BIS promotes Keynesian fiscal policy solutions

Geneva, 8 July (Chakravarthi Raghavan) - “If monetary policy were increasingly ‘pushing on a string’, the principal insight from Keynesian analysis is that fiscal policy could still have an important role to play.”

These are words from the Basle-based Bank for International Settlements (the central bank of the central banks) in the concluding chapter of its 72^nd Annual Report.

Starting from the premise that further reductions in interest rates would not work (as is the case in Japan) or not so feasible (as in the US and EU, where it may come in the way of restructuring and would not provide a stable climate to bring down long-term rates), the BIS report in essence seems to advocate Keynes ideas of running government budget deficits in times of lack of demand and running surpluses to pay back the deficits in times of robust growth.

True, the BIS (of all the institutions controlled and run by the powerful countries and their central banks) has not had the kind of hangups of the others - the IMF, the World Bank, the OECD or the WTO - and has cited John Maynard Keynes in the past too.

Keynes and his writings spanned a wide-range of economic policy issues and events - from his ‘Economic Consequences of Peace’ (1920), through his treatise on Money (October 1930), writings on the Wall Street Crash and the Great Slump, the General Theory of Employment, Money and Interest (1938), his writings on non-inflationary financing of the British war effort during the Second World War, and the post-war reconstruction vision and the negotiations with the US for the financing of the war and the Bretton Woods Agreements. His views evolved and changed over time; so much so that it is easy to cite him almost for any kind of policy advice. And Keynes himself retorted once (to a critic charging him with inconsistency), “when circumstances change, I change my views. What do you do Sir?”

Keynes did not really advocate printing money or undertaking profligate government spending; he did say (in his Tract on Monetary Reform), “Thus inflation is unjust and deflation inexpedient. Of the two perhaps deflation ....  is the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier.”

As a fiscal policy, he advocated running deficits when there is a decline in demand, and paying back the deficits with surpluses in the future when growth is robust, that is to run a balanced budget over the business cycle. He was also in favour of running deficits on the government’s investment or capital account budget and keeping the current expenditure budget in balance all the time, so it was the investment budget that ran deficit and surplus to average out over the cycle.

Much of the analysis and the policy recommendations and views in the BIS report are similar to those in UNCTAD’s Trade and Development Report, 2001.

But when Central Bankers evoke the policy advice of Keynes, even while cautioning against reckless government spending, it is time for heads of governments of powerful countries, their finance ministers and policy-makers and other international institutions to take notice.

However, as Keynes biographer Robert Skidelsky has brought out in his second volume, politicians often seek the views of the economists, not to change policies, but to provide arguments to justify their own.

According to Mr. William R. White, the chief economist of the BIS, who wrote the introduction and the conclusions of the report, he had in mind Keynes General Theory of Employment, Money and Interest. As to whether and how the fiscal stimulation could be applied in the EU, with its stability pact and the European Central Bank (ECB), White pointed to the distinction between the objectives and targets of the stability pact and the annual budgets.

The BIS conclusions start from the position whether further reductions in interest rates in the industrialized world are feasible and would work. It concludes that they can’t be reduced further in Japan; and that in the US and EU, it may not be a good idea either since it would come in the way of restructuring; and it may be difficult to get long rates down in a stable manner to impact investment if there is fear of an inflationary uptick.

Thus the only alternative would be fiscal policy, limited to automatic stabilisers, making sure that it does not become permanent or have little demand impact as in Japan (where much of the infrastructural spending has been misused for political patronage). Thus it would be fine to have deficits now to offset the decline in demand on condition that the deficits are paid back with surpluses in the future when growth is robust, a clear Keynesian view on running a balanced budget over the cycle.

But this would not allow for Enron accounting - of hiding current deficits against possible future surpluses or anticipations of revenues from sales of public sector undertakings (as was attempted in Italy) - nor of the tax-cuts (based on assumptions and budget forecasts into the future) for corporate funders and the rich, with the tax-cuts to expire at a future date (as in the US) - an unbelievable statutory provision.

