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.”
Resource:
