As noted in my previous post, the Bank for International Settlements has taken the occasion of its annual report on global economic conditions to reiterate its concerns about the emergence of financial market imbalances in the world economy:
One simply cannot ignore the number of indicators that are now simultaneously exhibiting marked deviations from historical norms. Among the internal imbalances that compel attention, real policy rates in many industrial countries and in emerging Asia continue to hover around zero. Nominal rates on long bonds, as well as credit spreads and measures of market volatility, are remarkably low. The household saving rate in many industrial countries has been trending sharply downwards, and debt levels are at record highs. House prices in many countries have never been higher. And in China, the investment ratio has risen to a startling 50% of GDP. Finally, external imbalances have never been larger in the postwar period. Any or all of these numbers might well revert to the mean, with associated implications for global economic growth.
The report does more than wave the yellow flag, however. It also contains some advice:
What can policy do about these internal and external imbalances? With respect to internal imbalances, one obvious answer is to increase interest rates to induce reductions in long-term exposures. But this immediately raises the prospect of conflict with more traditional short-term objectives of policy ,namely low unemployment and the avoidance of excessive disinflation. As for external imbalances, here too many conflicts arise. For example, fiscal tightening might help remedy external imbalance problems for deficit countries, but could also lead to uncomfortable levels of unemployment. In such circumstances, perhaps the best that can be hoped for is “opportunistic” progress. That is, look for opportunities to cut these longer-term exposures, but only as other priorities allow.
This one is no surprise:
Turning to external imbalances, the widening current account deficit of the United States is a serious longer-term problem...
What could policy do at this juncture? The textbook answer, against the backdrop of declining levels of excess capacity, is that deficit countries should reduce the rate of growth of domestic spending below that of domestic production. Allowing their currencies to depreciate in real terms would make their products more competitive, and also provide an incentive for production to shift out of non-tradables into tradables. The opposite should occur in surplus countries: that is, higher real exchange rates and more domestic spending.
The question is, how are the required fix-ups accomplished? The BIS suggests rethinking the policy framework:
A guiding principle, should one wish to introduce a macrofinancial stabilisation framework, would be that both regulatory and monetary policies should be applied more symmetrically over the cycle... In the case of regulatory policy, more symmetry would imply that more capital should be built up in good times. Not only would this help restrain credit excesses, but it would also allow capital to be run down in bad times, up to a point, to cushion the economy from associated credit constraints. Tightening monetary policy in the face of excessive credit growth would also attenuate the worst excesses, and could obviate the need for radical easing later that might result in policy rates facing the constraint of the zero lower bound. This would be of considerable advantage should an unwelcome degree of disinflation emerge in such an environment.
In practice, a more symmetrical regulatory policy might be implemented in various ways. Were the regulators to be convinced that systemic risks were rising to dangerous levels, they could have recourse to discretionary action. Liquidity ratios, loan-to-value ratios, collateral requirements, margin requirements and repayment periods could all be tightened... In contrast, were the authorities to be less certain about their capacity to predict stressful events, they might rely more on some simple indicators to encourage more prudent behaviour. Prudential norms pertaining to the rate of growth of credit or asset prices could in principle be used to influence the pricing of risk, provisions for losses (for expected losses) or the accumulation of capital (for unexpected losses).
Regarding a more symmetrical monetary policy, this too might rely on either discretion or simple normative indicators. As to the former, both the Bank of England and the Reserve Bank of Australia have, in the last year, indicated that concerns about rising house prices and debt played a role, along with strong demand growth, in explaining their respective interest rate increases. Sveriges Riksbank, for similar reasons, did not lower interest rates as much as might have been expected given that it was actually undershooting its inflation target. As for the use of normative indicators, the two-pillar approach of the ECB could be noted. However, the suggestion here would be somewhat different: namely, to use monetary and credit data as a basis for resisting financial excesses in general, rather than inflationary pressures in particular.
To be honest, I'm not sure how discretion amounts to a framework, and it's my impression that monetary and credit aggregates have very much been the lesser of the ECB's two pillars when it comes to actual policy decisions. But I think the general message is that policymakers ought to move beyond the traditional emphasis on things like inflation targets and "output gaps" and concentrate more on financial stability goals:
Identifying when financial imbalances are building up, to a point likely to involve substantial macroeconomic costs, is a serious practical problem. Yet a macrofinancial orientation should at least ensure that policymakers are looking in the right direction. Those concerned with weaknesses in the financial sector would thus focus more carefully on areas where stresses were more likely to have knock-on effects elsewhere.
Fair enough. I would argue that this already describes how monetary policy is conducted. The Federal Reserve was created, after all, to protect the financial system from systemic meltdown. This is not a relic of the past, and the proof is no further in the past than September 11, 2001. But I cannot argue at all with this conclusion:
... while progress has been made in strengthening our assessment powers, significant shortcomings remain. Improvements in financial intermediation make higher debt/income ratios more sustainable than in the past, complicating the quantitative assessment of just when these ratios become excessive. In addition, some basic data tend to be flawed. External ratings, internal ratings and market-based measures of credit risk are all likely, at times, to be affected by waves of optimism or pessimism. They may then give misleading indications of the dangers faced by individual components of the system looking forward. Moreover, the use of aggregated data for prediction purposes fails to capture interactions that can be both complex and non-linear.
We need to know more about the distribution of risks within the system, as well as the likelihood that different market participants might react to similar shocks in the same way. In effect, we need better means to stress-test the financial system as a whole, as well as to test the manner in which stresses might then feed back on the real economy, leading in turn to another set of shocks to the financial system and so on.
The BIS report concludes with some thoughts on how international arrangements might be improved to the service of global financial stability, albeit ones that will probably make more than a few people a little bit queasy:
First, one might contemplate going back to a more rule-based system. Several academics have suggested the establishment of a single international currency. In the context of the impossible trinity, this would imply national authorities relinquishing domestic monetary control and moving away from still existing capital controls. A more realistic recommendation might be to have a small number of more formal currency blocs (say, based on the dollar, euro and renminbi/yen), but clearly they would have to float more freely against each other...
A second possibility could be to revert to a system more like that of Bretton Woods. History teaches that this would only work smoothly if there were more controls on capital flows than is currently the case, which would entail its own costs. Moreover, the IMF would have to be given substantially more power to force both creditors and debtors to play their role in the international adjustment process...
Third, and most promising in the real world, consideration could be given to informal cooperative solutions, recognising interdependencies and the need to avoid circumstances that could lead to systemic disruptions.
The first two are likely to be unpalatable to most, and the third belongs to the "Why can't we all just get along?" class of solutions (which are useful, but of limited effectiveness).
I think the best advice in the report is the call for policymakers to continue with efforts to elevate our abilities to model, monitor, and respond to the financial stability challenges that show no signs of abating any time soon. I said so myself not long ago:
In my time at the Fed, I have come to appreciate that most of the really important policy choices have nothing to do with Taylor rules or the like. They have to do with those episodes of financial crisis in which Taylor-like rules are woefully inadequate. Think here October 1987, the period from summer 1997 through the end of 1998, and the aftermath of September 11, 2001.
I have in the past argued that it is useful to think of the policy choices in those periods as policy shocks. I would still argue that today. But it sure would be helpful if at least some of these events would appear as something more than completely random disturbances. In other words, it would be very useful to have usable measures of what we loosely call “financial market fragility,” and more useful still to have a coherent quantitative model... that captures them.
UPDATE: The Prudent Investor notes similar warnings from the IMF.