Bank for International Settlements (BIS) warning on stimulus spendings

July 5th, 2009

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This week, the Bank for International Settlements (BIS), which is known as the central bankers’ central bank, warned governments all over the world from getting carried away with economic ‘stimulus’ spending. The BIS is the only international body that had correctly anticipated the global financial crisis (GFC) and warned of another great depression back in June 2007, when they released their 77th annual report (see Bank for International Settlements warns of another Great Depression).

In the 79th annual report, they warned,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly. External constraints could also bind for some countries. Particularly in smaller and more open economies [e.g. Australia], pressure on the currency could force central banks to follow a tighter policy than would be warranted by domestic economic conditions.

In other words, if economic stimulus spending failed to re-ignite economic growth, the bond vigilantes will lose their patience and make governments accountable. This means they will sell down government bonds, resulting in rising long-term interest rates. As a result, governments will find it harder and harder to raise money to spend in order to ‘stimuluate’ the economy further.

From this point, there can be two choices for governments:

  1. Cut spendings and raise taxes
  2. Print money

In a stagnating economy (with high household debts), we doubt the government will have the guts to undertake option (1). In Australia, judging from the howls of protests over the latest budgets, it is clear that the masses will not tolerate government austerity. The only alternative will be to undertake option (2)- printing money.

For countries like Australia, as we highlighted in bold in the above quotation of the BIS report, there is an added risk. Should there be any run on the Australian dollar, the RBA will be forced to raise interest rates regardless of how bad the domestic conditions are. With the Rudd government promising the moon (see Australian government?s contingent liability to exceed AU$1 trillion),the risk is that should they be required to deliver the moon, the Australian dollar will come under immense pressure and the Australian government bonds can be relegated to junk bonds.

At this point in time, the BIS is not sure whether stimulus spendings will work,

An open question as of this writing is whether the expansionary set of policies enacted in response to the sharp contraction in economic activity in late 2008 and early 2009 will succeed in stabilising the economy. A major cause for concern is the limited progress in addressing the underlying problems in the financial sector. The experience of the Nordic countries in the 1990s and other historical episodes suggest that a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuild its capital base. These conditions are not being met. A significant risk is therefore that the current stimulus will lead only to a temporary pickup in growth, followed by protracted stagnation. Moreover, a temporary respite may make it more difficult for authorities to take the actions that are necessary, if unpopular, to restore the health of the financial system, and may thus ultimately prolong the period of slow growth.

Without the financial system restored to health, it will result in economic stagnation, which will result in even more government economic stimulus, which eventually can only be financed by printing money. Evemtually, if this goes on, it will be, as we wrote in Supplying never-ending drugs till stagflation

Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ?printed.? That is the nightmare of stagflation (low or negative real growth with sky-rocketing price inflation- look at Zimbabwe).

Currently, we are in this “temporary pickup in growth” stage.

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  • David

    The other problem not mentioned here (and I wonder if it is mentioned in the BIS report) is peak oil. Some interpretations of the 08 Bust put $147 bbl oil as a tipping point phenomenon that led to the crash. What is the cut off point for oil price to squelch a recovery?

    Right now there is an oil glut and prices might fall significantly, but part of the problem peak oil is the mismatch of supply and demand and how they interact with economic activity leading to wider swings and miss allocations of resources. Regardless of the price of oil at any given time, or whether oil peak has happened, or will happen in 5 or 10 years, the world is about at the point where supply and demand don’t meet at a “cheap oil” level.

    My question really is, without a new supply of cheap energy that can do all the things oil and natural gas can do, aren’t we looking a stagnation and negative growth anyway, just because of our energy problem let alone our liquidity, solvency, and fiscal ones?

  • David

    The other problem not mentioned here (and I wonder if it is mentioned in the BIS report) is peak oil. Some interpretations of the 08 Bust put $147 bbl oil as a tipping point phenomenon that led to the crash. What is the cut off point for oil price to squelch a recovery?

    Right now there is an oil glut and prices might fall significantly, but part of the problem peak oil is the mismatch of supply and demand and how they interact with economic activity leading to wider swings and miss allocations of resources. Regardless of the price of oil at any given time, or whether oil peak has happened, or will happen in 5 or 10 years, the world is about at the point where supply and demand don’t meet at a “cheap oil” level.

    My question really is, without a new supply of cheap energy that can do all the things oil and natural gas can do, aren’t we looking a stagnation and negative growth anyway, just because of our energy problem let alone our liquidity, solvency, and fiscal ones?

  • Hi David!

