The Bank for International Settlements strikes a reflective pose in its latest annual report on the global economy:
On the occasion of the 75th anniversary of the BIS, it seems appropriate in this Annual Report to look back over a longer historical period than normal...
Looking back over the last two decades or so, four features stand out. The first has been a welcome reduction in the level of inflation worldwide and an associated decline in its volatility. The second has been generally robust growth in the global economy, again accompanied by lower short-term volatility, with sluggish growth in Japan and Germany more recently an important exception to the rule. The third feature has been the widening of external imbalances. And finally, one must note the increasing prominence of credit, asset price and investment booms, often followed by financial difficulties of various kinds...
Here's the good news:
... inflation in every industrial country has fallen sharply from its peaks in the 1970s. A similar pattern has been observed in the majority of emerging market economies. Even in countries which previously suffered from hyperinflation, notably in Latin America, inflation is now generally at single digit levels. Significantly, in Argentina and Brazil the pass-through from the most recent large depreciations failed to reignite inflation expectations as had almost always happened previously...
A second broad trend has been towards faster economic growth at the global level, often accompanied by lower short-term output volatility. As to growth rates, phases of expansion in industrial countries have lengthened, while the rate of expansion in many emerging market economies has turned sharply upwards.
That said:
In contrast, all the countries hit by financial crisis over recent decades, as described below, did experience a very sharp slowdown during the worst phase of the crisis. Moreover, in the case of Japan, very rapid growth through the 1980s gave way to a much more sluggish output trend after the bubble burst...
Even if the economic features described above have been broadly satisfactory, two other, less welcome, longer-term trends deserve to be singled out. The first of these has to do with global current account imbalances. For at least the last 15 years, the US external deficit has been trending upwards, accompanied by rising, if still relatively low, external debt... It is unprecedented for a reserve currency country to have a current account deficit of such magnitude.
Concerns about the implications over time of these external imbalances have been heightened by another longer-term trend. The global financial system seems to have become increasingly prone to financial turbulence of various sorts. The Mexican, Asian and Russian crises of the last decade indicated the force with which shocks could be transmitted both across liberalised financial markets and across countries. Short-term price volatility in financial markets, often associated with a sudden drying-up of previously abundant liquidity (as in the Long-Term Capital Management (LTCM) episode), has at times been another source of turbulence. A number of small but high profile bankruptcies of financial firms (eg Drexel Burnham Lambert and Barings) have occurred, raising sensitivities to the potential implications of larger and more complex institutions getting into difficulties. And finally, financial losses due to operational risks seem to have been on an upward trend. This has reflected not only the increased complexity and IT dependence of modern financial systems, but also governance issues (eg Enron, Parmalat and AIG) and the new reality of terrorist disruptions (11 September 2001).
Yet the single most remarkable feature in the financial area has been the recurrence of credit, asset price and investment booms and busts. A first cycle began in the industrial countries in the 1970s, affecting both equities and real estate. A second cycle started in the mid-1980s, ending in a property bust a few years later... Moreover, it seems increasingly evident that we are today well into the boom phase of a third such cycle, dating from the economic upturn of the mid-1990s. Equity prices were affected first but, after their sharp decline in early 2001, the upward momentum of demand was transferred to the housing market.
The BIS report suggests that traditional demand-driven explanations of business cycle dynamics are no apropos to the nature of the modern global economy:
In virtually every instance, the bust phase of credit, asset price and investment cycles has been accompanied by some kind of headwind that has slowed down the subsequent economic recovery. The most serious effects have generally been due to outright crises in the banking system, as was the case in the Nordic countries in the late 1980s, Mexico in 1994 and a number of Asian countries in 1997–98...
In any event, even short of financial crisis there have been many examples in recent decades of loss-impaired financial institutions restricting lending, with negative effects on real economic activity. Moreover, headwinds seem sometimes to have arisen also from overstretched corporate and household balance sheets and the overhang of unprofitable capital investment.
What to think about this?
The recurrence of bouts of financial instability, even after inflation had been sharply reduced, also allows for alternative explanations, and perhaps alternative policy responses. One possibility is that problems encountered to date will, in the end, prove only transitional. Learning to live with low inflation, a liberalised financial sector and recent advances in financial technology simply takes time. During the learning process, disruptive mistakes have been made but their incidence and costs will decline.
An alternative possibility is that such instability might be longer-lasting. Liberalised financial systems, while more efficient than repressed ones, might be inherently prone to instability if competitive pressures occasionally lead to excessive risk-taking. A second point is that they also seem to be inherently procyclical. That is, perceptions of value and risk move up and down with the economy, as does the willingness to take on risk. Credit spreads, asset prices, external ratings, internal ratings and loan loss provisions have all demonstrated this characteristic over the last few decades at least. This can result in powerful financial forces spurring real growth during an economic upturn, but an equally powerful downdraft should the initial optimism eventually come to be seen as excessive.
The bottom line? We're not out of the woods just yet.
A continuation of steady, non-inflationary growth might seem the most likely outcome, given the positive aspects of the fundamental structural changes described above. However, it is by no means guaranteed. On the one hand, the significant monetary stimulus seen to date could yet end in overt inflation. On the other hand, the implications of growing debt levels, both domestic and international, remain a great unknown. Either debtors or creditors, or both, might retrench as debt levels mount. Reductions in asset prices and assessments of private sector wealth could reinforce such behaviour. Conversely, increases in debt levels might simply be a normal part of financial deepening as markets mature and become more complete.
Given how little experience we have had with the interactions of the many structural changes identified above, these less welcome possibilities cannot be ruled out.
UPDATE: catallaxis has a chapter-by-chapter summary of the BIS report.