Friday 6 December 2019

Analysts now ask if falling prices are really so bad

Falling Falling: The
Falling Falling: The "central bankers' central bank" says the financial system is too fragile and incapable of doing its job

Nobody fully understood how fragile the western financial system had become prior to its implosion in 2008. Even those who were most pessimistic, such as Nouriel Roubini (aka Dr Doom) turned out to underestimate the scale of the crash when it came. Indeed, if anyone in the summer of 2008 correctly predicted how the next six years would play out he/she would have been dismissed as a crank and a catastrophist.

Of the many lessons that should have been learnt from the crash, and the enormous consequences that followed it, is the inherent fragility of a system that has become as big and as complex as modern finance. It is not at all clear that even that lesson has been learnt.

That one of the few organisations to have been even close to correct in its pre-crisis analysis of finance's fragilities is again warning of big weaknesses in the system is cause for concern. The Bank for International Settlements - often called the central bankers' central bank - is a global body headquartered in the Swiss city of Basel.

Its annual report*, published last week, declared bluntly "the legacy of the Great Financial Crisis and the forces that led up to it remain unresolved". There has been, it says, "a collective failure to get to grips with the financial cycle".

That such a mainstream organisation not known for radical views or excitable analysis is calling for greater action is indicative of the scale of challenge that remains in making the financial system less dangerous.

Such changes are needed in order to avoid another crash of the magnitude of 2008, which the report quite accurately describes "a defining moment in economic history".

What makes this report more interesting and original than most other such analyses is its explicit 
long view. Although it may not 
quite be something to peruse on the beach while on holiday, it reads more like a well-written and accessible history than just another institutional report which will be out of date in a year's time.

It notes that much economic and financial analysis is very short term and even those analyses that seek to look at matters in greater context tend to look at the "business cycle" time period, which BIS analysts measure to average around eight years. Instead, they belief that financial cycles, which are longer lasting, extending for 15-20 years on average, also need to be considered when analysing economic matters and, in particular, when policy decisions are being made.

That is because when policy has focused on business cycles, while ignoring financial cycles, there is a downward bias in how interest rates are set. This has certainly been the case in recent times. Every time economies have turned down in recent decades policy has been eased "aggressively and persistently". Easing has also taken place to reassure financial markets, as happened after the 1987 and 2000 equity market crashes.

This, in turn, has "induced an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy - a debt trap".

And it gets worse. The BIS has long been pointing to the downsides of the unconventional monetary policies, such as quantitative easing, which have been pursued in recent years. It has done so not because it takes an excessively conservative and anti-experimental position but because it weighs the downsides of the measures, which tend too often to be ignored because of the desire to provide stimulus in the short term.

Among the downsides are, again, a bias towards higher debt levels and the inflating of asset price bubbles, both in the economy where the measures are taken and internationally as liquidity inevitably flows into non-national asset markets.

Without the improvements in "fiscal, monetary and prudential" policy frameworks that the BIS is calling for, it states that "the risk is that instability will entrench itself in the global economy and room for policy manoeuvre will run out".

These final words are more than worrying. Most analysts agree that the global economy was following the pattern of the Great Depression in the immediate aftermath of the 2008 and that it was a massive policy response which prevented that outcome. That the BIS is talking about room for a policy response "running out" means that it may not be possible to prevent the next crash from spiralling into another Great Depression.

But the report does not just discuss risks. It highlights "a puzzling disconnect between the markets' buoyancy and underlying economic developments globally".

This raises an entirely separate concern from the fragilities issue, and one that is perhaps even more fundamental: is the financial system doing what it exists to do?

Let's recall that the purpose of that system is simple - it is about matching savers with investors so that economic growth can be facilitated. But that is not happening as it should in the industrialised world. As a series of other reports that happened to be published last week highlighted, investment in productive capacity has come nowhere near recovering in many rich countries.

The failure to boost productive investment by companies despite what the BIS describes as "extremely accommodative financial conditions" and while financial markets have "roared", points to the decoupling of a casino-like financial services industry from the real economy it is supposed to serve.

Another issue of immediate concern for Europe in the report is deflation, and the appropriate policy response to the threat of falling consumer prices. The International Monetary Fund, among others, has recently been pressing the European Central Bank to move more aggressively down the route of unorthodoxy policy measures to prevent the inflation turning to deflation (that has already happened in some peripheral eurozone countries and the aggregate annual rate on inflation in the zone is at 0.5pc, far below the ECB's mandate of "close to, but below 2pc").

But the BIS, while not dismissing the deflation threat, notes that it tends to be associated too readily with the 1930s, despite huge changes having taken place since then. It notes that the association with the Great Depression tends to exacerbate the perceived downsides of deflation.

It goes on to point out that periods of falling prices have often coincided with sustained economic growth from recent times going all the way back to the 19th century because beneficial supply side changes can lead to a one-off decline in prices, something which is in no way bad.

In its analysis of previous periods of deflation it also finds that the cases of deflationary spirals taking hold have very much been the exception, as in the case of the 1930s, rather than norm, and that the risk of such a spiral may be overstated.

This analysis is highly relevant to Europe. The BIS expects the current period of very low inflation in the eurozone to be temporary, in large part because of its causes, which the Basel analysts believe to be good rather than bad - supply side increases in competition driven by globalisation rather than chronically weak demand.

The ECB has often been accused of being slow and indecisive in acting during the crisis. The accusations, which are not baseless, are mostly because there are serious policy disagreements among the large and unwieldy 24-member governing council. The considered views of the central bankers' central bank will, if anything, make those disagreements sharper and more protracted.


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