The Bank for International Settlements is a powerful behind-the-scenes institution. Based in Basel, Switzerland, it is more than just a bank; it is a think tank relied upon by central banks, and the global financial and political worlds as a whole. Handelsblatt’s Torsten Riecke and Holger Alich met with General Manager Jaime Caruana and Claudio Borio, Head of the Monetary and Economic Department to talk about its new annual report and how it guides global banks.
Handelsblatt: In the new annual report you describe the difficulties of policy makers who deal with the repercussions of the financial crisis. Is Greece the perfect example of their helplessness at the moment?
Jaime Caruana: We know that these are very complex issues. The important thing is to find a solution that is sustainable. It is also important to continue with reforms. We have to make sure that we remove all the impediments to growth. That is a lesson not only for Greece but for all countries.
If Greece has to exit the euro zone what would be the contagion risk to other countries?
Mr. Caruana: The resilience of the financial system is now considerably greater than it was a few years ago. On the other hand, we should not be complacent. There is always the risk of a shock to the financial system.
Mr: Borio: We have to keep in mind that today it is mostly governments that hold the debt. This provides more room for maneuver and reduces uncertainty about the possible consequences.
Mr. Caruana: One big risk at the moment is low liquidity in some financial market segments, lower than in the past. This could lead to more volatility from time to time. Financial institutions need to be well aware that liquidity might not be there when it is needed.
We think that steady monetary policy normalization is welcome. But we do not give central banks specific recommendations about when and how they should act.
What are the biggest risks when monetary policy goes back to normal?
Mr. Caruana: Financial markets could become more volatile. That is normal because investors have to reassess the situation. That should not discourage us. What is more important is that intermediation has moved away from banks and towards financial markets. We have seen that in a financial crisis high bank leverage can cause a vicious circle, amplifying price drops and the evaporation of liquidity. Nowadays banks are less leveraged but leverage is still high in the economy as a whole. In particular, corporates in emerging markets have piled up lots of debt. The danger is that market participants will think that liquidity never dries up. Banks and asset managers should not take liquidity for granted.
Should asset managers restrict the redemption from their funds to prevent a fire sale?
Mr. Caruana: This is one option that is being explored. But we should not think that regulation is always the answer. We need to analyze this further.
The BIS has a very different narrative about the causes and the consequences of the financial crisis from most central banks around the world. How can you be the “bank of central banks” and one of their biggest critics at the same time?
Mr. Caruana: It is normal after such a big crisis to see a variety of views emerge. We try to bring a long-term perspective to the analysis – which also means keeping a closer eye on the financial sector and its interaction with the real economy. And we also try to offer a more global perspective – one which highlights spillovers of national policy decisions on other countries.
You also argue that it is not enough to look at inflation to ensure financial stability. Are central banks looking at the wrong compass?
Mr. Caruana: We need to pay more attention to financial stability issues. And we need to do that with a medium and long-term perspective.
Should central banks change their mandate and take on board financial stability as a policy goal?
Mr. Caruana: It depends whether they have enough flexibility within their current mandate.
Mr. Borio: We don’t say they need to change their mandate. The issue of whether to revise it or not should come up only at the very end of the road, after other alternatives have been explored. And even if the mandate were to be amended, this would not mean dropping price stability. We see price and financial stability as two sides of the same coin. All we are saying is that a possible revision should not be taboo. But the way central banks look at the world is more important than their mandate.
As we saw before the crisis, low and stable inflation is no guarantee of macroeconomic stability. And nothing we have seen since the crisis leads us to believe we need to change that view.
But there is a trade-off between price stability and financial stability, at least in the short term.
Mr. Borio: There can be trade-offs. The question is how to tackle them. What we are suggesting is to look more closely at the sources of disinflationary pressures. Are they positive or negative? Are they persistent or transitory? And what is happening on the financial side at the same time? We are simply talking about rebalancing current frameworks to give more room to address financial stability concerns in a more systematic way.
What does this mean in the day-to-day business of a central banker? Does it come down to the courage of policy makers to ensure financial stability?
Mr. Borio: The frameworks for monetary policy differ from country to country. Some have more flexibility and some have less. It is not a question of courage but a question of how one perceives the relevant trade-offs. Here, our view is somewhat different from the mainstream.
