Tuesday, June 26, 2012

The Vicious Cycle Hindering the Global Economic Recovery

The Bank for International Settlements or BIS has recently released its 82nd annual report for the year 2011.  As you may recall, BIS is an intergovernmental organization of the world's central banks located in Basel, Switzerland; in other words, it's the central bank for the world's central banks.  Scattered throughout this rather large document are a few gems that I would like to include in this posting since, surprisingly, the mainstream media pays very, very little attention to what BIS has to say.

BIS opens by noting that the global economy is still struggling with the legacies of the financial crisis and that "vicious cycles are hindering the transition for both the advanced and emerging market economies".  Not unexpectedly, the world is experiencing a two-speed recovery; rather unexpectedly, this time things are different because it is the world's "advanced" economies that are suffering from lagging economic growth while emerging markets are seeing their share of the world's economic growth rising as shown on these graphs:

The economies that were at the centre of the 2008 - 2009 financial crisis are still experiencing that splitting hangover headache from the collapse of their respective real estate booms and their excessive household debt levels.  BIS states that household debt levels remain close to 100 percent of GDP in several countries including Ireland, Spain and the United Kingdom.  Accompanying high household debt levels is the problem of highly leveraged governments and financial sectors that are very slow to improve the problems on their balance sheets, particularly in the world's developed economies.

This has left the world's central bank system stuck between a rock and a very hard place.  Over the year that was 2011, central banks increased their purchases of government bonds in an effort to shove stubborn interest rates down right along the yield curve as a last ditch effort to prod the world's reluctant economy back to life.  At this point in time, the total assets of the world's central banks stand at $18 trillion (and growing), a level that is roughly 30 percent of global GDP.  As I have posted before, here are a handful of graphs showing how central bank balance sheets have grown and the assets that they hold:

BIS points the fickle finger of fate at government inaction for backing the world's central banks into a corner as average government deficits have risen from 1.5 percent of GDP in 2007 to 6.5 percent in 2011 and debt has risen from 75 percent of GDP to more than 110 percent in the same timeframe.  To bring government fiscal situations back to pre-crisis levels, it will take 20 consecutive years of surpluses exceeding 2 percent of GDP just to bring the debt-to-GDP levels back to pre-Great Recession levels.  To put it mildly, that is about as likely as pigs learning how to fly between now and 2032.  Unfortunately, as I have said before, central banks have been their own worst enemies in some ways; their ultra-cheap credit has led the ruling class around the world to believe that they can continue to accrue debt at breakneck speed with no repercussion.  Here are two graphs showing the sharp contrast between interest rates for the world's advanced and emerging market economies showing how cheap credit is for what turns out to be the world’s most indebted economies:

Here's what BIS has to say about where the fault lies (all bold is mine):

"The extraordinary persistence of loose monetary policy is largely the result of insufficient action by governments in addressing structural problems. Simply put: central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed. As we discuss in Chapter IV, any positive effects of such central bank efforts may be shrinking, whereas the negative side effects may be growing. Both conventionally and unconventionally accommodative monetary policies are palliatives and have their limits....In fact, near zero policy rates, combined with abundant and nearly unconditional liquidity support, weaken incentives for the private sector to repair balance sheets and for fiscal authorities to limit their borrowing requirements. They distort the financial system and in turn place added burdens on supervisors.

With nominal interest rates staying as low as they can go and central bank balance sheets continuing to expand, risks are surely building up. To a large extent they are the risks of unintended consequences, and they must be anticipated and managed. These consequences could include the wasteful support of effectively insolvent borrowers and banks – a phenomenon that haunted Japan in the 1990s – and artificially inflated asset prices that generate risks to financial stability down the road. One message of the crisis was that central banks could do much to avert a collapse. An even more important lesson is that underlying structural problems must be corrected during the recovery or we risk creating conditions that will lead rapidly to the next crisis.

In addition, central banks face the risk that, once the time comes to tighten monetary policy, the sheer size and scale of their unconventional measures will prevent a timely exit from monetary stimulus, thereby jeopardising price stability (i.e. inflation). The result would be a decisive loss of central bank credibility and possibly even independence."

Not that a loss of central bank credibility hasn't already happened!

When talking about "wasteful support of effectively insolvent...banks" perhaps BIS need look no further than the bailout of the banking systems of Spain, Ireland, Greece, Italy and many other nations.

Here is a graphic from the report showing the "vicious cycle" that the world's central banks are trapped in today:

Lest those of us who live on the west side of the Atlantic get cocky, in closing, here is an interesting comment from the annual report:

"Over the past year, much of the world has focused on Europe, where sovereign debt crises have been erupting at an alarming rate. But, as recently underscored by credit downgrades of the United States and Japan and rating agency warnings on the United Kingdom, underlying long-term fiscal imbalances extend far beyond the euro area."

BIS' annual report for 2011 paints a rather grim but quite realistic picture of what lies ahead for the global economy.  What is particularly concerning is that the outlook is so grim three years into the "recovery".  Unfortunately, it likely means that the next global economic downturn will be even more painful than the Great Recession since, in many ways, the economy never recovered from the last crisis.


  1. Why are the stock markets not reacting? Is that because they think the consequences will not impact them for quite some time, or that they also rely on the MSM? I really can't image they rely on the MSM.

    1. I have sadly come to the conclusion that the only outcome of this mess is government default at some point in the future--essentially a financial earthquake that will shake developed nations and the global economy.
      That central banks proceeded as they did has only had the effect of delaying the inevitable bust.
      Alas, as Reinhart & Rogoff indicate we have been in this space before.

    2. I agree. I'm putting my money into an bear ETF's.