SOME GOOD READING. PART ONE
69TH ANNUAL REPORT
1st April 1998-31st March 1999
Basle, 7th June 1999
VIII. Conclusion: finding light among the shadows
There is no single or simple answer to current economic problems. While it might be thought easy to distinguish policies directed to macroeconomic stability from those related to financial stability, in practice it is not so straightforward. A lack of stability in one area commonly contributes to instability in the other. It may be recalled that in many industrial countries relatively high inflation in the 1970s and 1980s led investors to seek protection in property, which in turn contributed to excessive credit creation, bad loans and overexposed banks. More recently, in Japan, Mexico and South-East Asia, the other side of this process can be seen as weak banks and an associated credit crunch retarded recovery from macroeconomic disturbances. The challenging implication of this insight is that policy initiatives must be undertaken on a wide front if they are to produce a sustained improvement in living standards.
What is also being increasingly recognised is that the different policies required to support macroeconomic and financial stability share a number of underlying characteristics. Transparency in the conduct of monetary and fiscal policies is needed to provide an anchor for expectations. But transparency is also needed on the part of participants in financial markets if market discipline is to contribute to prudent behaviour. Another shared feature is that policies in both areas must avoid solving today's problems at the cost of making tomorrow's problems worse; moral hazard is a real issue. Finally, there seems to be a shared recognition in both areas that underlying processes are imperfectly understood and outcomes inevitably subject to uncertainty. Since even well-conceived plans do not always produce the results intended, perhaps the objective of avoiding truly bad outcomes needs to be given higher priority in designing policies.
What happened in financial markets between August and October last year reminded policymakers that the probability distributions which characterise asset price movements may have fat tails, at least on the downside. Interactions between various forms of risk, previously assumed to be separable, led to massive price movements which threatened the health of financial institutions and even the functioning of markets themselves. Recent dramatic events in many parts of the emerging world have made it clear that macroeconomic variables can be subject to extreme outcomes as well. Nor should one suppose that the advanced industrial countries are immune to such problems. While most forecasters expect continued and indeed accelerating growth, there are many specific uncertainties which imply that current forecasts must have a wide margin of error. What will be the effects on consumer confidence in Japan when corporate restructuring really gathers pace? What will be the effects of the introduction of the euro on competition and prices in Europe, and on the financial structure through which monetary policy works? Will the spread of new technology lower unemployment by opening up new production possibilities or will it raise unemployment by displacing labour? Will Asian bank restructuring proceed rapidly or hardly at all? To these questions many more might be added, and the answers and policy implications are not obvious. Nor is it obvious that the balance of current risks is symmetrical. In fact, a generalised resurgence of inflation seems less likely than further disinflation or even deflation. Uncertainty in itself erodes confidence and leads to lower spending. Imbalances work in the same direction. When they are eventually resolved, those who gain may not adjust spending upwards while those who lose commonly have little alternative but to retrench. Moreover, the specific imbalances referred to in the Introduction to this Annual Report also seem to imply some downside risk to the forecast. The overhang of productive capacity in traded goods worldwide could have a number of implications. It is already putting downward pressure on prices in the advanced industrial countries, even though export volumes from Asia have not yet fully responded to earlier depreciations. In the United States, protectionist pressures are on the rise even as the unemployment rate keeps falling from one low to another. And the intensification of price competition makes firms vulnerable to any significant acceleration of costs. Should profits come under further pressure in the United States, the effect on equity prices could be significant and this would in turn be expected to have an impact on consumption. Finally, record trade imbalances must at some point imply a lower dollar and an appreciation of the yen and the euro. Should this happen before the economies of Japan and continental Europe are growing healthily again, the downside potential for the global economy is obvious.
