TWN
Info Service on Finance and Development (Jul15/04)
3 July 2015
Third World Network
BIS for rise in policy rates, structural supply-side reforms
Published in SUNS #8052 dated 30 June 2015
Geneva, 29 Jun (Chakravarthi Raghavan*) -- The Bank for International
Settlements (BIS) has again repeated its warning over the dangers
posed by prolonged ultra-low policy interest rates, and the need to
focus on medium- to longer-term structural changes on the supply-side
rather than current short-term focus on demand-side economics.
Structural change on the supply-side are code words for product and
labour market flexibility.
The warning and advice from the Basel-based BIS, often described as
the central bank for the world's central banks, has come in its 2015
Annual Report, advance media briefings on the report, and the speeches
of the BIS General Manager and top officials at the annual General
Meeting on Sunday (28 June) in Basel.
Globally, interest rates have been extraordinarily low for an exceptionally
long time, in nominal and inflation-adjusted terms, against any benchmark,
the BIS said, and added: "Such low rates are the most remarkable
symptom of a broader malaise in the global economy: the economic expansion
is unbalanced, debt burdens and financial risks are still too high,
productivity growth too low, and the room for manoeuvre in macroeconomic
policy too limited."
The BIS report, speeches and remarks at the annual meeting, preceded
by the usual private meeting of the central bankers only and their
frank exchange of views (with no records kept or issued), and renewed
push by BIS for reversing current ultra-low policy rates in the most
important advanced economies, have tried to focus on the global economy
and the International Monetary and Financial System.
There is "something deeply troubling when the unthinkable risks
becoming routine and being perceived as the new normal," says
the BIS in advocating policy measures, tailored to particular situations
in individual economies, but taking advantage of the current low energy
prices, to promote structural changes focussing on supply-side, conceding
that decision-makers have difficult political choices of short-term
pain for long-term benefit.
How difficult the choice is posed in headlines in newspapers on Monday
of the fast-moving Greek financial crisis and a possible "Grexit"
(Greek exit from eurozone) with consequences for Europe itself: the
breakdown of talks between Greece on one side and the Troika (European
Commission, European Central Bank and the IMF) and Germany (the eurozone
hegemon) on the other, with the Syriza government in Athens calling
for a referendum and recourse to democracy.
Over the weekend, one of the financial web-logs, "zerohedgefund.
com", presented it in a post as the "butterfly effect",
a reference to "chaos theory" where the term was used in
late 19th century to explain the sensitive dependence on initial conditions
in which a small change in one state of a deterministic non-linear
system can result in large differences in a later state: the fluttering
of a giant butterfly over the Amazon jungles, setting off hurricanes
and storms half the world away.
This theory is now seen as less applicable to meteorology and much
more to quantum systems - where physicists find it difficult to unify
or reconcile Einstein's relativity theories in the cosmic scale, with
Max Planck's theory of contra-functioning of sub-atomic particles.
The Greek crisis (with the banks and market shut down and not opening
Monday, and probably closed till after the referendum), with the Troika
pushing for regime change in Athens (to reverse the referendum and
democratic decision-making), and Germany increasingly perceived in
the European periphery as a hegemonic power trying to achieve through
economic power what it failed to do in the last century, and the state
of governance in the international monetary and financial system (or
non-system as perceived), has put the world and the global political
economy into the territory of the "law of unintended consequences."
Interest rates across some of the most important advanced economies
have been at historical lows for the better part of a decade. In the
US, the federal funds rate has hovered just above zero since 2008.
The Bank of England has kept the bank rate at a record low of 0.5
per cent since 2009.
Both of those central banks are now shifting towards the exit. But
the ECB in the eurozone appears set to leave rates in negative territory
- an increasingly common experiment for continental European central
banks - for years.
The situation in Europe is such that there are warnings about Europe
facing deflation, and conditions akin to that before the Great Depression,
and voices raised on the need for better coordination among central
banks, and the International Monetary Fund (IMF) taking a leading
role in fashioning new rules of the game - speech in London by Raghuram
Rajan.