Keynes also favoured running deficits on the government’s investment or capital account budget and keeping the current expenditure budget in balance all the time, so it was the investment budget that went in deficit and surplus to average out over the cycle.

The BIS report speaks of the ‘unexpected resilience’ shown by the global economy and the financial system in the face of ‘unexpected events’ - the 11 September events, the war against terrorism, the failure of Enron, the collapse of the Argentine Currency Board and the conflict in the Middle East. Each one of these could have had unpleasant economic side effects; their cumulative impact could have been far more serious, coming as they did on top of a global economic slowdown. However, the system coped remarkably and the global economy began expanding again., with the US leading the way in spite of its many perceived imbalances.

The financial sector responded flexibly; the payments and settlement systems coped well, even under the extreme strains of the terrorist attack on the financial district in New York; credit generally continued to flow freely, albeit more expensively for the less credit-worthy.

However, cautions the BIS, despite these very welcome developments and the expectation that they are likely to continue, “it would be premature to conclude that all must now be well.” Some of the concerns may yet be realised, and a number of last year’s shocks may prove to have longer-lasting implications.

In drawing some policy conclusions dealing with “possible headwind,” the BIS says that there are grounds for “considerable satisfaction,” since, given the stresses and strains placed on the global economy, its performance could have been a great deal worse. An aggressive set of stimulative macroeconomic policies, allied with a financial sector made more robust by structural reforms, have proved pivotal.

Nevertheless, points out the BIS report, although partly attributable to unforeseen events, the actual outcomes in terms of growth, profits and employment have put the global economy on “a lower expansionary path than many had counted on.”

Savings plans in some countries will eventually have to be adjusted upwards in consequence and, in addition, there is no guarantee that even today s more moderate expectations will be realised. There are still “considerable risks and uncertainties” that will test the limits of our understanding of both economic processes and sound policies.

On the positive side is the quiescence of global inflation. While a legitimate source of pride for central bankers, it is also the result of supply side potential and the effects of liberalisation in a large number of countries, not least Korea and China. Corporate pricing power has been reduced everywhere.  Financial liberalisation has further spurred a supply side response, although not always in desirable ways. Much of the investment in the IT sector everywhere will never prove profitable, and a large part of this excess capacity has yet to be fully written off. All these forces remain in play and some are even strengthening.

Allied with persistently weak demand in Japan and parts of continental Europe, the implication is that global price trends for internationally traded goods and services are likely to stay deflationary even if domestic compensation and oil price increases retain some potential for near-term inflationary mischief.

In these circumstances, the English-speaking countries were effectively the global importers of last resort for much of the last decade. In both business investment and house-hold sectors there has been significant recourse to debt financing, as evidenced by a sharp increase in mortgage debt and an even sharper one in mortgage refinancing in many countries. Much of the cash raised seems to have been used to support consumption at uncommonly high levels through the slowdown.

How will all these weigh on future spending plans? Household and corporate debt levels in a number of the English-speaking countries seem very high when measured against disposable income and cash flow respectively. Unless profits recover significantly, balance sheet constraints and high levels of excess capacity may work against a rebound of investment. Moreover, the scope for further mortgage refinancing is much lower and the stock of recently purchased consumer durables much higher; but debt service burdens still seem manageable and the ratio of debt to assets is still relatively low.

However, both these more positive indicators would deteriorate were interest rates to rise back to more usual levels. In contemplating when and how quickly to raise interest rates, assuming the current recovery continues, the possible fragility of balance sheets may need to be taken into account.

If the recent past is any guide, the near-term fortunes of the rest of the world~will continue to be much affected by what happens in the English-speaking countries, especially the US. Global trade links, more integrated capital markets and a remarkable expansion of transatlantic mergers and acquisitions are increasingly pointing continental Europe in the same direction as the North American economies. Yet the potential for dissimilar behaviour also remains high. For example, with the important exception of the telecommunications companies, there is in Europe much less evidence of the debt imbalances. Profit levels have also been relatively well maintained and, again outside the telecoms sector, there does not appear to be the level of overinvestment seen recently elsewhere.

