The BIS Annual Report: From Goldilocks to the Three Bears

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Pri­or to the NASDAQ crash in ear­ly 2000, Amer­i­can com­men­ta­tors were fond of describ­ing their econ­o­my as being in a “Goldilocks” phase–with all eco­nom­ic indi­ca­tors being “just right”.

That phrase dropped out of cir­cu­la­tion after April 2000, but a lev­el of com­pla­cen­cy still ruled when that stock mar­ket crash appeared to have lit­tle impact on the real econ­o­my.

Com­pla­cen­cy dra­mat­i­cal­ly left the build­ing today, with the release of the Bank of Inter­na­tion­al Set­tle­men­t’s (BIS) 77th Annu­al Report. The BIS turns the Goldilocks sto­ry around, and sees it not from Goldilocks’ per­spec­tive, but from that of the Bears. Just as the Bears’ domes­tic idyll was dis­turbed by Goldilocks the Home Invad­er, the appar­ent­ly neat glob­al finan­cial sys­tem has been put at risk by out of con­trol spec­u­la­tive lend­ing.

It appears that Cen­tral Banks do indeed divide into three camps as they dis­cuss the impact of this inter­lop­er. The BIS iden­ti­fies three schools of thought with­in Cen­tral Banks. The first–whom we might call the Dad­dy Bear fac­tion (since he was least affect­ed by Goldilock­s’s intrusion)–disputes the impor­tance of the growth in debt; the sec­ond Mum­my Bear fac­tion wor­ries about the increas­ing lev­els of cred­it mon­ey, see­ing it as a har­bin­ger of future infla­tion; and the third, Baby Bear fac­tion, sees the seeds of a future Great Depres­sion. In the BIS’s own words:

A close look at how cen­tral banks behave, and how they com­mu­ni­cate, indi­cates that there are dif­fer­ent views about the appro­pri­ate role of mon­e­tary and cred­it (“quantitative”) aggre­gates in the con­duct of mon­e­tary pol­i­cy. These views com­bine, to vary­ing degrees, three con­cep­tu­al per­spec­tives on the role of such aggre­gates in the econ­o­my.

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    • The first per­spec­tive reflects scep­ti­cism about the reli­a­bil­i­ty of aggre­gates in help­ing to chart the course of eco­nom­ic activ­i­ty and infla­tion, espe­cial­ly at short hori­zons. It would there­fore not assign a promi­nent role to them in pol­i­cy frame­works.
    • The sec­ond stress­es the cen­tral role of mon­ey as a causal dri­ver of infla­tion. In par­tic­u­lar, it empha­sis­es the spe­cial infor­ma­tion con­tent that mon­e­tary aggre­gates can have for medi­umterm trends in infla­tion. Thus, it would assign a promi­nent role to these aggre­gates in pol­i­cy frame­works.
    • The third, more recent, per­spec­tive stress­es the infor­ma­tion con­tent that unusu­al­ly rapid increas­es in mon­e­tary and, par­tic­u­lar­ly, cred­it aggre­gates can have, espe­cial­ly if observed in asso­ci­a­tion with a surge in asset prices and unusu­al spend­ing pat­terns. It regards these increas­es as a poten­tial sign of the build-up of finan­cial imbal­ances and hence of a prospec­tive boom-bust cycle, with impli­ca­tions of sig­nif­i­cant eco­nom­ic costs over time. Like the sec­ond per­spec­tive, this view would assign a promi­nent role to quan­ti­ta­tive aggre­gates in pol­i­cy frame­works, but pri­mar­i­ly as indi­ca­tors of medi­um-term risks in the form of reces­sion, finan­cial insta­bil­i­ty and unwel­come dis­in­fla­tion.” (pp. 70–71)

In a sur­pris­ing devel­op­ment, it’s fair­ly obvi­ous that the BIS itself now belongs to the Baby Bear fac­tion (and I wel­come them aboard). The BIS pio­neered the reg­u­la­tion of cred­it mar­kets through large­ly mar­ket-based means–the so-called Basel Accords. The fact that these mech­a­nisms have not con­strained cred­it creation–that they may in fact have enabled debt to grow more rapidly–has now become evi­dent to the BIS.

As some­one who has been empha­sis­ing the dan­gers of dereg­u­lat­ed finance for twen­ty years, and large­ly from the wilder­ness of the fringes of the eco­nom­ics pro­fes­sion, it is a strange expe­ri­ence to sud­den­ly find myself stand­ing in a crowd. I could have writ­ten many seg­ments of the BIS Report–and espe­cial­ly its con­clu­sion, which I would proud­ly put my name to (I’ll quote it at length below).

