World Economy

BIS Warns of Risks to Global Financial Stability

BIS Warns of Risks to  Global Financial StabilityBIS Warns of Risks to  Global Financial Stability

The world economy is still suffering from the aftermath of a massive and unsustainable financial boom, the Bank for International Settlements has argued, and not, as the IMF maintains, from a shortfall in global demand.

BIS has used its annual report to argue against the theory advanced by former US Treasury Secretary Larry Summers and largely endorsed by the International Monetary Fund that the global economy is suffering from “secular stagnation” requiring further stimulus, AAP reported.

The difference is more than academic: if the world economy is suffering from a shortfall of demand, then easing monetary policy is a solution.

But if, as BIS argues, the problems are on the supply side, then structural economic and fiscal reform, led by government, is required.

BIS says the focus on monetary policy and lowering rates is having a “pernicious” effect on the economy.

“By sapping banks’ profitability and resilience, low yields may reduce banks’ capacity to support the economy. They may also distort financial and real economic decisions more generally, for instance by encouraging unproductive firms to maintain capacity or by inflating asset prices, thereby weakening productivity.

“And they may encourage further debt build-up, which could make it harder for the economy to withstand higher rates.”

BIS says the world economy is in fact performing much better than is widely thought, with the growth shortfall since the financial crisis entirely explained by the ageing of the world population.

Debt-Fuelled Growth

However, it says the continuing impact of the financial crisis is evident in unusually low productivity growth, which threatens living standards, and elevated debt levels, which are a risk to financial stability.

“The global economy cannot afford to rely any longer on the debt-fuelled growth model that has brought it to the current juncture,” it says. “Debt has been acting as a political and social substitute for income growth for far too long.”

BIS has given relatively free rein to its leading economists, Claudio Borio and Hyun Song Shin, in its annual report.

They argue that the fall of inflation over the past year should not be interpreted as an indicator of idle capacity in the economy. And the fall of inflation does not mean near-zero interest rates are at the right level. They say inflation is an unreliable indicator of slack in the economy and financial market variables—such as credit growth and the level of debt—are the ones that matter.

Secular Stagnation

The secular stagnation thesis argues that there was a shortfall in global demand even before the financial crisis, and this was evident in the low interest rates and inflation in the mid-2000s. It attributes this deficiency in demand to deep-seated factors, including an ageing population, unequal income distribution and technological advances.

Summers argues that the “neutral” level of interest rates—the level that achieves a balance between supply and demand—is now negative, so even interest rates at zero are too high to encourage business to borrow and invest. The fall in real interest rates points to disinflationary pressure.

BIS says there are several problems with this thesis. In the period before the crisis, the US was running a huge current account deficit, indicating that its domestic demand was exceeding output.

Demographic factors are reducing potential output in almost all countries. Although global growth last year was 0.5 percentage points below the average level in the 20 years before the financial crisis, the growth in global GDP per working age person was actually 0.1 percentage points above its average.

Falling commodity prices, caused by the build-up of supplies to feed estimates of Chinese demand that proved excessive, have also been an important force depressing inflation.

BIS says the overhang of large debts is one of the reasons why easy monetary policy has become less effective in raising inflation. Lower rates are more likely to be used to reduce leverage than increase consumption or investment.

High debt also makes business more likely to take on additional staff than to invest in additional equipment, leading to reduced levels of productivity.