Part 1 - What the Bank for International Settlements said about the global economy in its annual report
July 4, 2019
Erik Fertsman
It's clear the BIS has its finger on the economic pulse, citing inflation and productivity issues, and that's exactly what everyone expected to find in its annual report. What wasn’t anticipated is the emphasis on the economic fallout caused by the neoliberal paradigm and the business of banking.
Carstens told Reuters that, "monetary policy should be considered more as a backstop rather than as a spearhead of a strategy to induce higher sustainable growth." As I've reported here, inflation is not that far from central bank targets, and nominal GDP growth is still chugging along. Carstens argued that lowering interest rates forms "potential risks in terms of asset misallocation and asset mispricing and financial stability risks as we move forward." Nobody wants to hear this at the moment in advanced economies, they just want some cuts and some sweet, sweet stimulus!
Carstens seems pretty eager to steer monetary policymakers in favor of an L-I-T-E approach. Why is this very influential institution going against those vocal economists? To be honest, it's no surprise: the BIS and central banks around the world have had a decade to study the effects of low interest rates and their asset purchasing schemes, wherein they've loaded up their balance sheets full of non-performing loans, government securities, and have pushed interest rates down so hard it caused a hard landing (in Europe they have gone below the ground, into the negative!).
It's clear that these operations, conducted using trillions of dollars worth of fresh-issued credit, have some side effects- like asset price inflation. Low interest rates, especially negative rates, are a death sentence to most banks. But, while there's a pull for restraint from central bankers, there's a shove from political leaders. It's becoming a bit of a thorny issue at the moment. Economists are looking at the economic data ranging from contracting manufacturing, anemic inflation, hot real estate, massively indebted consumers, to wild corporate debt markets with sketchy covenants and risk … and they're getting nervous. The result is Donald Trump breathing down the neck of the Fed's Colin Powell on Twitter.
The markets, who are pricing in near guarantees of interest rate cuts, are also putting pressure on central banks. Perhaps, Carstens is not worried about the markets, given their horrendous predictive track record (see this
article I wrote). Yes, central bankers in Japan, the EU, and the US have "signaled" that rate cuts are possible, and until they do it doesn't count. But Carstens and his organization are worried about cuts and further QE...
What the BIS thinks about the economy
The report begins with the things we already know:
In the second half of the year, global trade came to a halt, manufacturing decelerated and investment lost pace. By comparison, services and consumption held up relatively well, propping up the expansion.
- Political factors weighed on the economy and prompted economic policymakers to respond. These included trade tensions, which had a large impact on investment.
- China's deleveraging has slowed economic growth and pushed down economic activity around the world due to its size and presence in global markets and supply chains. This has been perceived as a necessary move to bring China into a more sustainable growth pattern.
- Rising US dollar interest rates in various parts of the world spelled trouble for emerging markets economies. This is because these markets are heavily reliant on US dollar financing.
- Shifting credit behaviors in numerous advanced economies and emerging economies. This shifted house prices and consumer/business expenditures into contraction territory.
Of course, not everything is gloomy. I mean, the stock market is still going near the all-time high. So, they cite current "resilience" factors:
- Labor markets and wage growth helped muddle things along, particularly employment expansions and historically-low unemployment levels. Outside of economies where housing prices cooled, consumption was a "relative strength" that floated economies.
- The US and other advanced economies are still firmly within the upswings of their financial cycles. For the US especially, the deleveraging that many households experienced after the Financial Crisis created room for corporate leveraging (but this is becoming a problem, which we'll get to).
Long-term problems: anemic inflation, the business of banking, poor productivity, and the damage of the neoliberal paradigm
Much ink has been spilt over this surprising development [anemic inflation]. Some, like us, have for a long time stressed globalisation and technological advances. In addition, demographics-induced changes in the labour force may have led to underestimates of economic slack. What is clear is that labour has been struggling to regain the bargaining power lost over the past decades. And while wages have finally been responding more clearly to tighter labour markets, firms have shown little sign of reacquiring pricing power.
