Financial Times
June 28, 2011
Enjoy the coming slump. That is not what the Bank for International Settlements says to the US and other overindebted economies. But it is what its latest annual report implies. I admired the warnings of monetary and financial excesses that the BIS gave under its former economic adviser, William White. I respect Stephen Cecchetti, his successor. But I disagree with the thrust of this report. It understates the obstacles to across-the-board austerity.
Persisting with monetary and fiscal accommodation is uncomfortable. But unconventional times demand unconventional policies. What makes these times unconventional? The answer is that a number of economies are in what the Jerome Levy Forecasting Center calls a “contained depression” – a period of sustained private sector deleveraging.
Implicitly, the BIS report rejects such a view. It argues for monetary and fiscal tightening across the globe. This argument rests on two beliefs. First, the world economy is close to full capacity. Second, “addressing overindebtedness, private as well as public, is the key to building a solid foundation for high, balanced real growth and a stable financial system. This means both driving up private savings and taking substantial action now to reduce deficits in the countries that were at the core of the crisis.”
Consider, first, monetary policy. Suppose we had an inflation-targeting central bank for the world. How should it respond to rising commodity prices when inflation expectations are also under control? Such a bank would recognise that this is a shift in relative prices, which reduces capacity and real wages. It would not know whether the rises are a one-off or a lasting trend. It would want to avoid a jump in inflationary expectation or a wage-price spiral. But would it also wish to reduce nominal wage rises, to offset the inflationary impact of the rise in commodity prices, even if that risked a significant slowdown? I think not. If it did, it would impart instability into the real economy in response to erratic and unpredictable movements in prices of commodities.
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