The must read new heterodox paper from Claudio Borio, economist at the Bank for International Settlements
Claudio Borio, economist at the Bank of International Settlements, has written a paper about the Great Financial Crisis: “The financial cycle and macroeconomics: what have we learned”. It’s quite consistent with many of the remarks made on this blog. Read it! Some cutting and pasting:
The Post-Keynesian approach:
Modelling the financial cycle correctly, rather than simply mimicking some of its features superficially, requires recognising fully the fundamental monetary nature of our economies: the financial system does not just allocate, but also generates, purchasing power, and has very much a life of its own.
The Georgist approach:
Arguably, the most parsimonious description of the financial cycle is in terms of credit and property prices … across the seven economies covered in Drehmannet al (2012), the average length of the financial cycle is 16 years
the banks easy credit, stupid!
Financial liberalisation weakens financing constraints, supporting the full selfreinforcing interplay between perceptions of value and risk, risk attitudes and funding conditions. A monetary policy regime narrowly focused on controlling near-term inflation removes the need to tighten policy when financial booms take hold against the backdrop of low and stable inflation. And major positive supply side developments, such as those associated with the globalisation of the real side of the economy, provide plenty of fuel for financial booms: they raise growth potential and hence the scope for credit and asset price booms while at the same time putting downward pressure on inflation, thereby constraining the room for monetary policy tightening…. it is no coincidence that the only significant financial cycle ending in a financial crisis pre-1985 took place in the United Kingdom, following a phase of financial liberalisation in the early 1970s (Competition and Credit Control).
The statistical approach:
Specifically, the most promising leading indicators of financial crises are based on simultaneous positive deviations (or “gaps”) of the ratio of (private sector) credit-to-GDP and asset prices, especially property prices, from historical norms. In addition, there is growing evidence that the cross-border component of credit tends to outgrow the purely domestic one during financial booms, especially those that precede serious financial strains. Importantly, but rarely appreciated, the commonly used monetary statistics do not capture this component
(This post, which argues in favor of household and non-financial company in stead of bank centered monetary statistics is consistent with that idea)
Austrian: the ‘output gap’ has a monetary side, too.
The graph clearly shows that, especially in the 2000s, the credit-adjusted output gaps pointed to output being considerably higher than potential than the other two indicators. By contrast, before the mid-1980s, the various estimates tracked each other quite closely for the United States, which is consistent with much more subdued financial cycles at the time.
Yes, a kind of debt jubilee might sometimes be necessary
The first case, universally recognised as a good example, is how the Nordic countries addressed the balance sheet recessions they confronted in the early 1990s (Borio et al (2010)). The crisis management phase was prompt and short. The authorities stabilised the financial system through public guarantees and, where necessary, central bank liquidity support. Then, almost without any discontinuity, they tackled the crisis resolution phase. With an external crisis constraining the room for manoeuvre for monetary and fiscal policy, they addressed balance sheet repair head-on. They enforced comprehensive loss recognition
(writedowns); they recapitalised institutions subject to tough tests, including though temporary public ownership; they sorted institutions based on viability; they dealt with bad assets, including though disposal; they reduced the excess capacity27 in the financial system and promoted operational efficiencies, so as to lay the basis for sustainable profitability. The recovery was comparatively quick and self-sustained.
No, Borio does not like Fantasy ‘DSGE’ economics
Modelling the financial cycle raises major analytical challenges for prevailing paradigms. It calls for booms that do not just precede but generate subsequent busts, for the explicit treatment of disequilibrium debt and capital stock overhangs during the busts, and for a clear distinction between non-inflationary and sustainable output, ie, a richer notion of potential output – all features outside the mainstream. Moving in this direction requires capturing better the coordination failures that drive financial and business fluctuations. This suggests moving away from model-consistent expectations, thereby allowing for endemic uncertainty and disagreement over the workings of the economy. It suggests incorporating perceptions of risk and attitudes towards risk that vary systematically over the cycle, interacting tightly with the waxing and waning of financing constraints. Above all, it suggests capturing more deeply the monetary nature of our economies, ie, working with economies in which financial intermediaries do not just allocate real resources but generate purchasing power ex nihilo and in which these processes interact with loosely anchored perceptions of value, thereby generating instability. In turn, this in all probability means moving away from equilibrium settings and tackling disequilibrium explicitly. In many respects, all this takes us back to previous economic intellectual traditions that have been progressively abandoned in recent decades.