Saturday, November 24, 2012

The mismatch of time horizons and financial cycles

Claudio Borio of the BIS has provided an interesting paper "On time, stocks, and flows: Understanding the global economic Challenges" which may be one of the most thought provoking research pieces for investors trying to understand the current environment.

We have been through the Age of Stagflation, the Great Moderation, the Age of Turbulence, The Great Recession, but we are now entering a new area, the Age of Policy Drama.  Borio takes a economic historian's view of the crisis and concludes that the time between economic cycles and policy behavior is not in sync, so we have a disconnect that cannot be easily solved.

In Burns and Mitchell’s terminology, economic time has slowed down relative to calendar time. That is, the macroeconomic developments that matter take much longer to unfold...Yet the planning horizons of market participants and policymakers have not adjusted accordingly – indeed, if anything, they have shrunk.

There seems to be less patience with policy-makers. I want a solution and I want it now without any pain.

Stocks build up above trend during financial booms, as credit and asset prices grow beyond sustainable levels, and generate stubborn overhangs once the boom turns to bust. Stocks raise serious policy challenges. In the presence of policy responses that react too little to booms and too much to busts – in jargon, that are asymmetric – stocks grow over consecutive business cycles.

If this diagnosis is right, the remedy is not hard to find, although it may be extraordinarily difficult to implement. In a nutshell, it is to lengthen policy horizons, to put in place more symmetrical policies, and to tackle the debt problems head-on.

Borio argues that the financial busts we saw in 2008 are not dissimilar to what we have seen in other financial crises. These earlier financial crises do not have derivatives or the Wall Street of today, yet there were crises. there is something inherent within the economic system that leads to boom and then busts. Historian have noted this is the past.

There are some similar characteristics to all financial cycles.

First, there are imbalances based on excesses. Excess credit and excess borrowing. The excess could be caused by financial liberalization. This could regulation or it could just be looser credit, but there are fewer constraints on the financial excess.

Second, there is a regime of stable and low inflation which provides the view that the central bank is credible and and there are limited risks in the system, This has been called the paradox of creditability.

Third, globalization makes the world more sensitive to supply shocks. Changes in the global environment can carry over to other parts of the globe.

Government have focused on the micro prudential issues of how to regulate a bank and not on the systematic issue of how the protect an economy. The macro risks of a financial cycle will actually grow. For example, monetary policy focused on the equity markets during the crash of 1987 and the dotcom boom and not on the overall credit conditions of credit expansion and property values. The focus on the micro lead to further excesses toward the financial cycle.

A financial cycle decline leads to a balance sheet recession and not a classic inventory recession. Hence, if you fight with tools and a view toward business cycle problems, you will addressing the wrong problem. The focus has to be on balance sheet repair.

In a balance sheet recession, fiscal and monetary policy may not be effective as in an inventory recession. First, fiscal policy may not prime aggregate demand because balances sheet will be in repair. Spending will decline. Monetary policy will not be effective because the balance sheet of financial institutions will be in disarray. Lower rates will not serve as a solution. Liquidity will be needed but driving rates to zero is not the solution.

Are there clear solutions to the problem. There are clear policies that can help repair balance sheets, but to avoid the financial cycle in the first place there needs to be a macro buffer to slowdown growth and financial excesses during the boom period.

Navigating the tricky waters ahead will require a balance between Gramscian “pessimism of the intellect and optimism of the will”: pessimism to assess the challenges ruthlessly, never underestimating them; optimism to overcome them. And, as the late Tommaso Padoa Schioppa stressed, it will require a long- term view. 

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