Former Fed governor Ben Bernanke points to macro-prudential tools to ensure financial stability. Jens Weidman from the Bundesbank argues that monetary policy is too much of a blunt tool for this purpose. Are they both wrong?
Mr. Borio: I would prefer not to comment on specific statements. We have been saying for a number of years that we need to find ways to incorporate financial stability more systematically into monetary policy frameworks. As we saw before the crisis, low and stable inflation is no guarantee of macroeconomic stability. And nothing we have seen since the crisis leads us to believe we need to change that view.
How do you spot a bubble, how do you define financial stability?
Mr. Borio: It’s a bit odd to argue it’s impossible to spot the symptoms of risks to financial stability. I am not saying it is easy, far from it. But under the header of “macro-prudential frameworks” we have created a whole machinery to do just that which operates on the presumption that it can be done. Moreover, central banks rightly play a key role in that.
What about the blunt tool argument?
Mr: Borio: Monetary policy sets the universal price of leverage. As such, as some have put it, it has the advantage of filling in all the cracks of the financial system. Macroprudential tools have a smaller reach. Macro prudential tools and monetary policy tools complement each other. They can both lean against a build-up of financial risks, as they operate in similar ways. They restrain credit expansion. They restrain increases in asset prices. They restrain risk-taking.
We need both?
Mr. Borio: In the end, there is an obvious tension if you press on the accelerator and the brake at the same time. And that’s precisely what happens when you loosen monetary policy and then use macro-prudential tools to take care of its impact on financial stability risks. Monetary and prudential policies work best when they push in similar directions. Moreover, financial booms are so powerful that there is a role for fiscal policy as well.
Do you think that central banks should raise the interest rate earlier and faster in order to preserve financial stability? Would that be your advice for the Fed?
Mr. Caruana: We think there are risks and costs if central banks raise interest rates too late. They become apparent only once you fully factor financial stability considerations into monetary policy. But at present the debate is not paying much attention to this. Rather, it focuses on the costs of raising interest rates too early.
What would be too late then?
Mr. Borio: From the perspective we highlight, an interest rate hike takes place too late when you see that the path you have been following is not consistent with preserving financial stability. This is so even if inflation is in line with your objective. This is not qualitatively different from the criteria one uses to assess whether one is too late with respect to preserving price stability. I find it interesting that we seem to pretend we have all the answers when it comes to fighting inflation. In fact, this is not the case. We have some answers, but not all the answers. And when inflation targeting was first implemented many years ago it was seen as a step in the dark. So, even if we do not have yet all the answers regarding financial stability, this should not prevent us from taking it into account when setting monetary policy.
Too much credit damages the economy because it weighs down on productivity. If you have too much credit, you have less growth.
What about deflation? Do you think that policy makers overestimate that risk?
Mr. Borio: Historical evidence indicates that there is only a weak relationship between deflation and output. The strongest link was observed during the Great Depression but this was a unique historical episode. There is a much stronger and systematic link between asset prices, especially property prices and output. How should we interpret this evidence? We think that the costs of deflation depend on the factors driving it. And that positive supply-side factors, such as the globalization of the world economy, technological progress and stronger competition, have exerted significant, trend disinflationary pressures for a long time now. And more recently, of course, lower oil prices have played a big role. These are all factors that help the economy and boost output.
More generally, in the historical record there is little evidence that deflation should be seen as a red line which, once crossed, necessarily triggers a self-reinforcing negative spiral. Look at Switzerland, the country has seen falling prices for several years but the economy has been doing comparatively well and a strong boom in the mortgage market has been under way. Of course, within this broad picture, specific countries will face specific conditions that need to be taken into account when deciding policy.
Is there a risk of deflation in Europe?
Mr. Borio: To a significant extent, more recently prices in Europe have been falling because of one-time supply side factors, like the oil price. And according to the latest data from the ECB disinflationary pressures have eased.
Mr. Caruana: There have been positive monthly inflation data now for several months in a row.
But the IMF does not share your view. Christine Lagarde has argued that the Fed should delay its first interest rate hike until 2016 because of the risk for growth and deflationary pressures.
