Mike Callaghan is Director of the Lowy Institute's G20 Studies Centre.
The Bank of International Settlements (BIS) sounds like a dull place. It is the central banks' central bank. But its latest Annual report provides a loud wake-up call for governments everywhere. The summary chapter, 'Making the Most of Borrowed Time', should be read out in full at the next meeting of G20 finance ministers to make sure they get the message.
And the message is that unconventional monetary policies in large advanced countries bought time to let countries repair their balance sheets, both public and private, and implement reforms to get growth going. But that time has not been well used. In fact, ultra-low interest rates and rising asset prices resulted in policy complacency. As the BIS says: 'After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change'.
Furthermore, there was a cost to buying this time and that cost is rising. BIS General Manager Jamie Caruana noted when releasing the report that 'As the stimulus is maintained, it magnifies the challenges of normalising monetary policy; it increases financial stability risks; and it worsens the misallocation of capital'.
When US Fed Chairman Ben Bernanke reminded everyone last week of the of the obvious, namely that the party of cheap money and low interest rates cannot last forever, there was a sharp and indiscriminate sell-off in currencies, equities and bonds. Stephen Grenville recently observed that Bernanke's attempts to prepare the ground is a reminder of how 'difficult it is to have a sensible conversation with financial markets.'
Some have criticised the timing of Bernanke's statement, saying it would have been prudent to wait for more tangible signs that the economy is strengthening before making such an announcement. Or as Paul Krugman would say, Bernanke is taking away the punch bowl before the party had started.
Markets have been complacent, overlooking policy shortcomings and government failures to act, and believing there would be no end to cheap and abundant central bank money. Now the BIS has given a warning to markets. The exit from quantitative easing will inevitably see interest rates rise. That is obvious. But as Caruana points out, 'experience suggests that the upward trajectory of long-term rates could be abrupt and volatile – and the complexity of the global financial system makes it impossible to predict what the adjustment will look like'.
The BIS report also provides a telling wake-up call to governments about what they must do to restore growth. Central banks cannot enact the structural economic and financial reforms needed to achieve economic and employment growth, says the BIS. Yet rigidities in labour and product markets are among the most important obstacles standing in the way of long-term economic health. It is critical to implement labour and product market reforms as quickly as possible to facilitate the movement of capital and labour to more productive areas, help propel growth and increase the incentives for firms to invest and hire staff. But as the BIS report notes, such arguments rarely get much of a hearing. It is to be hoped that this will change in the G20 leaders' and finance ministers' meetings.
The BIS report also cuts through the misleading debate on whether there is a trade-off between fiscal austerity and growth. In the words of Caruana, 'the belief that governments do not face a solvency constraint is a dangerous illusion'. The BIS points out that high public debt represents a clear vulnerability. It leads to higher interest payments, higher taxes, and less room for countercyclical policy. It makes investors fret about future inflation or default, meaning they will command higher risk premiums.
Again, cheap financing has taken the pressure off governments to take the necessary steps to put their fiscal positions on a long-term sustainable basis. The Economist criticises the BIS for calling for more austerity, saying that it is almost quixotic given the damage done by overzealous fiscal tightening to date. But the BIS is calling for governments to put in place credible measures that will consolidate budgets over the medium-term while minimising the short-term costs of fiscal action. They also emphasise that the quality of the fiscal adjustment is important and that it is not a call for 'undifferentiated, simultaneous and comprehensive tightening' everywhere.
It is to be hoped that the next G20 Finance Ministers' meeting has a full discussion of the messages outlined in the BIS report. For as Caruana concludes, 'today's large flows of gods, services and capital across borders make economic and financial stability a shared international financial responsibility'. The volatility taking place in financial markets across the globe emphasises again that we live in an integrated world. Let's hope it is also a collective spur for more decisive policy actions.
Photo by Flickr user bobaliciouslondon.