Rajan, now the Governor of the Reserve Bank of India (RBI), and a
former chief economist for the IMF, in 2007 had raised his voice at
the US Fed-hosted Jackson Hole meetings against Alan Greenspan's policies
at the Fed, with such personalities like Larry Summers snubbing and
ridiculing Rajan at that time.
In his London speech, further explained in a press release in Bombay
by the RBI, Rajan has stressed the need for more coordination among
central banks to avoid competitive monetary policies by leading central
banks.
The IMF, in a just published staff paper, has sought to put the blame
for the 2008 Financial Crisis on the regulatory situation, rather
than on interest rate policies.
However, the IMF and the World Bank, the US Treasury (under Robert
Rubin and Summers) and the Fed under Greenspan were all pushing from
the mid-1990s for financial liberalisation by developing countries
and end to financial repression (meaning deregulation), with the IMF
until the Asian financial crisis calling on developing countries to
move onto full capital convertibility.
Around that time, in the final stages of the Uruguay Round/GATS negotiations,
the US, under President Bill Clinton and Rubin and Summers at Treasury,
were pushing for full market access for US banks and financial services
in the developing world, and post-Marrakesh, Rubin and Summers used
the WTO to end the vestiges of the Glass-Steagall Act to enable Citibank
to get into the non-banking business.
In the revolving door exercises of the US government, Rubin quickly
moved to Citibank, where for ten years he got $115 million, while
pushing Citibank to move into the high-risk business, and its subsequent
rescue by the US taxpayer (under Presidents Bush and Obama).
The BIS, in its report, says that policy rates in advanced industrial
economies have remained so low for so long and it is symptomatic of
a broader malaise facing the global economy: an unbalanced recovery,
bringing in its wake a host of problems.
The BIS brings out in this regard the extreme caution currently shown
by banks in lending or providing liquidity through "market-making"
trading operations, the bigger role now of hedge funds and other such
non-banking firms in market liquidity operations.
The BIS report also brings out what it considers the correlation between
low-interest easy money conditions and the misallocation of resources,
resulting in low productivity growth in the real economy, and the
unbalanced growth and imbalances within and among economies.
It alludes to, but does not elaborate, what is now more widely known
and bemoaned in academia and institutions of higher learning: students
specialising in higher mathematics, physics and hard sciences, preferring
to find employment in the financial sector where their knowledge and
ability to work with algorithms are in demand in financial trading
and speculative activities.
High technical knowledge and talent needed for innovation and productivity
increases in the real economy is now engaged in the trading and financial
economies.
The remedies against this state of affairs are not amenable to economy-wide
macro-economic policy changes and signals. They even need reversal
of course to reduce the role and size of finance in the current economy
for growth in the real economy.
The BIS report brings out in some detail, how the ample liquidity
to lenders provided by central banks, which was beneficial at the
early stages to rescue banks, is now facing major problems, with capital
markets - the fixed-income market, in particular - in danger of drying
up.
"The yield curve is very flat and, while there aren't many signs
of big increases in leverage, there have been warnings that these
patches of illiquidity are affecting businesses who cannot easily
access cash from central banks," said Hyun Song Shin, head of
research at the BIS.
This has had serious negative impacts on pension funds, insurance
firms, and retired people living on social security and incomes from
life savings.
In the face of this, and as a result of anaemic or uneven economic
recovery, youth, entering the labour market facing uncertainties,
lack of permanent job security with good earnings and future retirement
benefits, are more reluctant to take risks and engage in consumerism
or taking on debt, for e. g. in the US.
The same financial sector firms that have been pushing policies with
such consequences are now bemoaning the "millennials" not
willing to buy and indulge.
The Basel-based bank also found that the credit boom which led to
the financial crisis had a long-lasting impact on productivity growth.
"Financial booms create a shift in the factors of production
over and above what could be expected from the viewpoint of productivity.
There's a clear misallocation of labour," said Claudio Borio,
the head of the BIS's monetary and economic department.