Mr. Caruana: The process of normalization of monetary policy has already started in the US, as the Fed has stopped buying assets. We argue that this process should continue at a steady pace. Along the road there will be volatility in markets but this should not, by itself, be a reason to change course. We think that the persistent very low interest rates we have been seeing are not equilibrium rates. They may in part reflect a disequilibrium process. That is why we think that steady monetary policy normalization is welcome. But we do not give central banks specific recommendations about when and how they should act. This will naturally depend on country-specific circumstances.
Should central banks cooperate more to reduce the spillovers from their actions on other countries?
Mr. Caruana: Central banks need to internalize the possible spillover effects of their decisions. One example: non-financial borrowers located outside the U.S. have taken on over 9 trillion dollars, much of it from creditors located outside the country. Obviously, the associated risks cannot be tackled by US macro-prudential policies; it is U.S. monetary policy that could have an impact on them. More generally, very easy monetary and financial conditions in large economies that issue international currencies, notably the dollar, have directly and indirectly boosted credit booms in those countries less affected by the crisis, notably in emerging economies. This has helped to spur global growth but has also fostered the build-up of financial vulnerabilities there. Now those financial cycles in Emerging Market Econonies have been peaking and growth is slowing. And this will generate spill backs to the economies that were the source of the spillovers in the first place. We do not have a fully worked-out framework to analyze these spillovers sufficiently well. But this should not prevent policymakers from seeking to incorporate them more fully into their decisions, out of enlightened self-interest. That said, we are definitely not calling for an institution that should coordinate global monetary policies.
How do policy makers react to your recommendations?
Mr. Caruana: They have to deal with their specific trade-offs and national issues, which are much more complex. They are trying to do their best.
Mr. Borio: The big difference is that we at the BIS don’t have to press the button and decide on interest rates. That allows us to take a more detached perspective. In addition, we can also take a more global perspective, which national central banks find much harder because of their mandate.
You are much more polite now than you are in your annual report. In the report you criticize very bluntly the policy failures and argue that the current frameworks of most central banks are ineffective in dealing with the cycle of financial boom and bust.
Mr. Borio: Bismarck famously said that policy making is the art of the possible. And I think it was Paul Valéry who put it even better, noting that policy making is the art of making possible what is necessary. Our role is to identify what we think is necessary. If policy makers are persuaded by our arguments, then their role is to make possible what is necessary.
Besides Axel Weber, who also argues for a bigger role of financial stability in monetary policy frameworks, you are pretty much alone and considered an outsider. Is it not frustrating to have only a very limited impact on policy makers?
Mr. Borio: Change doesn’t come overnight. It takes time to change the intellectual climate. Take, for example, macro-prudential policy. We recommended those tools a long time ago, many years before the crisis, but only after the crisis did they become a reality.
Mr. Caruana: Every year we bring additional insights to the debate. This year, for example, we argue that strong credit expansion has a negative impact on productivity. We found that there is a link between financial booms and busts, on the one hand, and low productivity growth, on the other.
Mr. Borio: Too much credit damages the economy because it weighs down on productivity. If you have too much credit, you have less growth.
This seems to be contradictory…
Mr. Borio: Not really. We find that the main channel is the misallocaton of resources. When credit grows too fast, capital and labour shift from sectors that perform better to sectors that perform worse, for example towards the construction sector or the financial industry. This creates problems not only during the boom but also – in fact, especially – during the bust, because you have to shift resources from the low productivity sectors, which have grown too much, to those where productivity is higher. That is hard because you cannot easily employ a construction worker in the pharmaceutical industry, for example.
The OECD has said that the expansion of the financial sector is generally bad for growth?
Mr. Borio: I would not generalize. You can have too much of a good thing. We need to ensure that the financial sector serves the real economy rather than undermines it. This means making sure that it works effectively and is stable. And it calls for a broad range of policies – prudential, macroeconomic and structural. This is what our annual report is largely about.
Video: key messages of the BIS Annual Report delivered by Mr Jaime Caruana,
General Manager of the BIS, at the Bank’s Annual General Meeting, Basel, 28 June 2015.
Torsten Riecke is an international correspondent at Handelsblatt, covering finance and economics. Holger Alich has been the Switzerland correspondent since 2011. To contact the authors: firstname.lastname@example.org, email@example.com.