    Yes, Peak Oil is another spanner in the works. In fact, Dr Steve Keen, who is strongly in the deflation camp, believes that Peak Oil can potentially turn the outcome into inflation.

  • Hi David!

    Yes, Peak Oil is another spanner in the works. In fact, Dr Steve Keen, who is strongly in the deflation camp, believes that Peak Oil can potentially turn the outcome into inflation.

  • David

    Hi CIJ,

    Your comment reminds me of a vocabulary question I have. Is there some way to distinguish inflation that is driven by something like commodity price rise (especially oil) and inflation that is driven by central bank money creation. The Austrian School of Economics (ASofE) suggests that inflation should mean the inflation of the money supply (and the costs of goods rising may be a symptom of that, but rising prices is not what the inflation is). Rising prices of oil, and all the things oil is in, because of legitimate supply and demand dynamics is not really inflation by the strict definition of the ASofE, as far as I can tell, but what is a better term for it that gets at the underlying cause?

    This reminds me of another question. Inflation, disinflation, deflation, etc are all terms that want to capture system scale macroeconomic phenomenon, and they are often used in ways that make it seem like you can’t have this one if you have that one. But, it seems like the US is entering a phase where it may have different asset classes and sectors behaving differently in terms of these macro level trends. For example, even as the US money supply changes up and down over the next few years, I expect food prices and energy prices in the US to rise in general, and housing prices and stock prices in the US to decline in general. Maybe it is a monetary phenomenon in the sense that the part of the money supply for home purchase and stocks purchase has declined because mortgages are harder to get and the crashing stock market and increasing unemployment has made investment money scarce, while the supply of money for food and energy has gone up in some way particularly because the increased savings rate (up 10% in the US) will make food and energy purchasing less elastic as consumers will have more savings to tap into to buy these products.

    So, in addition to my question at the beginning, what is a way to understand (and talk about clearly) contradictory macro level phenomenon? And is it legitimate to understand different components of the economy having different monetary directions (less money for housing, more money for food)?

    Thanks!

  • David

    Hi CIJ,

    Your comment reminds me of a vocabulary question I have. Is there some way to distinguish inflation that is driven by something like commodity price rise (especially oil) and inflation that is driven by central bank money creation. The Austrian School of Economics (ASofE) suggests that inflation should mean the inflation of the money supply (and the costs of goods rising may be a symptom of that, but rising prices is not what the inflation is). Rising prices of oil, and all the things oil is in, because of legitimate supply and demand dynamics is not really inflation by the strict definition of the ASofE, as far as I can tell, but what is a better term for it that gets at the underlying cause?

    This reminds me of another question. Inflation, disinflation, deflation, etc are all terms that want to capture system scale macroeconomic phenomenon, and they are often used in ways that make it seem like you can’t have this one if you have that one. But, it seems like the US is entering a phase where it may have different asset classes and sectors behaving differently in terms of these macro level trends. For example, even as the US money supply changes up and down over the next few years, I expect food prices and energy prices in the US to rise in general, and housing prices and stock prices in the US to decline in general. Maybe it is a monetary phenomenon in the sense that the part of the money supply for home purchase and stocks purchase has declined because mortgages are harder to get and the crashing stock market and increasing unemployment has made investment money scarce, while the supply of money for food and energy has gone up in some way particularly because the increased savings rate (up 10% in the US) will make food and energy purchasing less elastic as consumers will have more savings to tap into to buy these products.

    So, in addition to my question at the beginning, what is a way to understand (and talk about clearly) contradictory macro level phenomenon? And is it legitimate to understand different components of the economy having different monetary directions (less money for housing, more money for food)?

    Thanks!

  • Hi David!

    A good suggestion will be to use the definitions used in this article: Cause of inflation: Shanghai bubble case study.

  • Hi David!

    A good suggestion will be to use the definitions used in this article: Cause of inflation: Shanghai bubble case study.

  • pb

    Hi,

    when you say the government has the option of ‘printing money’ do you mean physical notes and coins? do you have any articles on how the process of printing physical money works and what regulations are in place to control it??

  • pb

    Hi,

    when you say the government has the option of ‘printing money’ do you mean physical notes and coins? do you have any articles on how the process of printing physical money works and what regulations are in place to control it??

  • Hi pb!

    when you say the government has the option of ‘printing money’ do you mean physical notes and coins? do you have any articles on how the process of printing physical money works and what regulations are in place to control it??

    The phrase “printing money” is more metaphorical than literal because we live in a modern age of electronic money.

    We have quite many articles describing the various aspects of “printing” money. Maybe you can start with What are exchange settlement funds? as the starting point. Then we will go on from there.

