Lately, not a month passes without the IMF [12], or the G-20 [13], or the BIS [14]or the Fed itself [15]issuing some warning about asset bubbles, systemic bank-runs, excessive risk taking, "levitating markets", and yet the second the market almost enters correction territory, some Fed official, such as James Bullard for example. will "utter" a flashing red headline reminding the "market" it doesn't actually exist and is merely a centrally-planned policy vehicle designed to stimulate the wealth effect: drop more and we unleash QEX+1. End result: one after another 10% surge such as that in the past month, which prevents even the chance at true price discovery ex-central bankers.
Yet, to keep the farce going, once the "market" hits its the upper bound of its trading corridor, the theater restarts as the same people who a few days ago said more easing is imminent, now demand a halt to that easing! Much to the amazement of anyone with a frontal lobe, and what should be his humiliation, James Bullard did just that earlier today [16].
And in case that was not enough, here is the BIS once again with its noble - and now thoroughly 'Austrian' - public service announcement, this time warning about the implications of a global "debt trap" and how everything will end in tears (stop us when this becomes familiar).
From a Luncheon speech by Jaime Caruana, General Manager at the Bank for International Settlements during the International Finance Forum 2014 Annual Global Conference in Beijing, on 1 November 2014 (source [17])
Debt trouble comes in threes
In my introduction, I said that the debt trouble comes in threes. At the origin is the build-up of financial imbalances that leads to excessive credit growth. What are the three types of trouble?
The first and the most obvious: the build-up of financial imbalances risks a future financial crisis, an impaired financial sector and a debt overhang.
The leverage that builds up during the boom weakens balance sheets, which reduces borrowers’ capacity to repay and their resiliency to shocks. This vulnerability, in turn, magnifies creditors’ losses, amplifies market participants’ responses and contributes to generating market dynamics that are abrupt and non-linear. Relatively small declines in asset prices can force borrowers to cut back their activities, and in some cases default or reschedule their debts, which is costly for lenders and a potential drag on borrowers’ finances. We have seen this type of effect most recently in response to the sharp falls in house prices in countries such as the United States, Spain and Ireland. Similar adverse dynamics can occur if problems hit an overleveraged corporate sector, as several Asian economies learnt in the crises of the 1990s.
This excess sensitivity is just a symptom of the fact that leverage increases procyclicality. Small downside shocks to the economy become transformed, through various channels, into large ones. But the seeds of the problems that materialise in the bust are in fact sown during the boom. There, the procyclicality operates on the upside: borrowers can expand their balance sheets and take on risks too easily, pushing up asset prices and making it easier still to borrow more. The boom sets the stage for the subsequent bust. History has taught us that large external debt is correlated with greater vulnerabilities and potentially sudden stops.
Indeed, research at the BIS has found that when private sector credit-to-GDP ratios are significantly above their long-term trend, banking strains are likely to follow within three years. And right now, a number of emerging economies, as well as some advanced ones, have reached this point in the financial cycle.
And the subsequent debt overhang holds back growth. Households and firms seek to pay back what turn out to be excessive debt burdens, built on the illusory promise of permanent prosperity that the boom had fostered. Expansionary aggregate demand policies lose effectiveness. And, unless the financial sector is fixed quickly, it restricts and, more importantly, misallocates credit: reluctance to take losses keeps credit available for the weaker borrowers and curtails or makes it more expensive for the healthier ones. The damage caused by delayed balance sheet repair following the bust of the boom in Japan is well documented.
The second, but less obvious, kind of trouble is that debt accumulation fosters misallocations of real resources.
The GDP and credit growth in the pre-crisis boom years were not evenly spread. They were concentrated disproportionately in specific sectors. For instance, in countries like Spain and Ireland, growth in the boom years was largely propelled by the construction sector as well as finance. Leverage can distort investment decision-making, giving incentives to put resources into projects that promise quick, measurable returns, rather than into longer-term ventures with less certain but potentially more valuable rewards. Such incentives are arguably stronger when leverage is cheap.
The consequence of this association between debt accumulation and real resource misallocation is important. When boom turns to bust, the bloated sectors will have to shrink. Reviving growth in this kind of recession requires flexibility and capacity in the economy to reallocate resources efficiently from less productive to more productive sectors.
Third, financial booms mask deficiencies in the real economy.
Credit booms can act as a smokescreen. They tend to mask the sectoral misallocations that I just described, making it difficult to detect and prevent these misallocations in time. Boom times also tend to hide other slow-moving forms of deterioration in real growth potential. One such example is the trend decline in productivity growth in the advanced economies that started decades ago. Arresting this decline is crucial to achieving sustainable economic growth. Additional examples are adverse demographics and the secular decline of job reallocation rates. What appears fantastically harmonious on the way up thanks to the flattering effect of the credit-driven boom becomes cacophony and fragmentation on the way down.
Conclusion
And so that’s why I said debt trouble comes in threes. The combination of these three types of debt-related phenomenon together with policies that neglect the power of financial cycles can give rise to serious risks in the long term. A sequence of such boom-bust cycles can sap strength from the global economy. And polices – fiscal, monetary and prudential – that do not lean sufficiently against the buildup of the financial booms but ease aggressively and persistently against the bust risk entrenching instability and chronic weakness: policy ammunition is progressively eroded while debt levels fail to adjust. A debt trap looms large.
Moving away from the debt-driven growth model of the last few decades is in my view essential in order for the global economy to truly recover from the crisis. This will require efforts from the public and the private sector alike to restore the resilience and reliability of the financial system. But no less importantly, it will require a rebalancing of economic policies so as to support greater flexibility and productivity in the real economy. In other words, a wider but country-specific reform agenda is needed.
Brilliant, Jamie, as usual. In fact, it is almost as if we are reading this very fringe, tinfoil-hatted website at any one moment over the past 6 years which has issued the same warning, after warning, after warning, virtually verbatim.
We have just one request. Next time, instead of sharing these profoundly Austrian observations with the general public, maybe you can just discuss them at the next BIS Board of Directors' meeting which consists of...
[18]
