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Global monetary policy has been “ultra-easy” for many years. Yet it is becoming clear it is now caught in a debt trap of its own making.
Continuing on the current monetary path is ineffective and increasingly dangerous. But any reversal also involves great risks. It follows that the odds of another crisis blowing up continue to rise.
It is to be hoped that the preparations being made by policymakers to manage such a situation are evolving at the same pace. Simply crossing your fingers and praying that “it might never happen” would seem imprudent, to say the least.
Carrying on with current monetary policy brings with it the threat of inflation. And given economists’ lack of understanding of either the level of “potential” or the inflationary process itself, it could easily get out of hand.
However, inflation is not the only danger. First, debt ratios have been allowed to rise for decades, even after the crisis began. Moreover, whereas before the crisis this was primarily a problem of the advanced economies, it has since gone global. Second, tolerance of risk-taking threatens future financial stability, as does the narrowing of the profit margins for many traditional financial institutions. Third, the misallocation of real resources by banks and other financial institutions is encouraged by this monetary environment. With markets unable to allocate resources properly, due to the actions of central banks, the likelihood that rising debt commitments will not be honoured has risen sharply.
Unfortunately, normalising monetary policy also carries significant risks. Clearly, a strengthening global economy is preferable to a faltering one. Yet, in such a situation, rising inflationary pressures would likely lead to a monetary tightening that could have destabilising effects.
An unintended consequence of regulatory reforms has been to reduce market liquidity. Even in the absence of inflationary pressures, financial markets themselves might react in a disorderly way to signals of stronger growth. Sovereign bond yields in advanced countries are at historically low levels and are ripe for a reversal. If they do start heading in the opposite direction, this could have important implications for the over-extended prices of many other assets.
What action should prudent policymakers take to prepare, in advance, for such an outcome? National governments and central banks, in association with international organisations, should be negotiating memorandums of understanding about who does what in a crisis. “War games” would be a useful adjunct to this. And measures to ensure that adequate levels of liquidity can be provided to stabilise markets and the financial system are also crucial. As things stand, in the US for example, many provisions of the Dodd-Frank act, passed in the wake of the financial crisis, would hinder the Federal Reserve in attempts to provide both domestic and international liquidity.
Perhaps most important is the need for governments and international forums to revisit bankruptcy procedures. Debt that cannot be serviced will not be serviced. Governments must enact legislation to ensure this can happen in as orderly a way as possible. Unfortunately, recent work at the OECD indicates that bankruptcy procedures for private agents fall some way short of best practice in many countries. Nor, despite great efforts, have we adequately improved our legal capacity to deal in an orderly way with banks that are no longer viable, but are still “too big to fail”. Procedures for the restructuring of sovereign debt are inadequate too.
It is essential we take measures now to limit the likelihood of disorder in markets in the next downturn. Early action to help resolve the debt overhang problem might even serve to reduce the likelihood of that downturn occurring. This need for preparatory action is amplified, given our scope for reacting with counter-cyclical macroeconomic policies is now limited. These policies might spark the disorder we wish to avoid. Far better then to prepare for the worst, even as we hope for the best.
The writer is chairman of the economic and development review committee at the OECD