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ViewpointJanuary 4 2016

The financial cycle, productivity and the real economy

Without help from balance sheet repair and structural reforms, easy monetary policy will not restore economic growth after a financial crisis – and may even make things worse, writes Jaime Caruana, the general manager of the Bank for International Settlements.
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The financial cycle, productivity and the real economy

Sluggish growth and below-target inflation characterise the post-crisis macroeconomic landscape in many advanced economies. The mainstream view emphasises that behind these unsatisfactory developments lies weak demand, which needs to be addressed through demand stimulus. Indeed, central banks have responded to the recession and a weak recovery in its aftermath with unprecedented monetary easing. Policy rates in the major advanced economies have been near zero for seven years now. The key policy interest rates in some cases have even gone negative. In addition, large-scale central bank asset purchases have pushed long-term interest rates to very low levels.

Looking at the post-crisis macro-financial landscape through a financial cycle lens suggests a different interpretation, however. From that perspective, weak economic performance post-crisis would reflect not only weak demand but also some more entrenched impediments to growth, specifically impaired balance sheets and resource misallocations. Since these impediments cannot ultimately be removed through expansionary monetary policy alone, prolonged monetary easing may not succeed in reviving economic dynamism. Moreover, from this perspective, persistently low or negative interest rates are not a new equilibrium but at least in part a disequilibrium phenomenon.

Resource misallocations

The recession that accompanied the Great Financial Crisis was not a typical post-war recession. It was a balance sheet recession driven by a financial bust. Balance sheet recessions commonly coincide with permanent output losses and weak recoveries. The permanent output losses reflect to a considerable extent the fact that output growth was unsustainable during the preceding financial boom. The persistent drop in growth rates reflects a number of factors.

First, debt and capital overhangs as well as disruptions to financial intermediation weigh on growth. As agents seek to or are forced to deleverage, they cut back consumption and investment. And an impaired financial sector holds back and misallocates credit.

Second, recent Bank for International Settlements (BIS) research using data from 21 advanced economies since 1979 finds evidence that credit booms undermine productivity growth (see BIS's June 2015 annual report). During periods of strong credit growth, workers shift to sectors with low productivity gains, notably construction. This reallocation depresses aggregate productivity growth and thus potential output. Importantly, the impact of misallocations during the boom lingers on and becomes much larger if subsequently a financial crisis follows.

The intuition is simple. In normal recessions, displaced workers can be rehired once economic activity picks up. In a balance sheet recession, though, sectors that were artificially bloated cannot be expected to return to boom times. Therefore, the misallocated labour needs to move to other sectors, which takes more time and requires a flexible economy.

To give a rough sense of the magnitudes involved, let’s consider a typical credit boom of 10 years. During the boom, the estimated loss of productivity growth is about 0.25 percentage points every year, while it is of the order of 0.5 percentage points per year during the bust.

Finally, credit booms can act as a smokescreen. They have surely masked the sectoral misallocations just described and the other structural deficiencies behind the trend decline in productivity growth in the advanced economies that started decades ago. This makes it harder to address the underlying problems in a timely fashion. Arresting this decline is crucial to achieving sustainable economic growth.

The case for a balanced response

The policy implications are clear. If a debt overhang and resource misallocations are at the root of the economic malaise, then demand-side policies alone will not suffice. Ultimately, balance sheet repair and structural reforms that enhance flexibility and facilitate resource reallocations are essential to get the economy back on track. This is a key lesson from previous crisis episodes. For instance, after the banking crises in the Nordic countries in the late 1980s and early 1990s, prompt and thorough balance sheet repair supported rapid recoveries. And after the financial bust in Japan in the 1990s, recovery set in only once balance sheet repair was implemented seriously in the early 2000s. 

Thus, monetary policy must be part of the answer but cannot be the whole answer. Monetary policy stimulus is essential early on to stabilise the financial system. And maintaining an easy stance thereafter can borrow time for other policies to take over. But monetary policy cannot substitute for the necessary measures. And if it ends up being overburdened and kept in crisis management mode for many years, it may ultimately become counterproductive. Its effectiveness wanes and prolonged dependence on it reduces the incentives for others to act.

One phenomenon that seems to stand against the policy prescriptions of a financial-cycle interpretation of post-crisis economic developments is the persistence of below-target inflation in many countries. This is commonly interpreted as indicating weak aggregate demand relative to the economy’s output potential and supporting the notion that yet more monetary easing is needed.

However, this is only part of the story. Evidence suggests that the beneficial positive supply-side forces of globalisation and possibly also technological progress are still at work, making low inflation both less costly and less responsive to country-specific demand conditions. And as monetary policy is increasingly pushing on a string, easy monetary conditions appear to be influencing primarily financial risk-taking and asset prices rather than boosting inflation.

There are also signs that monetary conditions have been highly expansionary globally. Global debt – of households, non-financial corporates and governments combined – currently stands at above 240% of gross domestic product, up from about 210% at the end of 2007. This has gone hand in hand with worrying signs of financial imbalances in many emerging market economies – not unlike those seen pre-crisis in the advanced economies that were later hit by it. Easy conditions in the key advanced economies have spread globally. US dollar credit to non-US borrowers has surged. And central banks elsewhere have kept their interest rates low in part to resist unwelcome exchange rate appreciation and strong capital inflows. Easing begets easing.  

Systematic approach

In the years ahead, dealing more systematically with financial cycles will be crucial to enhancing financial stability and ensuring stronger and more sustainable global growth. This calls for a holistic policy approach, involving prudential, monetary, fiscal and structural policies.

Prudential or macroprudential tools alone are not sufficient. They are more effective in building resilience than in constraining financial booms. And they are subject to regulatory arbitrage in a way that monetary policy, in particular, is not. After all, the interest rate determines the universal price of leverage in a given currency. Fiscal policy should retain precious fiscal space during financial booms in order to be able to address financial busts, especially by supporting balance sheet repair when needed, while the tax code could avoid subsidising debt over equity. Greater reliance on structural policies could relieve some of the pressure to use aggregate demand management in an illusory effort to promote long-term growth.

All this requires long-term policy horizons. Financial booms and busts take many years to unfold and are much longer than traditional business cycles. And it cannot be done by the public sector alone. In the current economic landscape, the private financial sector has an important role to play. It needs to complete balance sheet repair, adjust its business models to better serve the real economy and pay attention to old and new risks emerging in this abnormal post-crisis world. Taming the financial cycle with its adverse consequences for the real economy is a collective responsibility.

Jaime Caruana is general manager of the Bank for International Settlements.

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