Bursting the bubbles

Date: 30/06/05

Governments and central bankers in Europe and around the world should change the methods they use for stabilising their economies, according to the Bank for International Settlements (BIS), the bank of the central bankers.

The BIS says in its annual report published this week that a focus on fighting inflation is no longer enough on its own to achieve economic stability. Instead governments need to adjust the regulation of private-sector banks as well as interest rates so that booms and busts fuelled by asset prices do not replace inflationary blow-outs as the primary source of national and international economic instability.

The BIS's views represent a radical re-assessment of the way central banks and bank regulators should co-operate to prevent booms and busts and come, ironically, at time when the US Federal Reserve Board (a BIS member) is examining whether it should join other nations around the world, including the UK, in introducing an inflation-targeting monetary policy system - something the BIS implies is already out of date.

The BIS says that, rather than inflation targeting, the 'twin pillar' strategy of the European Central Bank (ECB) is better designed for the new financially driven world in which "deflationary pressures may, in the future, be almost as frequently observed as inflationary pressures". But it warns that even the ECB model may be inadequate.

"A guiding principle [for] the introduction of a macrofinancial stabilisation framework would be that both regulatory and monetary policies should be applied more symmetrically over the cycle," the BIS says. So, just as under the Stability and Growth Pact, governments are expected to use "good" economic times to build up budget surpluses, private sector financial institutions should build up more capital in good times which could then be run down when the economy weakens.

Such a linked bank regulatory and monetary policy regime would not only put a brake on bank lending and "help restrain credit excesses" during the economic upturns, it would also limit the extent to which stricter lending criteria exacerbate economic slumps.

The BIS assessment casts a shadow over the Basel II-based Capital Adequacy Directive which the European Union is pushing forward. It would also have implications for the Solvency II Directive for insurance companies which the Commission is preparing.

The Basel-based BIS cites approvingly the example of Spain, which has required banks to increase loan loss provisions in proportion to the increase in their lending volumes - so-called 'dynamic provisioning for loan losses' as an example of how regulatory mechanisms can help to complement interest rate changes in stabilising the economy.

"Tightening monetary policy in the face of excessive credit growth would also attenuate the worst excesses and could obviate the need for radical easing later that might result in policy [interest] rates facing the constraint of the zero lower bound," it says.

What is called the "zero lower bound" describes the difficulty of lowering central bank lending rates to below zero in periods of deflationary declines in the price level, a constraint which weakens the ability of lower interest rates to stimulate a slumping economy.

Behind the BIS view lies analysis of how the globalised, low-inflation and financially driven international economy now functions. It says that globalisation and liberalisation of the real (international) economy have massively boosted supply potential, substantially changed relative prices and given a downward tilt to inflation at a time when demand, especially for goods, has lagged behind.

Second, it says deregulation and technological progress have had profound effects on financial systems.

Third, monetary policy has shifted towards the overriding objective of keeping inflation down.

The BIS then says that it is not so much the impact of each of these changes separately which is important, but rather their interactions "which point to new lessons as well as new uncertainties".

It also suggests that, even though interest rates globally are very low and oil prices surging, a repeat of the inflationary boom of the 1970s is unlikely.

Strong and aggressive labour unions are not, now, the force driving inflationary "second-round" price pressures that they were then.

Incomes policies which tried automatically to link wage growth with inflation are no longer the norm either. Supply pressures, especially from low-cost exporters like China, are also keeping prices and inflation down. And oil prices are not having the same impact on the price level that they used to have, in part because of the wider use of energy-efficient technologies and the bigger role of the services sector in the modern ecoomy.

• Stewart Fleming is a Brussels-based freelance journalist.

In its 75th Annual Report published on 27 June 2005, the Bank for International Settlements (BIS) argued that Governments and central bankers in Europe and around the world should change the methods they use for stabilising their economies.

BIS: 75th Annual Report http://www.bis.org/publ/ar2005e.htm

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