A more balanced policy mix for a sustainable economic growth

Original quotes from interview with Mr Claudio Borio, Head of the Monetary and Economic Department of the BIS, with Il Sole 24 Ore, conducted by Mr Riccardo Sorrentino and published on 30 June 2019.

BIS speech  | 
04 July 2019

Sustainable growth: that is the catchword that summarises the 2019 Annual Economic Report that the Bank for International Settlements (BIS) has presented today in Basel. It is the view that Claudio Borio, Head of the BIS's Monetary and Economic Department, conveys in an interview with Il Sole 24 Ore. "The key message is that we need sustainable growth. In order to have sustainable growth, we need a more balanced policy mix. And that policy mix has to have a longer-term horizon," he says.

Why do we need sustainable growth? What risks do you see to global economic activity?

I would say that one obvious risk has to do with the escalation of trade tensions and the broader political environment. An escalation would threaten the open multilateral trading system that has served the global economy so well in the postwar era. In addition, there are some countries where the political situation, in terms of the potential implications for the economy, is something to be watched. The second big issue has to do with China. The fact is that, there, the authorities are engaged in an unprecedented balancing act between inducing the necessary deleveraging of the economy and avoiding a slowdown in growth. And last year growth did slow down, so it is a kind of "push and pull".

Finally, in one third of the world economy, including China, the financial cycle has turned, and that could mean headwinds ahead. That's mainly in the countries that were not at the heart of the Great Financial Crisis (GFC) of 2007-09. But more generally, debt in the global economy in relation to GDP has continued to increase since the GFC: both public sector debt and private sector debt, meaning household and corporate debt. Corporate debt, in particular, is something to watch very closely.

The other thing to bear in mind is that, interestingly enough, while the authorities have done a lot of good and successful work to strengthen the capitalisation of the banking sector, in many jurisdictions bank profitability is quite weak. That is important, because profitability is the first line of defence against losses and the main source of capital for the banks - essential to lending and to supporting the economy.

You mentioned a more balanced policy mix. So far central banks have borne the burden of stimulating the economy. Can we go on with the same recipe?

We are concerned about a certain general perception that seems to be out there: that central banks and monetary policy specifically can be the engine of sustainable - and let me stress sustainable - growth. This is the expectation that whenever something happens, central banks will be there to take care of it - whenever growth slows and for whatever reason, you can count on them to push it back up. This is not the right recipe, because it is a recipe for monetary policy to lose its room for manoeuvre - as to some extent it already has - a recipe for policy to have diminishing returns and to generate growing unwelcome side effects over time. This policy mix cannot ensure a sustainable expansion. That's why in the Annual Economic Report we say that it is important to ignite all four engines: we talk about monetary policy, but we also talk about macroprudential policy, we talk about fiscal policy and, above all, we talk about structural policy. A plane cannot fly on one engine only.

Is fiscal policy still an option in the current context of high sovereign debt?

We have to be careful about two things. First, many countries don't have fiscal space, or at least not enough for an expansion of fiscal deficits to be prudent because they have been running out of it. And when you have it and use it, it is better to use it for structural types of measures as opposed to short-term turbo-boosting. It is important to bear in mind that a key reason why public sector debt-to-GDP ratios are at a peacetime high in so many countries around the world is precisely because authorities have not been able to consolidate in good times. So, policy has been asymmetrical over the business cycle. This is something that has to be avoided at all costs. Otherwise, in the future we will find ourselves in an even worse situation.

What could a government do if it doesn't have fiscal space?

If you don't have fiscal space, you have to regain it - and that requires judicious policies. I know that these are not very popular, but one should not be lulled into a false sense of security by extraordinarily low interest rates. When debt levels are already very high, borrowing more could actually make matters worse and be a drag on the economy. In addition, it would make it harder for central banks to raise interest rates when needed, as this could generate strains in the fiscal position. So, if you want to protect the monetary policy room for manoeuvre and safeguard central banks' autonomy, which is so valuable, ie avoid fiscal dominance, having a very large government debt in relation to GDP is not the way to go.

Could the huge monetary base, of liquidity, provided by central banks, become a source of tension?

The monetary base is not a particularly useful concept to understand what happens to the money supply. The key anchor of our monetary systems is the interest rate. I don't think it would matter so much how large the monetary base is, in terms of the impact on economic activity. What is more important is how much and what the central bank buys as a counterpart to the increase in the monetary base. At the end of the day, it is the combination of large central bank asset purchases and very low, sometimes negative, interest rates for very long that contributes to some of the vulnerabilities we have seen - vulnerabilities in terms of risk-taking, of increases in debt and of low bank profitability. Obviously, even if the short-run impact of monetary policy on banks is positive because it can boost economic activity and asset prices, these effects are temporary. In the longer term, what stays is lower interest margins. Slowly over time, the longer that interest rates remain low, the more difficult it is for banks. Just look at Japan. That's one of the reasons, not the only reason, why banks are not as profitable as we would like.