However, what is more worrying at the European corporate level is the pressure for higher wages. Given global competitive conditions, this seems more likely to reduce employment and growth potential than to raise prices.

In Japan, the balance sheet picture is much less positive: very high private sector debt levels, despite the successes of some larger Japanese corporations in restructuring and paying down deb; for the vast bulk of smaller firms in Japan’s still largely closed economy, profits remain anaemic and excess capacity the rule. And while consumers have continued to spend at a moderate pace, rising unemployment and falling confidence might yet dampen spending further.

Prospects for the emerging market economies will also be much affected by developments in the industrial world. Broadly speaking, Asia looks set to perform much better in terms of both growth and inflation than does Latin America, with the transition economies in Europe occupying an intermediate position. Clearly, the relatively favourable position of the Asian region reflects both the size and composition of the traded goods sector.

Perhaps the biggest risk to the outlook for Latin American countries comes from the external side. Should financial flows dry up, reflecting either increased risk aversion or domestic political instability, current account deficits would have to be reduced through corresponding cuts in domestic spending. This could prove painful, as in Argentina and in Turkey. While Turkey now seems to be on a path to recovery, albeit subject to still high inflation and eroding competitiveness, the outlook for Argentina is more uncertain than ever.

On the extent to which difficulties and imbalances in the global financial sector itself might moderate an incipient recovery, the BIS, while inclining to some optimism, says that in most industrial countries, capital constraints on the supply of bank credit do not seem likely to be a major impediment to growth.

However, there are major problems in the Japanese banking system; also, there are signs that some banks in continental Europe may be becoming more hesitant in making loans, particularly to smaller firms, at the same time as they are becoming less hesitant to pull the plug on bad credits. The global insurance industry has been negatively affected by the fall in investment income as interest rates and equity prices have declined. And general insurers have been hit by a succession of natural disasters as well as the events of 11 September 2001.

There has also been a tendency for some companies, in both the insurance and reinsurance businesses, to compensate by moving into new areas such as credit derivatives, a trend that may expose them to significant new risks.

While financial markets have been remarkably robust to date, many concerns and long-standing worries remain: Elevated stock prices and the value of the dollar are long-standing worries. Concerns about rising house prices and the sustainability of financing through global bond markets are of more recent vintage. Significant changes in one or other of these areas are not implausible, and such changes could conceivably feed back negatively on global economic prospects.

The correction in stock prices in the technology, media and telecommunications sectors has already been massive, but one hopes that the worst is over.  Nevertheless, while declines have been substantial, conventional valuations still leave stocks in aggregate, particularly in the United States, looking rather highly priced. This is especially the case when measured against recent earnings, but remains so even using bottom-up expectations of future earnings, many of which seem quite optimistic in the broader macroeconomic context.

“More bad investments might have to be written off and pension funds might have to be topped up. The Enron affair underlines the possibility that artificial profits might yet be revealed elsewhere.”

In the housing market, not only are prices high relative to fundamentals, but the ratio of prices to disposable income is also near record highs in many countries, and seem to be playing a crucial and potentially unsustainable role in supporting consumption. And in the US, where government-sponsored enterprises (GSEs) are providing easier access to mortgage credit, the rise in indebtedness may leave many borrowers exposed.

In the US, where the current account is being financed by foreign capital flows, European investments which hitherto had been in the form of FDI and equities, has now switched to bond inflows (similar to those from Japan and Asian investors), and even these are shrinking (in response to losses on previous investments), while US investors are looking for investment opportunities in Europe.

Another source of general concern, to which the BIS points, is the downside of modern financial markets, where consumers, companies and even sovereign borrowers, aren’t always good judges of their capacity to service the debt, and a manageable debt under one set of circumstances may not be manageable in another. And markets can be subject to sudden shifts in sentiment and herd-like behaviour leading to drying-up of liquidity in key sectors.

