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Commentary

BIS warns against continuing stimulus too long

28 Jun 2010 by Jim Fickett.

The Bank for International Settlements gained significant credibility when, in June of 2007, they took credit market risks more seriously than most. Now they are warning that continuing the bail-out/stimulus mentality for too long poses significant dangers. These include zombie companies and slow growth, continued high leverage and possible further crises, distorted markets and higher risk-taking, and unsustainable government debt.

The Bank for International Settlements has its origins in the 1930 Treaty of Versailles. Today it is mainly concerned with pragmatic research on monetary policy, and coordination of international standards and responses among central banks. To give some feeling for their credibility, here is an excerpt of what they had to say in the concluding sections of the Annual Report published in June 2007:

The consensus forecast for the global economy, which is obtained through a poll of economists, anticipates that recent high levels of growth will continue, that global inflation will stay quite subdued, and that global current account imbalances will gradually moderate. …

Yet it is not difficult to identify uncertainties that could conceivably cause this near-term forecast to come unstuck, or that could result in less welcome outcomes over a longer horizon. …

The attention of financial markets first focused on the US subprime mortgage market, but the underlying issue is much broader. The household saving rate in the United States fell for a time into negative territory, as sluggish wage growth failed to provide adequate support for a sharp increase in consumer spending and residential investment. Easy credit terms, especially in the mortgage market, encouraged both higher debt levels and higher house prices. The latter, in turn, provided both the collateral to justify more lending, and the perception of increased wealth to justify more spending.

The concern is that this might all reverse. Debt service levels are already elevated and mortgage rates might rise further. House prices only need to stop rising (indeed, this may already have happened) to slow both the recourse to credit and the sense of confidence arising from increases in wealth. Moreover, when cuts in construction jobs begin to match the much larger fall in housing starts to date, then wage income, job security and confidence could be further affected. …

Assuming that the big banks have managed to distribute more widely the risks inherent in the loans they have made, who now holds these risks, and can they manage them adequately? The honest answer is that we do not know. Much of the risk is embodied in various forms of asset-backed securities of growing complexity and opacity. They have been purchased by a wide range of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals, who have been encouraged to invest by the generally high ratings given to these instruments. Unfortunately, the ratings reflect only expected credit losses, and not the unusually high probability of tail events that could have large effects on market values. …

It is not, by definition, possible to put all these uncertainties together and arrive at a prediction. Rather, if one believes that a range of possible developments could all interact in various ways, such interactions could form the basis of a thousand stories. Yet it must be noted that behind each set of concerns lurks the common factor of the highly accommodating financial conditions noted in the Introduction. While this observation need not call into question the consensus forecast as such, it should at least serve to remind us that tail events affecting the global economy might at some point have much higher costs than is commonly supposed.

In short, at the same time that Bernanke was saying subprime problems were contained, the BIS was pointing out that easy monetary policy, a housing bubble, and misleading ratings on securitized debt had created deep-seated problems in the credit markets, and there was significant danger of a “tail event” with “higher costs than is commonly supposed”.

Not a bad call. So what are they saying now? The 2010 Annual Report was released today, and the central theme is the danger inherent in continuing the bail-out mentality for too long.

When the transatlantic financial crisis began nearly three years ago, policymakers responded with emergency room treatment and strong medicine: large doses of direct support to the financial system, low interest rates, vastly expanded central bank balance sheets and massive fiscal stimulus. But such powerful measures have strong side effects, and their dangers are beginning to become apparent.

