Monday, December 15, 2014

BIS Annual Report 2013 – How to tackle a balance sheet recession

In its annual report for 2013, the Bank for International Settlements writes that we are in a balance sheet recession. It also proposes ways how we should tackle it. Here are the essentials.

What is a balance sheet recession?

The last financial cycle ended in 2009 and gave birth to a balance sheet recession. The BIS explains what a balance sheet recession is, using three key features:

  • A balance sheet recession is very costly and tends to be deeper, gives way to weaker recoveries, and results in permanent output losses, i.e. output may return to its previous long-term growth rate but hardly to its previous growth path.
  • It is less responsive to traditional demand management measures because banks need to repair their balance sheets. As long as asset quality is poor and capital meager, banks will tend to restrict overall credit supply and, more importantly, misallocate it.
  • Overly indebted agents will pay down debt and save more instead of spending. As one agent’s spending is another’s income, a balance sheet repair logically depresses income and value of asset holdings.

How can we tackle a balance sheet recession?

The first priority is to repair balance sheets by reducing debt. In the BIS' view, many countries have not completed this task yet. As a matter of fact, private and public sector debt levels remain high in many countries.

Second, countries should implement structural reforms, allowing resources to transfer from unprofitable to profitable sectors and, thus, raising the economy's productivity and growth potential.

Unless productivity growth picks up, the prospects for output growth are dim.”

More specifically, structural reforms can consist of

  • deregulating protected sectors, such as services;
  • improving labor market flexibility;
  • trimming public sector bloat; and
  • putting the fiscal house in order.

Which role plays monetary policy when it comes to balance sheet recoveries?

In short, extraordinary monetary policy is not the right tool for achieving a balance sheet recovery. Even though it is the first means to combat a financial crisis, it does, at the same time, encourage bad debt taking, through keeping interest rates low. Therefore, central banks need to pay attention to the risks of exiting too late and too gradually.

Low interest rates do not solve the problem of high debt. They may keep service costs low for some time, but by encouraging rather than discouraging the accumulation of debt they amplify the effect of the eventual normalization.”

After so many years of an exceptional monetary expansion, the risk of normalizing too slowly and too late deserves special attention.”