The annual report has looked at the impact of credit growth on labour
productivity in 22 economies since 1979. It found that during the
financial boom, workers appear to flock to sectors of the economy
where productivity grows more slowly. Even when the boom times end
it is hard to reshuffle workers.
For the US, the BIS thinks the trend was so pronounced that changes
in the labour force from 2004 to 2007 cut productivity growth between
2008 and 2013 by almost half a percentage point a year.
During this prolonged period of low Central banks' interest rates,
labour productivity rose 2.1 per cent in 2014, compared with an annual
average of 2.6 per cent in the years between 1999 and 2006. Total
factor productivity, a measure of workers' efficiency which accounts
for the accumulation of building and machinery, fell 0.2 per cent
last year.
The solution, the BIS said in its report, is for governments to take
the reins from central banks and play a much more active role in rebalancing
their economies. Key to that goal are deeper structural reforms which,
while often politically unpopular, can help boost growth in the longer
term.
The reform prescription will differ from country to country. But economists
in Basel said it was crucial not only to ensure labour and product
markets were more flexible but also to modernise judicial systems.
"Structural reforms allow your economy to rebound quickly from
every type of recession," Mr Borio said.
The BIS points out that globally, interest rates have been extraordinarily
low for an exceptionally long time, in nominal and inflation-adjusted
terms, against any benchmark. Such low rates are the most remarkable
symptom of a broader malaise in the global economy: the economic expansion
is unbalanced, debt burdens and financial risks are still too high,
productivity growth too low, and the room for manoeuvre in macroeconomic
policy too limited.
The malaise has proved exceedingly difficult to understand, reflecting
to a considerable extent the failure to come to grips with financial
booms and busts that leave deep and enduring economic scars, the BIS
argues.
In the long term, this runs the risk of entrenching instability and
chronic weakness, with both a domestic and an international dimension.
Domestic policy regimes have been too narrowly concerned with stabilising
short-term output and inflation and have lost sight of slower-moving
but more costly financial booms and busts.
And the international monetary and financial system has spread easy
monetary and financial conditions in the core economies to other economies
through exchange rate and capital flow pressures, furthering the build-up
of financial vulnerabilities.
Addressing these deficiencies, BIS says, requires a triple rebalancing
in national and international policy frameworks: away from illusory
short-term macroeconomic fine-tuning towards medium-term strategies;
away from overwhelming attention to near-term output and inflation
towards a more systematic response to slower-moving financial cycles;
and away from a narrow own-house-in-order doctrine to one that recognises
the costly interplay of domestic-focused policies.
One essential element of this rebalancing will be to rely less on
demand management policies and more on structural ones, so as to abandon
the debt-fuelled growth model that has acted as a political and social
substitute for productivity-enhancing reforms. The dividend from lower
oil prices provides an opportunity that should not be missed.
Monetary policy has been overburdened for far too long. It must be
part of the answer but cannot be the whole answer. The unthinkable
should not be allowed to become routine.
Global financial markets, the BIS says, remain dependent on central
banks. While accommodative monetary policies have continued to lift
prices in global asset markets in the past year, the diverging expectations
about US Federal Reserve and ECB policies have sent the dollar and
the euro in opposite directions. As the dollar soared, oil prices
fell sharply, reflecting a mix of expected production and consumption,
attitudes to risk and financing conditions.
Bond yields in advanced economies continued to fall throughout much
of the period under review and bond markets entered uncharted territory
as nominal bond yields fell below zero in many markets. This reflected
falling term premia and lower expected policy rates.
The fragility of otherwise buoyant markets was underscored by increasingly
frequent bouts of volatility and signs of reduced market liquidity.
Such signs were perhaps clearest in fixed income markets, where market-makers
have scaled back their activities and market-making has increasingly
concentrated in the most liquid bonds.
As other types of players, such as asset managers, have taken their
place, the risk of "liquidity illusion" has increased: market
liquidity appears ample in normal times, but vanishes quickly during
market stress.
