Summary:
Martin Wolf summarising the Bank for International Settlements' 2008 report, which focusses on the current market turmoil in the world's main financial centres. The crisis is unprecedented since WWII. The report argues that the drivers for crisis happened ultimately were not dodgy financial innovations, but old-fashioned long period of easy money, asset price inflation and rapid credit growth. It estimates that the risks for the global economy are currently very high. The range of possible outcomes is so large that nobody can credibly claim to know what lies ahead. The report calls for a less accommodating monetary policy and favours a sharp global slowdown to a big inflationary upsurge. The BIS takes strong stance on the need to tighten monetary policy when credit growth soars and asset prices explode. (Published: 01/07/08)
Notes:
- BIS report:
- "The current market turmoil in the world's main financial centres is without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point. These fears are not groundless."
- Provides answers to the four big questions:
- Why did it happen?
- "loans of increasingly poor quality have been made and then sold to the gullible and greedy, the latter often relying on leverage and short-term funding to further increase their profits. This alone is a serious source of vulnerability. Worse, the opacity of the process implies that the ultimate location of the exposures is not always evident."
- internal governance and external oversight were deficient
- How could a huge shadow banking system emerge without provoking clear statements of official concern?
- the drivers were not so much new inventions as old errors:
- a long period of easy money, asset price inflation and rapid credit growth
- i.e. central bankers bear part of the blame
- Wolf: the "savings glut" and reserve accumulations by exchange-rate-targeting countries also explain the low long-term real interest rates and monetary easing of the US in the early 2000s
- How big are the risks now?
- very large
- partly because the world economy is poised between deflationary financial and house-price collapses in several high-income countries and an inflationary global commodity price boom
- many huge uncertainties
- Will the recent surge in commodity prices prove to be a short-term bubble or long-lasting?
- Will US households cut back sharply on consumption, which ran at 70 per cent of gross domestic product between 2003 and 2007?
- Can the deleveraging of the US and other high-income countries occur smoothly, without high inflation?
- How much more bad debt is still to emerge?
- Will emerging economies suffer such big inflationary surges that they will be forced to abandon intervention in currency markets?
- If so, will long-term interest rates jump in the US?
- Are emerging economies more vulnerable to the slowdown in US imports than many now believe?
- When will financial markets recover?
- Are equity markets adequately assessing the risks ahead?
- divergence in possible outcomes is so large that nobody can credibly claim to know what lies ahead.
- The combination of a massive re-rating of risk with global inflationary pressure is unprecedented and still quite scary.
- What policies do we need right now?
- BIS view is that the right bias in monetary policy is towards being "much less accommodating"
- Better a sharp global slowdown than a big inflationary upsurge.
- but: also stresses, in today's varying circumstances, one monetary policy cannot fit all.
- Each central bank must assess domestic conditions.
- This is itself a good reason for larger emerging countries to abandon exchange-rate pegs.
- BIS also stresses the need for policymakers and private actors to recognise reality:
- "If asset prices are unrealistically high, they must eventually fall. If saving rates are unrealistically low, they must rise. And if debts cannot be serviced, they must be written off."
- What lessons can we learn?
- BIS analysis focuses not on what is new but on what is old
- not: the paraphernalia of the modern financial system
- but: "the inherent procyclicality of the financial system and excessive credit growth"
- important point here is that fiddling with details of the regulatory regime or tightening supervision of individual institutions is not the heart of the matter.
- What matters is the operation of the system as a whole.
- BIS takes strong stance on the need to tighten monetary policy when credit growth soars and asset prices explode
- even if that temporarily reduces inflation below target levels
