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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