What can the banking system do to become more profitable in this situation?

It is important that banks get their act together. An environment in which interest rates are low and are likely to stay low for a long time, in which there is excess capacity in some jurisdictions, and in which in some cases legacy problems - bad debts - have not been eliminated, is an environment that is likely to give rise to growing challenges over time. Addressing them requires finding the right business models, taking advantage of new technologies, succeeding in cutting costs, and consolidating where there is such a need. In the Annual Economic Report, we also have a chapter on the big techs - another looming threat for banks that is providing yet another reason for them to adjust. Of course, the authorities too have a role to play: they can encourage banks to sort out their bad loans. To the extent that there is excess capacity in the sector, they can make sure that mechanisms for an orderly exit are in place. And they can facilitate cross-border mergers, without trying to create national champions. Moreover, going back to the structural measures, it is important to make labour markets more flexible so that banks can adjust more easily.

According to some economists, a struggling banking sector and an accommodative monetary policy for a long time could create zombie firms, companies that in a "normal" environment would not be able to survive. It is really a problem? And how can we handle it?

In the Report, we use a definition of zombie firms which is narrower than that of the OECD, and on that basis we found that the number of listed companies in the sample of countries that we look at is about 6%. So, one should not overemphasise the issue. But our figures do not include non-listed companies. And zombie firms are not a problem just for themselves, they are a problem for the rest of the economy because they absorb resources that could be used more productively by other companies. Therefore, directly and indirectly, they have an impact on productivity. They might even put downward pressure on inflation, as firms that are kept alive by generous funding undercut rivals - an aspect worth investigating. The very accommodative monetary policy is one factor contributing to the existence of zombie firms; bank balance sheets saddled by non-performing loans is another - and the two are not unrelated. Ultimately, of course, what you would like to do is to get higher sustainable growth, and that basically goes back to our call for a more balanced policy mix.

It seems that a prolonged accommodative monetary policy has a lot of side effects. When will monetary policy get back to "normality"?

You need two conditions. An obvious one is that the economy does well. An even more important one, given central bank mandates, is higher inflation, and this is really the billion dollar question. We have seen that despite the fact that economies have been operating very close to potential - and in some cases even beyond standard estimates of potential - inflation has remained subdued. For a long time, this was because wages were very sluggish. And once wages started to increase at a more solid pace, it was the turn of prices not to adjust. Firms have been absorbing the increase in wages by cutting other costs or by squeezing profit margins.

This cannot go on forever. The so-called Phillips curve is not completely dead: it is dormant. At some point it will wake up, but it could take quite some time. To me, the biggest question we need to ask ourselves is: what is driving inflation? More specifically, to what extent are some of the driving forces not so much cyclical, but rather more structural and longer-term? At the BIS, we have been stressing the role of two forces. One is globalisation, which is still playing itself out, partly by depriving labour of its bargaining power and firms of their pricing power. The other force is technology, which operates in a similar way and whose role is undeniably growing. These are big questions that we need to answer before we can understand what the right monetary policy framework should be and how to adjust or refine current ones.

Globalisation and technology are two structural phenomena. Is it correct to use monetary policy, a typical tool for managing aggregate demand, to minimise their effects?

Central banks are trying to understand how far low inflation is an effect of globalisation or technology and how far it is the effect of the weakness of demand. In order to respond appropriately, clearly you need to get a sense of which of these two forces is at play. This is because they are benign forces: in one way or another they are engines of growth. Thus, to the extent that you regard these forces as important, you can afford to be more tolerant of shortfalls of inflation from strict objectives, to allow more time to get inflation back to target. In fact, some central banks have been moving in that direction - in Norway, Australia, Korea and Thailand, for example. But these are not the big central banks.

It is quite a new economic world. What has changed?

It is very important to understand that the nature of the business cycle has changed. Until the early 1980s in the postwar era, we had a very clear pattern: inflation would go up, central banks would tighten, and then the downturn would take place; meanwhile, nothing much would happen to credit. After that, as we have discussed in the Report, nothing much would happen to inflation, and nothing much would therefore happen to interest rates, but a big financial expansion would turn into a contraction. And so policy needs to adjust to this seismic change in how the economy works, which in a way is closer to what used to be the case during the previous globalisation era: the gold standard and up to the pre-1930s. I think this shift has not yet been fully recognised.