Here are the worst problems arising now from the continued use of the extraordinary programmes: Direct support is delaying vital post-crisis adjustment and runs the risk of creating zombie financial and non-financial firms. Low interest rates at the centre of the global economy are discouraging needed reductions in leverage, thereby adding to the distortions in the financial system and creating problems elsewhere. The sustained bloat in their balance sheets means that central banks still dominate some segments of financial markets, thereby distorting the pricing of some important bonds and loans, discouraging necessary market-making by private individuals and institutions, and increasing moral hazard by making it clear that there is a buyer of last resort for some instruments. And the fiscal stimulus is spawning high and growing government debt that, in a number of countries, is now clearly on an unsustainable path. …

The emergency policies were essential at the time and have been largely successful in meeting their short-term objectives. Many of them are still in effect today, however – three years after the onset of the crisis. To put it bluntly, the combination of remaining vulnerabilities in the financial system and the side effects of such a long period of intensive care threaten to send the patient into relapse. …

a prolonged period of exceptionally low real interest rates alters investment decisions, postpones the recognition of losses, increases risk-taking in the ensuing search for yield, and encourages high levels of borrowing. Our recent experience with exactly those consequences a mere five years ago should make us extremely wary this time around. True, the current environment is very different from what it was in the first half of the past decade, but the 2007–09 crisis suggests that the financial binges promoted by such low policy rates – booms in asset prices and credit, the underpricing of risk and the like – ultimately have devastating effects.

Much of the report is devoted to policy questions. But leaving “what should be” to others, I would prefer to ask, what does this report tell us about “what is” and “what is likely to be”? All signs are that Bernanke, Geithner and Summers are diametrically opposed to the BIS view, and strongly favor continuing the bail-outs and stimulus. Thus if the BIS is right, there is significant danger of

  • zombie companies and slow growth (i.e. Japan syndrome)
  • continued high leverage, implying increased risk of another crisis
  • distorted markets and higher risk-taking
  • unsustainable government debt

Here is a little bit more on each of these dangers.

Zombie companies and slow growth:

Past experience has shown that low policy rates allow “evergreening”, ie the rolling-over of non-viable loans. During the protracted run of low nominal interest rates in Japan in the 1990s, banks there permitted debtors to roll over loans on which they could afford the near zero interest payments but not repayments of principal. Banks evergreened loans instead of writing them off in order to preserve their own capital, which was already weak due to the earlier fall in asset prices. This delayed the necessary restructuring and shrinking of financial sector balance sheets. Moreover, the presence of non-viable (“zombie”) firms sustained by evergreened loans probably limited competition, reduced investment and prevented the entry of new enterprises.

Continued high leverage and risk of further crises:

Leverage remains high in the non-financial sectors of many countries at the centre of the crisis. As discussed in Chapter II, households in these economies have started to reduce their leverage. But including the large increases by the public sector, debt levels of the non-financial sector have risen substantially since 2007; they are expected to be higher by 20–40% of GDP by the end of 2010 in France, Germany, Spain, the United Kingdom and the United States. Not only does the continued high leverage imply fragility of private and public sector balance sheets, which will take years to resolve, but it also severely limits the scope for fiscal policy intervention if another bailout – public or private – is needed.

Distorted markets and higher risk-taking:

Short- term interest rates close to zero are holding down the cost of funding and propping up the net present value of future payment streams. In addition, central bank asset purchases have pushed up asset prices directly and indirectly. …

a primary goal of central bank and government actions during the 2007–09 crisis was to stop the collapse of asset prices and reduce the risk of insolvencies. The broad rise in asset prices and the reduction in risk spreads that took place in 2009 and the early months of 2010 is thus best seen as reflecting both the success of these policies and a new build-up of potentially overly risky portfolios.

Unsustainable government debt:

Remarkable declines in national incomes, large financial rescue programmes and expansionary fiscal policies in the wake of the financial crisis have led to a dramatic deterioration of fiscal positions in industrial economies (Graph V.1). The aggregate public debt of the advanced economies is projected to rise from 76% of GDP in 2007 to more than 100% in 2011 – a record high in recent decades. Moreover, the full cost of cleaning up the balance sheets of financial institutions – particularly against the backdrop of their continued high vulnerability to adverse shocks – is not yet known. And beyond 2011, many industrial countries face the large, rising pension and health costs associated with their ageing populations. Unless tackled effectively and in a timely manner, such costs could lead to ever increasing deficits and debt levels.