe doubled the global labour pool at a stroke, drastically containing wage pressure.
Yet it can hardly be disputed that Alan Greenspan, Ben Bernanke and their peers did in fact face a capital glut. The global savings rate rose relentlessly for two decades, reaching a peak of 25pc of GDP only last year.
China, the emerging states of Asia, the petropowers and sovereign wealth funds did push foreign reserves to $18 trillion, pulling the money out of the global reservoir of consumption and hoarding it as capital instead.
Be that as it may, the BIS is clearly right that zero rates and QE set off a tidal wave of stimulus through Asia, Latin America and emerging markets from 2009 onwards. It overwhelmed financial defences, pushed offshore dollar debt to $9.8 trillion, and drew the world's last holdouts into the Ponzi scheme. Only Cuba and North Korea seemed to escape the curse.
Radical stimulus may have worked for the US and the UK in one sense, but it was a "Pareto suboptimal" for the world as a whole.
The result is before our eyes. Total debt has risen to an all-time high of 265pc of GDP in the OECD club and 185pc in emerging markets, 35 percentage points higher than it was at the top of the last credit cycle eight years ago.
Mr Borio would like us to pluck up our courage and restore rates to their Wicksellian equilibrium, come what may. My fear is that it is already too late. The social and political consequences of a liquidation purge are too terrible. We are trapped in this insidious circle, and we will have to live with it.
Money and debt contracts are social conventions. They can be torn up, or reinvented. When we go into the next global downturn - perhaps in 2017 - we may have to resort to an entirely different form of QE. The next step is to print money to fund state spending directly, and probably behind capital constraints in a less "globalized" world.
Economic life will go on. As the Habsburgs used to say, the situation is desperate but not serious.