Our Overburdened Central Banks

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The annual report of the Bank for International Settlements--the Swiss-based agency that serves as a kind of central bank for central banks--may not be on your reading list, but if you're at all interested in economic policy it probably should be. I've just been studying the new report for the purposes of a column I've written. (I'll post a link to my article later when it goes online.)

The BIS writers have developed quite a talent for presenting complicated technical matters in an accessible way. They've also built an enviable reputation for being right. As John Taylor notes, they warned about the dangers of keeping monetary policy too loose for too long after the recession of 2001-02. Now they're worried we may be making the same mistake again. You can exaggerate the danger. Inflation as yet is nowhere on the horizon--but that's not the only risk and it's as well to be aware of what else might go wrong.

With nominal interest rates staying as low as they can go and central bank balance sheets continuing to expand, risks are surely building up. To a large extent they are the risks of unintended consequences, and they must be anticipated and managed. These consequences could include the wasteful support of effectively insolvent borrowers and banks - a phenomenon that haunted Japan in the 1990s - and artificially inflated asset prices that generate risks to financial stability down the road. One message of the crisis was that central banks could do much to avert a collapse. An even more important lesson is that underlying structural problems must be corrected during the recovery or we risk creating conditions that will lead rapidly to the next crisis.

Well said.

Here's a chart from the report that's worth a look. It shows the economic interactions among three sectors: government, households/firms, and finance. Each pairwise interaction is a self-aggravating cycle, and central banks are being asked to intervene at all three points. I remember when monetary policy used to be one target (prices), one instrument (interest rates). Happy days.

BIS.jpg

Congratulations to the BIS, by the way, for calling the global fiscal outlook "abysmal". "Abysmal" isn't a word you see very often in official documents. Bureaucrats (no disrespect, I used to be one) tend to the insipid. In their world, things aren't "abysmal", they "give rise to concern". When it comes to fiscal policy, I prefer abysmal.

Update: Here's the column I mentioned.


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