Less appreciated is the fact that ever since inflation has been low and stable, starting some three decades ago, the nature of business fluctuations has changed. Until then, it was sharply rising inflation, and the subsequent monetary policy tightening, that ushered in downturns. Since then, financial expansions and contractions have played a more prominent role.
Which brings us to the second force: finance and its role in the economy. The GFC [Great Financial Crisis] was just the most spectacular instance of this role. This justifies the greater attention policymakers now pay to financial markets, credit developments and real estate prices...Perhaps the forces that can be explored in more depth are finance and the inflation process... In many of the countries less affected by the GFC, financial expansions have reached an inflexion point. As a group, these economies account for around one third of global GDP. Private sector credit growth has slowed relative to GDP and, in a number of cases, property prices have started to fall. After the strong credit expansion, these countries are now saddled with historically high household debt levels, and some with high corporate debt as well.
The condition of the banking sector is, in some respects, paradoxical. Country differences aside, it is much better capitalised thanks to the post-crisis regulatory reforms. However, asset growth among the major banks has slowed sharply since the GFC. Book equity growth has been similarly lacklustre. The slow growth of book equity reflects, in part, banks’ chronically low profitability, particularly in many euro area countries. This matters. Profits are the first line of defence against losses and, as by far the primary source of capital, they are the foundation for banks’ ability to lend and support the economy. Some of the reasons for low profitability can be traced to legacies from the GFC and the macroeconomic environment, most notably persistently and unusually low nominal interest rates. Others reflect more structural factors, especially excess capacity in a number of key banking systems.
This “paradoxical” condition of banking is not as paradoxical as the BIS is making it out to be: regulation for European banks, like Basel I, II, and III, force banks to raise capitalization requirements, or the amount of money banks need to lend money. So, yeah, if you force the banks to have higher capital ratios, then you will inevitably get banks that experience better equity growth (after the ones who don’t find capital go bust), but asset growth (loans) will continue to struggle. And from there, profits will struggle, because banks don’t make money on equity, they make money lending fountain pen money.
Banks subject to tight capitalization requirements will eventually turn around and go somewhere else where they can lend more freely. It has nothing to do with nominal interest rates. If banks are restricted by capital ratios, they will go conservative and leave many potential and current borrowers in the dark. Maybe it’s telling, but capitalization requirements in Europe and elsewhere have enabled a boom-loop where credit freezes, rather than proliferates. Lowering interest rates to zero and beyond will not offset the tight noose.
The third force is productivity growth, or rather the lack thereof. Growth accelerations of the type experienced in 2017 could only lead to sustained growth at a new, higher pace if a level shift in productivity growth takes place. Productivity growth has been on a marked downward trend in advanced economies as a group for a long time. And the slowdown became more marked following the GFC. The impaired financial system is likely to have played a role in impeding the allocation of resources to their best use. And it is surely no coincidence that trade has lagged behind output and that investment has been correspondingly weak. Whatever the actual reasons, lower productivity growth is constraining sustainable expansions, at least in the advanced economies, where the frontier for the rest of the world is set.
Finally, the fourth issue is the fallout or "political and social backlash" against the "open international economic order." Or, as some would call it, the "neoliberal paradigm." As we know, this backlash has come in the form of populism, extremist right and left-leaning politics, protectionism, you name it. The result? Donald Trump, restrictive trade policies, erosion of rights and legal protections, and even political censorship. The BIS is worried about the hangover of the neoliberal paradigm. One form this hangover is rearing its ugly head within? Big tech firms:
Looking ahead, a looming competitive threat to banks comes in the form of the big techs...these huge companies that have started making inroads in financial services, leveraging the vast customer bases they have secured through their activities (eg social media, e-commerce and search engines). Payments, retail lending, asset management and even insurance have already seen deep incursions by these behemoths, whose market capitalisation far exceeds that of banks...They represent a wake-up call for banks, which need to raise their game in order to compete effectively.
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