With the continuing increase in concentration in financial markets, while probably implying better risk management overall, nevertheless could still be a source of concern. For example, the most important over-the-counter derivatives markets are dominated by a very small number of firms whose ratings have been trending downwards, while the US GSEs rely on such a small number of firms in the complicated business of hedging themselves against market risk, in particular mortgage prepayment risk. A material change in the circumstances of one of these major participants could have widespread implications for financial markets as a whole, and problems aggravated by “the growing trend for big to trade with big.”

Will bond markets remain as welcoming to borrowers, including those of lower quality, as they have been in the recent past? Aside from the most risky bonds, spreads have stayed quite low, presumably reflecting the view that the expected economic recovery will materially reduce the likelihood of default. “Were this view to change, however, firms and sovereigns might easily find themselves facing financial market conditions that would make a robust upturn even less likely.”

Whatever the economic processes playing out at any point in time, good macro-economic and macro-prudential policies and practices can improve future prospects, and growth trends can be increased, while cyclical variability can be reduced; and financial crises can be made both less numerous and less severe.

On the exchange rate framework and issues, and the behaviour of the G-3 currencies, and legitimate concerns about effects of exchange rate changes on competitiveness and financial stability or disorderly market conditions and self-fulfilling crises, the BIS reports flags the issue of other policy instruments, ranging in ascending order of intrusiveness, from verbal intervention through actual intervention to measures to limit speculation or capital movements, paying due consideration to the longer-term costs of interfering with market processes and clearly explaining to the public the motivation for all such policies.

[Media reports suggest that the IMF has been weighing and suggesting to Europe and Japan concerted moves so that the gradual decline in the value of the dollar does not become precipitate, with negative effects on the global economy.]

In terms of monetary policy and maintaining low inflation, these pose a number of questions for policy-makers: when is the time for tightening monetary policy, and how to ease against the constraints of zero lower bound for nominal interest rates.

Raising interest rates when there are no overt inflationary pressures is difficult, whether or not asset prices are rising rapidly at the same time, and given all the economic and measurement uncertainties, there is a very reasonable chance that tightening would actually prove to be the wrong policy. And convincing the public and politicians of the need for such a policy would be very difficult. Yet, should the economy actually be on a path to boom and bust, the longer the expansion were allowed to proceed, the greater would be the ultimate reckoning.

A further series of questions could come since a situation of deflation could easily arise. In such a situation, since nominal policy rates cannot fall below zero, deflation raises real interest rates and compounds the deflation problem (which is what Keynes contended with just before and during the Great Depression). Viewing various possibilities - ranging from a very vigorous easing of policy rates to prevent the emergence of deflation to more measured response in pursuit of the same objective, and establishing a set of expectations that rates would continue to go down and then stay down so as to bring down long rates, a logic that might apply in much of continental Europe - and the problems of restructuring excess capacity that could be impeded by very low interest rates (as happened in the 1930s), the BIS falls back to Keynes and his fiscal policy analysis and advice in his General Theory.

“If monetary policy were increasingly “pushing on a string”, the principal insight from Keynesian analysis is that fiscal policy could still have an important role to play,” while cautioning against “reckless government spending.”

Hence, the form of fiscal stimulus also matters. In Japan, for example, very heavy government investment in regional infrastructure over the last decade has been in large part wasted. Stuck with future liabilities but no matching assets, it is not surprising that Japanese consumers who are also taxpayers have remained cautious.

“Redirecting expenditures in Japan towards unemployment insurance and other social safety net provisions could help materially to foster the structural changes that Japan now so desperately needs,” BIS adds. Also, there is for fiscal prudence in normal times, to allow room for flexibility in less normal times, citing examples of fiscal imprudence in Europe and Asia, where the fiscal costs of bank restructuring may yet raise debt ratios to dangerously high levels.

And if the deficit has to rise for cyclical reasons, a medium term plan to restore fiscal stability over time is also needed (a Keynesian policy insight and recommendation). The BIS notes that legislation to ensure such an outcome has already been passed in a number of emerging market countries. – SUNS5156

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