That policymakers have been conscious of these concerns seems to have been borne out by the actions they have taken to date. Interest rates have been lowered sharply throughout the industrial world and in many emerging economies as well. The easing which took place in the advanced industrial countries late last year was also consistent with the desire to help calm market turbulence through a further injection of liquidity. Moreover, it may be the case that monetary policy would work less effectively should prices actually fall in a generalised way, largely but not solely because of the constraint that nominal interest rates cannot fall below zero. If this were thought to be a potential problem, then the recent reductions in interest rates in some countries might also have been intended as a form of insurance against entering a deflationary trap from which it might conceivably be difficult to exit. It would be a mistake, however, to conclude that the answer to current global economic problems is simply to ease monetary policy further. In a fundamental way, it was an excessively accommodating monetary policy over many years that created many of today's problems in the first place. In addition to considering some of the dilemmas faced in the conduct of monetary policy, greater attention has now to be paid to equally difficult issues concerning the choice of exchange rate regimes, fiscal policy and labour market reform. More directly in the area of financial stability, urgent action is required in many countries to restructure banking systems and often the corporate sector as well. And a whole host of recent recommendations must now be implemented to ensure that, once financial systems are made healthy, they stay that way for the foreseeable future.
Policies to promote macroeconomic stability
Unique circumstances are conditioning the conduct of monetary policy in virtually every major region of the world. In the United States, the uncertainties and trade-offs faced by the Federal Reserve are in some respects normal, but in other important respects not. In conducting monetary policy to pursue domestic price stability, it is common practice to base inflation forecasts on some notion of the amount of excess capacity in the economy. What is unusual, however, is the degree of uncertainty currently surrounding such forecasts in the United States. Estimates of capacity levels based on labour market data are completely different from estimates based on capital stock data. Moreover, there exists to date no conclusive evidence either for or against the US economy having entered a "new era" of enhanced productivity growth.
Asset price movements have also imposed increasingly severe side conditions on the normal conduct of US monetary policy. While the global financial turbulence of last autumn contributed in some measure to the decision to lower interest rates, the previous run-up in equity prices, in association with the robust growth of credit, might have suggested that higher rates were called for. A similar conclusion is suggested by the recent rebound of stock prices to record levels and the associated impact on consumer spending. One great danger to continued global expansion at present is that the US economy will overheat and that fears of subsequent recession will undermine stock markets, reduce wealth and cut spending. Were the dollar to fall simultaneously, under the weight of capital outflows and a large trade deficit, a period of stagflation would not be an impossibility. With global financial markets now calmer, the need to avoid such a combination of events should be an important consideration in formulating monetary policy in the period ahead.
Last year's unique challenge in Europe was the introduction of the euro. This was masterfully executed, as attested to by the stability of intra-European exchange rates through all of last year. The challenge for the coming year will be how to conduct monetary policy given not just a new economic environment, but one that by design is supposed to be rapidly changing under the impact of the introduction of the euro itself. The fact that the cyclical positions, and asset price experiences, of many of the member states were widely different at the beginning of this year poses problems for the conduct of policy. And further complications arise from fluctuations in the value of the euro: both how to interpret them and how to respond to them. What is clear, however, is that the European Central Bank's objective is price stability and that the dangers of undershooting now seem at least as great as those of overshooting. The ECB has made it clear more recently that its response to deviations from the inflation target will be symmetrical, implying that policy rates could indeed decline further depending on the circumstances.
Monetary policy in Japan is also being conducted in a highly unusual environment, namely one of falling prices. While the outcome is by no means certain, most of the ingredients seem to be in place for a continuation of such deflationary pressures. The burden of real debt borne by corporations continues to rise, impeding investment. Unit labour costs are increasing and restructuring will add to unemployment, further depressing confidence and consumer spending. While purchases do not yet appear to have been deferred in expectation of further price declines, as seems to be happening in China, the potential for this cannot be ruled out.
The Bank of Japan responded by lowering interest rates virtually to zero, increasing liquidity in the banking system and purchasing large quantities of private sector paper. To date, the effect has been essentially that of "pushing on a string", raising the issue of what more, if anything, might be done. The Japanese experience illustrates the limitations of monetary policy when nominal rates are already very low and excess capacity is already very high. It may also provide some indication of both the benefits and the limitations of making clear statements about the objectives of public policy.