  • Hi pb!

    when you say the government has the option of ‘printing money’ do you mean physical notes and coins? do you have any articles on how the process of printing physical money works and what regulations are in place to control it??

    The phrase “printing money” is more metaphorical than literal because we live in a modern age of electronic money.

    We have quite many articles describing the various aspects of “printing” money. Maybe you can start with What are exchange settlement funds? as the starting point. Then we will go on from there.

  • alan

    “Yes, Peak Oil is another spanner in the works. In fact, Dr Steve Keen, who is strongly in the deflation camp, believes that Peak Oil can potentially turn the outcome into inflation.”

    The reasons behind such a bout of inflation however would be different – this would stem from having less goods to go around. But I’m a bit more optimistic – the planet probably has another few decades worth of energy supplies.

    I’m actually more convinced of the deflation outlook – monetary contraction is still continuing, despite extraordinary efforts on the part of central bankers. At least in the short to middle term, hyperinflation is unlikely i.m.o. – so this is a bit like the Japanese scenario, but it’s also very different.

  • alan

    “Yes, Peak Oil is another spanner in the works. In fact, Dr Steve Keen, who is strongly in the deflation camp, believes that Peak Oil can potentially turn the outcome into inflation.”

    The reasons behind such a bout of inflation however would be different – this would stem from having less goods to go around. But I’m a bit more optimistic – the planet probably has another few decades worth of energy supplies.

    I’m actually more convinced of the deflation outlook – monetary contraction is still continuing, despite extraordinary efforts on the part of central bankers. At least in the short to middle term, hyperinflation is unlikely i.m.o. – so this is a bit like the Japanese scenario, but it’s also very different.

  • Dan

    Surely the inflation scenario is almost impossible in the short term? The primary problem has come about through the banking system obtaining too large a share of the economy – those who borrow are no longer credit worthy. Central banks undertaking “quantitative easing” and lending funds to banking institutions does nothing to address this imbalance, indeed it makes things worse. Until the economy recovers this balance by reducing the proportion of funds held by banks, it looks rather like disinflation or even deflation will be almost inevitable. Now if the bailout funds were distributed to ordinary people…that would be more useful as a recipe for inflation! I suspect real sustained inflation will be a political decision, either forced on us by bond markets, or decided on by governments as a response to high unemployment.

    Am I right in thinking the compound interest paradox makes this situation inevitable? As all funds in our system are created by lending them through central banks, but the funds to pay interest are not created, eventually the banking sector will own everything? Not just a possibility but a mathematical inevitability!

  • Dan

    Surely the inflation scenario is almost impossible in the short term? The primary problem has come about through the banking system obtaining too large a share of the economy – those who borrow are no longer credit worthy. Central banks undertaking “quantitative easing” and lending funds to banking institutions does nothing to address this imbalance, indeed it makes things worse. Until the economy recovers this balance by reducing the proportion of funds held by banks, it looks rather like disinflation or even deflation will be almost inevitable. Now if the bailout funds were distributed to ordinary people…that would be more useful as a recipe for inflation! I suspect real sustained inflation will be a political decision, either forced on us by bond markets, or decided on by governments as a response to high unemployment.

    Am I right in thinking the compound interest paradox makes this situation inevitable? As all funds in our system are created by lending them through central banks, but the funds to pay interest are not created, eventually the banking sector will own everything? Not just a possibility but a mathematical inevitability!

  • Hi Dan!

    Yes, inflation is not likely in the short term. But will be a problem in the longer term. See Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view.

    Am I right in thinking the compound interest paradox makes this situation inevitable? As all funds in our system are created by lending them through central banks, but the funds to pay interest are not created, eventually the banking sector will own everything? Not just a possibility but a mathematical inevitability!

    The interest rates to pay the borrower fund will ultimately come from more credit somewhere in the economy. Therefore, only way to keep this jig running is for economy to keep on growing non-stop and/or inflation. Once inflation or economic growth stalls, the system will break down.

  • Hi Dan!

    Yes, inflation is not likely in the short term. But will be a problem in the longer term. See Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view.

    Am I right in thinking the compound interest paradox makes this situation inevitable? As all funds in our system are created by lending them through central banks, but the funds to pay interest are not created, eventually the banking sector will own everything? Not just a possibility but a mathematical inevitability!

    The interest rates to pay the borrower fund will ultimately come from more credit somewhere in the economy. Therefore, only way to keep this jig running is for economy to keep on growing non-stop and/or inflation. Once inflation or economic growth stalls, the system will break down.