Basel's Gnomes Have a Point
The Bank for International Settlements was the only public institution that trumpeted the dangers building within the financial system during the 2000s. While academics and central bankers celebrated the false triumph of the "Great Moderation," the BIS, a central bank for the world's monetary authorities located in Basel, Switzerland, was warning that slow and stable inflation could encourage excessive risk-taking and questioning the models used by ratings companies to evaluate the risk of collateralized debt obligations.
Given this track record, I think it makes sense to start from the presumption that the BIS's latest annual report is a useful document. That doesn't seem to be the view of most commentators, however. Paul Krugman calls it "destructive incoherence," while the Financial Times's editorial board says that the report's conclusions are "deeply and dangerously wrong" as well as "sadomasochistic."
The critics are right that there are some objectionable passages -- as you would expect with anything nearly 100 pages long and written by a committee. The BIS's core conclusion, however, seems plausible: Low interest rates and asset purchases may have become counterproductive. While "accommodative monetary policy" can help keep weakened economies afloat, it also reduces politicians' incentives to address the underlying problems afflicting their countries. As a result, the BIS report suggests that central banks may have inadvertently ended up prolonging our suffering.
A little perspective helps make this point clearer. The U.S. isn't projected to return to full employment until more than a decade after the crisis began in 2007 -- and that's under the optimistic set of assumptions. (In Europe, the optimists believe that things are now getting worse less quickly than before.)
This is a tragedy, but it shouldn't be surprising. When Oscar Jorda, Moritz Schularick and Alan Taylor studied the experience of 14 rich countries since 1870, they found a close relationship between "the build-up of credit during an expansion and the severity of the subsequent recession." Historically, growth doesn't return until after the debt is liquidated through a combination of default, redistribution, inflation and "financial repression."
The BIS finds that, on average, the ratio of nonfinancial private debt to gross domestic product declines by about 40 percentage points in the aftermath of a financial crisis. The U.S. didn't escape the Great Depression until after the ratio of private debt to gross domestic product fell by about 100 percentage points from its level in 1929. Germany's rapid growth after World War II was facilitated by the Allied decision to forgive almost all of its debts. Yet, as the accompanying chart shows, today's rich countries have made little progress on such deleveraging.
As a result, many private borrowers are still stuck repaying old debts instead of buying new things they actually want. Many others are determined to save more and to own relatively safer assets, even if that ends up driving up financing costs for worthwhile projects. The collective effect of these individually sensible decisions has been less spending, lower incomes and fewer jobs.
What should governments do when faced with this situation? One school of thought has predominated more or less since the crisis began: Central banks ought to lean against the desires of the private sector by pushing interest rates very low. This lets creditworthy borrowers free up cash by refinancing their existing debts. At the same time, the low returns on "safe assets" are supposed compel savers to try riskier enterprises or spend their wealth on goods and services.
It isn't clear how well this has actually worked in practice. Yes, the U.S. has done better than the countries in the euro area. That, however, is a very low bar. (Monetary policy also isn't the only reason for this.) The question is whether we would have better dealt with the overhang of private debt if central banks had leaned the other way. I suspect that the Europeans would have been more willing to restructure their bloated banks and overly indebted sovereigns if the European Central Bank hadn't always stepped in at the last possible minute.
Or consider the following counterfactual: Suppose that the government, rather than providing the private sector with liquidity, had forced the private sector to liquidate its debts either through mass default or through some kind of jubilee.
If you had asked most people at the time whether that would have been a good idea, they would have said you were crazy. Yet I think the argument starts to seem less nutty the longer it takes to get back to full employment. At what point does it become attractive to trade an even deeper downturn for a faster and more sustainable recovery? The brutal medicine of the International Monetary Fund seemed to produce rapid recoveries in the economies of emerging Asia in the late 1990s.
Given the poor prospects for all the major rich countries on their current policy trajectories, we shouldn't reject the BIS's advice out of hand. The gnomes in Basel may have a point.
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