One important development affecting Japan was the sharp rise in the value of the yen during the second half of last year. While this might well be helpful to Japan's competitors in Asia, there is no question that it will hurt the export sector, which is one of the few sources of support for the Japanese economy. In more normal circumstances, this might have been resisted through lower interest rates or intervention designed to signal that rates would be reduced if need be. However, without a credible capacity to deliver on such a promise, this unwelcome appreciation of the yen was more difficult to resist. The fact that market expectations were not anchored in a clear understanding of the role of the exchange rate in the conduct of Japanese policy was also not helpful. At the least, it should be clearly stated that the goal of ending the Japanese recession and avoiding the development of a deflationary psychology must, for the time being, take priority over concerns about the trade account. Doubts about whether it would be possible to deliver on policy promises also militated against the adoption of explicit targets either for inflation or for the price level. In principle, either approach could play a useful role in helping prevent a downward spiral of price expectations and could thus lead to a welcome reduction in expectations about long-term real interest rates. In practice, however, economic agents must believe that the authorities have the policy instruments to achieve their targets. Currently this seems doubtful. While neither approach would thus seem very helpful on its own in the present circumstances, such a regime shift might still serve a useful ancillary function if only some other means could be found to effectively reduce the current output gap.
A combination of the very sharp fluctuations in the value of the yen and the introduction of the euro led, in the period under review, to renewed suggestions for better ways to manage cooperatively a tripolar global exchange rate system. Floating exchange rate regimes do indeed have their own problems, not least the possibility of asset price bubbles if interest rates stay low as a rising exchange rate bears much of the burden of fighting inflation. However, no political agreement seems likely to alter significantly the current regime in which domestic monetary policy is directed primarily to domestic needs. An underlying problem of both academic and practical importance is the continuing propensity of investors to borrow in low and lend in high interest rate centres without considering the full potential for having to pay back in appreciated currency. The destabilising aspects of market failures of this sort need further investigation.
New questions concerning exchange rates also arose in many emerging market economies, with the principal lesson being that countries should eschew variable peg regimes in favour of either something much harder or the voluntary adoption of managed floating. In support of the former alternative, Hong Kong and Argentina successfully defended their currency board systems last year, by managing the system more flexibly (Hong Kong) or by threatening to dollarise and retreat from managing it altogether (Argentina). In both cases uncomfortably high interest rates simply had to be accepted. Other countries, such as Brazil, did not choose to float their currencies but were forced to do so in an environment of crisis. The outcomes were generally unsatisfactory. As in Asia last year, the trend was for currencies to overshoot and then rebound under stabilising macroeconomic policies. The Brazilian authorities also chose to let high interest rates make a contribution to this process, even though the effects on domestic debt service and the fiscal deficit were thought likely over time to put offsetting downward pressure on the real. To date, aided by a sharp improvement in the primary surplus and an unexpectedly good inflation performance, the bet seems to have paid off.
The next challenge for Brazil and other countries with newly floating currencies is to find some other nominal anchor to guide their domestic monetary policy over the longer term. This will not be easy given the lack of an anti-inflationary history, poor data on credit and monetary aggregates and the absence of reliable procedures for forecasting inflation. And without a transparent framework for conducting monetary policy, the management of episodic exchange rate pressures will also be difficult, even if less so than under a regime based on an adjustable peg.
There has been little debate recently about fiscal policy. It is commonly asserted that in Japan fiscal stimulus has (or at least had) a useful role to play in stimulating aggregate demand; in continental Europe continued fiscal consolidation is thought desirable; in the United States the fiscal position has greatly improved and no tightening seems required at this time; and in emerging markets fiscal restraint appears to be the appropriate short-run response when the exchange rate is under pressure. While these assertions have a large measure of validity, they all need to be qualified in the light of circumstances. |
