The Bank for International Settlements, the organization of the world’s central banks, released its annual report on the state of the global economy
yesterday, and it isn’t pretty.
Jaime Caruana, the General Manager of the BIS and former governor of Spain’s central bank, told reporters in in Basel, Switzerland, that central banks in developed countries are reaching the limits of what they can do and warned that unconventional monetary policy can create “unreasonable expectations” about their ability to clear the fundamental roadblocks to sustainable growth.
“Central banks find themselves caught in the middle,” Caruana said. By supplying liquidity to troubled banks and easing government borrowing costs by keeping interest rates low even in the long term, central banks could be bringing about “undesirable side effects” if accommodative monetary policy is continued for very long.
“A worry is that monetary policy would be pressured to do still more because not enough action has been taken in other areas. While central bank actions can buy time, they cannot substitute for balance sheet repair or reforms to raise productivity and growth,” Caruana said. "Relying only on central bankers but failing to act on other fronts would ultimately damage confidence and increase the risks to macroeconomic and financial stability."
The advice from BIS comes at a time when the Federal Reserve is extending the Operation Twist program in which the Fed sells short term securities in order to buy long-term ones to depress the yield curve. Central banks in Japan and China are pursuing policies such as rate cuts and asset purchases to stimulate the economy.
The political narrative of growth vs. austerity is firmly implanted in Europe and the US at this point. Some pundits, like the BIS, are calling attention to the time bomb of government debt in developed countries. Keynesians like Paul Krugman, on the other hand, would rather put off fiscal consolidation until relatively fatter times, which is something that developed economies would have been wise to do in the early 2000s.
As the BIS points out, it isn’t that simple.
Here are a few charts from the report that bring these issues into focus. Make sure you are sitting down before you read any further.
This chart shows the enormous strain that central banks are under. Especially when banks are still making brazen bets, like JPMorgan Chase’s
(JPM) multi-billion dollar loss in derivatives, the burden to ease the pressure on the financial system and governments to keep investors’ confidence increasingly falls on central banks as “policymakers of last resort.” Ratings agencies (long-overdue) cuts to the credit ratings of major banks, such as last week’s downgrade of 15 global banks-- including Morgan Stanley
(MS), Bank of America
(BAC), Goldman Sachs
(GS), and Citigroup
(C) -- can lead to tighter credit and higher borrowing costs, which doesn’t help.
“Central banks find themselves in the middle of all of this, pushed to use what power they have to contain the damage: Pushed to directly fund the financial sector and pushed to maintain extraordinarily low interest rates to ease the strains on fiscal authorities, households, and firms. This intense pressure puts at risk the central banks’ price stability objective, their credibility and, ultimately, their independence,” the report says.
The bifurcation of export-oriented emerging economies, which are increasingly coming to the rescue of profligate European governments, is still a concern. Are "emerging markets" the new economic superpowers? Not really.
“Overall, the economic momentum in advanced economies was too weak to generate a robust, self-sustaining recovery. The drag on private consumption persisted,” the report says. A lot of the growth might be attributed to emerging market economies' (or EMEs) property bubbles.
The report goes on to say, “Rapid growth in EMEs was in many cases associated with signs of domestic overheating, including rising inflation, strong credit growth, and rising asset prices. Real credit continued to expand rapidly in emerging Asia and Latin America, and real residential property prices rose close to or above previous historical highs in major cities in China and Latin America.”
China bears like Hugh Hendry are famous for pointing to the bubble-like nature of property prices as a reason to expect weak growth in emerging markets in the coming years.
Many countries, including some developed economies, depend on trade for growth. This exposes those countries to their trading partners’ fortunes. At least 60% of GDP for Belgium, the Czech Republic, Hungary, the Netherlands, and Thailand depend on trade with partners that are projected to suffer downturns. The US, Japan, Canada, Indonesia, and Brazil are less exposed to this risk, as exports account for smaller portions of those economies.
China, France, Germany, Italy, and the United Kingdom “are likely to face a significant drop (of around one percentage point) in the growth of their trading partners, but their exports represent no more than around 40% of their GDP, which will limit the fallout from slower external demand growth,” the report says. “Among these countries, Germany may be the most vulnerable.”
Germany, arguably the biggest beneficiary of the eurozone, is starting to export more to Asia, North America, and Latin America now that European demand is slumping.
Regardless of what the Tea Party says, governments are working very hard to rein in fiscal deficits, especially in the eurozone. In emerging economies, policymakers are doing this to prevent overheating.
By most measures, banks are not in very good shape.
Consumers in Europe’s periphery are distrustful of their banks, and for good reason. All-out bank runs are coming about in the GIIPS. In the lead-up to the anti-climactic election this month, Greeks withdrew hundreds of billions per day from their already-shaky banks.
Toxic debt at banks is up almost all across the board, raising the possibility that global banks, like Spain’s, will need external help to stay afloat. This would presumably come from central banks, rescue funds, and outside creditors.
Skittish customers are deleveraging themselves, as are private-sector companies. The willingness to spend and borrow is less robust than it was during the bubble years...
...except in China, India, and Brazil.
So what are policy makers to do?
Government debts are only getting worse.
Stimulus in the form of Keynesian spending is less viable. And as for monetary policy, central banks around the world already have the gas pedal floored. Interest rates really can’t get any lower.
Thanks to asset purchase programs like quantitative easing, central bank balance sheets are already bloated.
Though separate national borders mean little to the eurozone, the BIS writes that "authorities in one country still have only limited responsibilities for actions that a financial intermediary takes in another country."
This discourages actors in any country from being careful enough for the entire system to benefit in the long term. In Mexico last week, Europe’s leaders broached the notion of a banking union that will further coordinate monetary and financial policy in the currency union, a move that the BIS lauds.