Hope­ful­ly this sig­nif­i­cant shift by the Cen­tral Bankers Cen­tral Bank presages a real­i­sa­tion that debt-defla­tion, and not infla­tion, is the great eco­nom­ic dan­ger we face at the begin­ning of the 21st Cen­tu­ry.


77th Annu­al Report

1 April 2006–31 March 2007

VIII. Con­clu­sion: pre­ven­tion rather than cure?

Eco­nom­ics is not a sci­ence, at least not in the sense that repeat­ed exper­i­ments always pro­duce the same results. Thus, eco­nom­ic fore­casts are often wide­ly off the mark, par­tic­u­lar­ly at cycli­cal turn­ing points, with inad­e­quate data, defi­cient mod­els and ran­dom shocks often con­spir­ing to pro­duce unsat­is­fac­to­ry out­comes.

Even trick­i­er is the task of assign­ing prob­a­bil­i­ties to the risks sur­round­ing fore­casts. Indeed, this is so dif­fi­cult that it is scarce­ly an exag­ger­a­tion to say that we face a fun­da­men­tal­ly uncer­tain world – one in which prob­a­bil­i­ties can­not be cal­cu­lat­ed – rather than sim­ply a risky one.

Eco­nom­ic his­to­ry is a use­ful guide in this respect. The Great Infla­tion in the 1970s took most com­men­ta­tors and pol­i­cy­mak­ers com­plete­ly by sur­prise, as did the pace of dis­in­fla­tion and the sub­se­quent eco­nom­ic recov­ery after the prob­lem was effec­tive­ly con­front­ed.

Sim­i­lar­ly, vir­tu­al­ly no one fore­saw the Great Depres­sion of the 1930s, or the crises which affect­ed Japan and South­east Asia in the ear­ly and late 1990s, respec­tive­ly. In fact, each down­turn was pre­ced­ed by a peri­od of non-infla­tion­ary growth exu­ber­ant enough to lead many com­men­ta­tors to sug­gest that a “new era” had arrived.

Sim­i­lar sur­pris­es can be not­ed at a more micro lev­el. Around the time of the fail­ure of LTCM in 1998, the firm faced price shocks in var­i­ous mar­kets that were almost 10 times larg­er than might rea­son­ably have been expect­ed based on pre­vi­ous his­to­ry. As a result, its fun­da­men­tal assump­tions – that it was ade­quate­ly diver­si­fied, had ample liq­uid­i­ty and was well cap­i­talised – all proved dis­as­trous­ly wrong.

Of course, many will say that our under­stand­ing of eco­nom­ic process­es has improved thanks to this expe­ri­ence. Yet this is not such an easy propo­si­tion to prove. Con­sid­er, for exam­ple, the typ­i­cal way in which cen­tral bank econ­o­mists fore­cast future infla­tion using econo­met­ric mod­els of how wages and prices inter­act.

To do this accu­rate­ly, at least five ques­tions have to be answered cor­rect­ly. What is the best way to mea­sure excess capac­i­ty in the domes­tic econ­o­my? What is the trend rate of growth of pro­duc­tiv­i­ty? Are for­eign influ­ences lim­it­ed to import prices alone? Are wages dri­ven by for­ward-look­ing price expec­ta­tions, or by past price devel­op­ments? If expec­ta­tions are impor­tant, are they influ­enced by the cred­i­bil­i­ty of cen­tral banks or by some­thing else, like actu­al or even per­ceived infla­tion? Each of these ques­tions is cur­rent­ly high­ly con­tentious. And when we turn to oth­er eco­nom­ic vari­ables, the degree of dis­agree­ment about many equal­ly fun­da­men­tal issues is just as great.

Indeed, in the light of mas­sive and ongo­ing struc­tur­al changes, it is not hard to argue that our under­stand­ing of eco­nom­ic process­es may even be less today than it was in the past. On the real side of the econ­o­my, a com­bi­na­tion of tech­no­log­i­cal progress and glob­al­i­sa­tion has rev­o­lu­tionised pro­duc­tion. On the finan­cial side, new play­ers, new instru­ments and new atti­tudes have proven equal­ly rev­o­lu­tion­ary. And on the mon­e­tary side, increas­ing­ly inde­pen­dent cen­tral banks have changed dra­mat­i­cal­ly in terms of both how they act and how they com­mu­ni­cate with the pub­lic.

In the midst of all this change, could any­one seri­ous­ly con­tend that it is busi­ness as usu­al? (pp. 139–140).

Amen to that! As I’ve argued in pre­vi­ous Debt­watch Reports, busi­ness as usu­al can’t per­sist when it is based upon unsus­tain­able trends. Now the BIS is mak­ing the same obser­va­tion.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.