Very large change in key markets, resulting from plummeting oil prices
and a surging US dollar, have caught economies at different stages
of their business and financial cycles. The business cycle upswing
in the advanced economies continued and growth returned to several
of the crisis-hit economies in the euro area. At the same time, financial
downswings are bottoming out in some of the economies hardest-hit
by the Great Financial Crisis.
The resource misallocations stemming from the pre-crisis financial
boom continue to hold back productivity growth. Other countries, less
affected by the crisis, notably many EMEs, are experiencing different
challenges. The shift in global conditions has coincided with slowing
output growth and peaks in domestic financial cycles. There is the
danger that slowing growth in EMEs could expose financial vulnerabilities.
Better macroeconomic management and more robust financial structures,
including longer debt maturities and reduced exposure to currency
risk, have increased resilience. But the overall amount of debt has
increased and the shift from banks to capital market funding could
raise new risks.
Monetary policy continued to be exceptionally accommodative, with
many authorities easing or delaying tightening. For some central banks,
the ultra-low policy rate environment was reinforced with large-scale
asset purchase programmes.
In the major advanced economies, though pursuing significantly divergent
policy trajectories, all central banks are concerned about the dangers
of inflation running well below inflation objectives.
In most other economies, inflation rates deviated from targets, being
surprisingly low for some and high for others.
The deviation of inflation from expected levels and questions surrounding
the sources of price changes, BIS says, underscore an incomplete understanding
of the inflation process, especially regarding its medium- and long-term
drivers.
At the same time, signs of growing financial imbalances around the
world, highlight the risks of accommodative monetary policies. The
persistence of those policies since the crisis casts doubt on the
suitability of current monetary policy frameworks and suggests that
resolving the tension between price stability and financial stability
is the key challenge.
This, says the BIS, puts a premium on accounting for financial stability
concerns much more systematically in monetary policy frameworks.
The suitable design of international monetary and financial arrangements
for the global economy is a long-standing issue. A key shortcoming
of the existing system is that it tends to heighten the risk of financial
imbalances, leading to booms and busts in credit and asset prices
with serious macroeconomic consequences.
These imbalances often occur simultaneously across countries, deriving
strength from international spillovers of various types. The global
use of the dollar and the euro allows monetary conditions to affect
borrowers well beyond the respective issuing economies.
Many countries also import monetary conditions when setting policy
rates to limit interest rate differentials and exchange rate movements
against the major currencies. The global integration of financial
markets tends to reinforce these dynamics, by allowing common factors
to drive capital flows and a common price of risk to move bond and
equity prices.
Policies to keep one's own house in order by managing financial cycles
would help to reduce such spillovers. In addition, central banks need
to better internalise spillovers, not least to avoid the effects of
their actions spilling back into their own economies. Moving beyond
enlightened self-interest would require international cooperation
on rules constraining domestic policies.
The risks in the financial system have evolved against the backdrop
of persistently low interest rates in advanced economies. Despite
substantial efforts to strengthen their capital and liquidity positions,
advanced economy banks still face market scepticism.
As a result, they have lost some of their traditional funding advantage
relative to potential customers. This adds to the challenges stemming
from the gradual erosion of interest income and banks' growing exposure
to interest rate risk, which could weaken their resilience in the
future. By contrast, EME banks have so far benefited from market optimism
amid buoyant conditions that may be masking the build-up of financial
imbalances.
For their part, insurance companies and pension funds have faced ballooning
liabilities and muted asset returns. Asset-liability mismatches are
weakening institutional investors and threaten to spill over into
the real economy.
As these investors offload risks onto their customers and banks retreat
from traditional intermediation, asset managers are taking on an increasingly
important role. Regulatory authorities, the BIS says, are carefully
monitoring the financial stability implications of the growing asset
management sector.
However, as pointed out in recent comments by Andrew Cornford of the
Observatoire de la Finance in Geneva (see SUNS #8038 dated 10 June
2015 and #8040 dated 12 June 2015), not enough attention is being
paid by those formulating global policies and standards to problems
faced by developing countries, including currency risks. +