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A warning from the BIS [ClearOnMoney]
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Commentary

A warning from the BIS

28 Jun 2011 by Jim Fickett.

In the summer of 2007 the Bank for International Settlements highlighted many of the issues that would lead to the crisis, and warned that the boom times were unsustainable. Now they are worried that, globally, monetary policy is being kept too loose for too long, risking high inflation and encouraging conditions that could lead to another crisis.

On Sunday the Bank for International Settlements (created to manage German reparations at the end of WWI; now more of a research institute helping to coordinate central bank policies globally) published its annual report.

I have a great deal of respect for the BIS; they speak clearly about risks to the global economy, and in 2007 saw quite clearly many of the problems that were about to result in the financial crisis:

The performance of the global economy over the last few years has been extraordinary … However, the combination of developments is so extraordinary that it must raise questions about the source and, closely related, the sustainability of all this good fortune. …

those providing credit increasingly follow a business model that involves originating credit and then transferring the exposure to others via securitisation or derivatives markets. Clearly, this raises a major principal-agent problem. What are the implications if originators no longer feel the need for due diligence, and the ultimate buyers do not have the skills or the information required to manage the risks inherent in the complex instruments they are buying? …

The ratio of house prices to rents is at an all-time high. …

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. …

it is notable that the United States is by no means alone in its dependence on debt-fuelled consumption, with some countries even having substantially negative household saving rates. This provides a further channel for possible contagion. …

the prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003. …

the market reaction to good news might have become irrationally exuberant. …

Another possible worry, linked to the “originate and distribute” strategy, is that originators might be stuck with a warehouse of depreciating assets in turbulent times. The fact that banks are now increasingly providing bridge equity, along with bridge loans, to support the still growing number of corporate mergers and acquisitions, is not a good sign. …

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 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.

Now they are worried, as I am, that monetary policy is being kept too loose for too long, raising the danger of inflation or another financial crisis:

Over the past year, the global economy has continued to improve. In emerging markets, growth has been strong, and advanced economies have been moving towards a self-sustaining recovery. But it would be a mistake for policymakers to relax. From our vantage point, numerous legacies and lessons of the financial crisis require attention. In many advanced economies, high debt levels still burden households as well as financial and non-financial institutions, and the consolidation of fiscal accounts has barely started. International financial imbalances are re-emerging. Highly accommodative monetary policies are fast becoming a threat to price stability. Financial reforms have yet to be completed and fully implemented. …

Turning to monetary policy, the challenges are intensifying even as central banks extend the already prolonged period of accommodation. The persistence of very low interest rates in major advanced economies delays the necessary balance sheet adjustments of households and financial institutions. And it is magnifying the risk that the distortions that arose ahead of the crisis will return. If we are to build a stable future, our attempts to cushion the blow from the last crisis must not sow the seeds of the next one. …

The sooner that advanced economies abandon the leverage-led growth that precipitated the Great Recession, the sooner they will shed the destabilising debt accumulated during the last decade and return to sustainable growth. The time for public and private consolidation is now. …

Many of the challenges facing us today are a direct consequence of a third consecutive year of extremely accommodative financial conditions. Near zero interest rates in the core advanced economies increasingly risk a reprise of the distortions they were originally designed to combat. Surging growth made emerging market economies the initial focus of concern as inflation began rising nearly two years ago. But now, with the arrival of sharper price increases for food, energy and other commodities, inflation has become a global concern. The logical conclusion is that, at the global level, current monetary policy settings are inconsistent with price stability. …

Emerging market economies managed to escape the worst of the crisis, but many now run the risk of building up imbalances very similar to those seen in advanced economies in the lead-up to the crisis. For example, property prices in a number of emerging market economies are advancing at staggeringly rapid rates, and private sector indebtedness is rising fast. Emerging market policymakers should recognise that the lessons from the financial crisis do not apply only to advanced economies. …

The historical record suggests that households will further reduce their debt. Almost all systemic banking crises that were preceded by an expansion in the ratio of credit to GDP were followed by marked decreases in that ratio. The extent of debt reduction varied across episodes but was generally substantial. On average, private credit-to-GDP fell by 38 percentage points over a period of about five years. The magnitude of the debt reduction was only slightly smaller than that of the increase before the crisis (which was 44 percentage points on average). …

At this writing, many emerging market economies are experiencing rapid growth, booming housing markets and rising indebtedness in the private sector. For instance, Brazil, China and India all saw credit grow by an annual average of more than 20% between 2006 and 2010, equal to or greater than the rates of growth recorded in Ireland and Spain.