Low inflation alone can’t deliver

Cleaning up after the housing bubble burst seven years ago turned out to be a lot harder than the Federal Reserve imagined. And for a while, it seemed as if the cost of risk-taking run amok was enough to put the fear of God in central bankers.

Then the pressure to find a cure for the prolonged period of slow growth and high unemployment superseded the effort to understand the cause. The role of asset prices moved to the back burner, even as the Fed made a concerted effort to reflate them.

That’s too bad. Unless the Fed acknowledges that a credit-fueled asset bubble was responsible for the current malaise, it is doomed to sow the seeds of the next one.

Why is this important? Because once a boom goes bust, the effectiveness of monetary and fiscal policies is neutered by the nature of the balance-sheet recession that follows, according to Claudio Borio, director of research and statistics at the Bank for International Settlements in Basel, Switzerland. The response is to deleverage, not to borrow and spend more, even in the face of ultralow interest rates.

The old postwar business cycle model was pretty straight forward by comparison:

1. An economy growing beyond its capacity starts to generate inflationary pressures.

2. The central bank raises interest rates to curtail inflation.

3. The economy goes into recession, inflation ebbs, the central bank lowers interest rates, the economy bounces back.

There was no big debt overhang to constrain the expansion, only an excess of labor and capital. Once inflation succumbed, the central bank was free to lower interest rates to stimulate demand. Deep recessions were almost always followed by big rebounds.

Not so with financial cycles, whose peaks are associated with systemic banking crises and deeper, more sustained economic contractions, according to Borio. Economists Ken Rogoff and Carmen Reinhart documented eight centuries of such crises and their aftermaths in their 2009 book, “This Time Is Different.” Borio began looking at the boom-bust cycle in asset prices in the early 1990s, using the banking crises in the Nordic countries and Japan, respectively, as models of how, and how not, to respond.

In a recent BIS working paper, “The Financial Cycle and Macroeconomics: What Have We Learnt?” Borio provides both an answer to his own question - not much - and some guidance to help policy makers do better next time.

He points out that the financial cycle is longer (12 years on average) than the business cycle (one to eight years) largely because governments, after a short crisis-management stage, fail to deal directly with the impaired balance sheets of financial institutions, businesses and households. Unless the issues of over-indebtedness and asset quality are resolved - even if it requires substituting public money for private - the result is continued slow growth.

What happened to predictions that low inflation would deliver us into the promised land of macroeconomic stability? It turns out stable prices are a necessary, but not sufficient, condition. Just look at the evidence.

During the last three decades, a period known as the Great Moderation, economies have become more susceptible to prolonged booms and busts. Borio attributes the change to a combination of financial liberalization, globalization and a commitment to price stability, which he calls the “paradox of credibility.”

The notion of a financial cycle, which fell out of favor in the post-World War II era, seems to have reasserted itself. Former Fed chief Alan Greenspan used to say that someone sitting at a desk in Washington was ill-equipped to determine which asset prices were rising for a reason and which represented speculative excess. He was right. He also said monetary policy could always clean up after a bubble burst. That assessment turned out to be dead wrong.

That’s why central bankers need a metric, or rule, to help them assess when credit and asset prices have gotten so out of whack as to threaten the financial system. Big increases in credit relative to trend, big increases in a variety of asset prices relative to trend, and sharp declines in savings ratios should be a tipoff of “an underlying credit bubble that could burst with dire effects,” said William White, a former chief economist at the BIS who, along with Borio, has been warning about the dangers of the financial cycle for two decades.

Borio and White, now the chairman of the economic development and review committee at the Organization for Economic Cooperation and Development in Paris, presented a paper at the Kansas City Fed’s Jackson Hole Economic Policy Symposium in 2003 warning that household debt and property prices posed a significant threat to world prosperity should the boom turn to bust.

The reception was hardly enthusiastic, but the two economists proved prescient.

Fed Chairman Ben Bernanke claims the central bank’s “multipronged approach,” including “monitoring, supervision and regulation, and communication,” will ensure financial stability. Those tools were available in 2007, as well.

What’s more, none of the macroeconomic models bankers rely on “have any debt, credit, stocks, or anything related to the financial system,” White said. “All of the things that cause us trouble.”

Borio said it is possible to measure the increased risk of financial crises “in real time with fairly good accuracy” by tracking a gap between credit and gross domestic product (a rough measure of leverage in an economy) and a real-property-price gap. Together, the two metrics gave “concrete signs of the build-up of systemic risk” over the past two decades, he said in his paper.

After the global financial crisis in 2008-9, the mindset among policy makers shifted. For the first time, they seemed open to examining the role of asset prices and developing some kind of early warning system to alert them to danger.

No more. One by one, central banks around the globe have joined hands and agreed to do “whatever it takes” to alleviate slumps or deflation in their respective countries. A more appropriate watchword might be “never again.”

*The author is a Bloomberg View columnist.

by Caroline Baum