What’s up everybody? The intro to this week’s episode was recorded
while I was on vacation in Greece, from a studio in Athens. I recorded the intro before I got my guest’s
audio from his side of the conversation. This episode was done remotely, and we had
some issues with the sound. My editor worked on it over the course of
last week, so we weren’t able to release it, but I think it shouldn’t be an issue. I’m kind of OCD with the quality of the audio
on Hidden Forces, as I am with all the quality at Hidden Forces. We were super lucky to have the Head of the
Monetary and Economic Department at the BIS on the program for an hour and a half. I don’t want to belabor this anymore. I’m going to give you guys a full detailed
explanation for why I wanted to release this early originally, and how prescient that the
episode is, in the intro that you’re about to hear. And also, everyone, if there were ever an
episode for you to subscribe to the Super Nerd tier on our Patreon page, this is the
one. The rundown for this episode is super valuable. I put a lot of time into it. Put a lot of links, a lot of citations. And besides the fact that I spent the weekend
reading my guest’s papers and work, I’ve spent the better half of my life reading the type
of material that we talk about in this episode. So, if you want access to that, if you want
access to the transcript of this week’s episode, and if you want access to the overtime where
we discuss the BIS 2019 report, you can head over to patreon.com/hiddenforces, and get
access to all of those. I don’t want to delay you any longer. With that, please enjoy this week’s episode. What’s up everybody? The conversation you’re about to hear was
recorded on Monday, August 19th, a few days before the annual Jackson Hole Economic Symposium. It wasn’t my intention to release this audio
until next week. I’ve actually been on vacation in Greece,
so I’m recording this intro from a studio in Athens. But, the contents of Chairman Powell’s speech
on August 23rd, as well as a Twitter thread published by former Treasury secretary, Larry
Summers, the day before, where he talked about the black hole problem of secular stagnation,
or Japanification, really motivated me to get this out early. Because I felt like this conversation was
super prescient given what Powell and Summers talked about, and how they broke down the
history of monetary policy in these different eras, and focusing on the lessons learned
from the stagflationary period of the 1970s and the great moderation of the 1990s to now,
this current period, and trying to really understand what type of economic environment
are we in. What’s driving the slow growth? Are rates low because central banks are keeping
them low? Or are they low because of the enormous buildup
of private sector debt? And have central banks basically gone from
being stewards of the expansion of the financial system to now being managers of the de-leveraging,
the de-leveraging of three decades of credit-fueled economic expansion where financial cycles
and asset booms have increasingly become the main drivers of the business cycle and where
central banks could well be stuck in a debt trap where they can only raise rates so far
before they tip the economy back into deflation, which is what I mean when I talk about the
managing the de-leveraging. And this, of course, leads to a conversation
about inflation and where central banks got these models of targeting the neutral rate,
and how this relates to price levels and unemployment, and just a super interesting discussion about
how central banks see the world, the origins of the models they use to perceive it, how
these models evolved, how they were updated and informed by each of these successive eras
that Powell mentions in his speech, how by focusing on inflation and seeing that inflation
was low, central banks may have kept interest rates below the natural rate for years, increasing
financial instability during a period where everything seemed more or less perfect. This was the Goldilocks economy, not too hot,
not too cold, but just right. And yet, my contention is that perhaps the
price stability of the Great Moderation led, a la Minsky, to financial instability through
a buildup of leverage in the financial system, which led to the great financial crisis from
which we are still recovering and whose de-leveraging process, I contend, central banks may now
be actively managing, and that this is the dominant paradigm of today’s global economy. And that is important as demographics and
trade and politics are, that these are not the forces of economic gravity that central
banks have been fighting against, and which are making it increasingly difficult to bring
interest rates back to anything we would consider to be historically normal. So this is what I speak about with my guest,
the Head of the Monetary and Economic Department at the Bank for International Settlements,
Claudio Borio, who has been at the BIS since 1987, and whose contributions to the academic
debate in this field are immense. I spent the entire weekend before this recording,
reading paper after paper that he’s written going back to 2002. His work really resonated with me. It’s very empirical, and although I was very
direct with my questions, he was very measured in his responses. And so, I think the conversation really provides
for some interesting insights into some of the topics I mentioned earlier. And I think again, it’s quite prescient, given
the news surrounding Jackson Hole, and I think, if you want a deeper perspective, and if you
want more context in order to understand what’s happening in the global economy today, and
what some of the recent financial market volatility might be reflecting, I highly suggest you
listen carefully to this episode. Read between the lines. Read Powell’s speech. I link to it, as well as to Summers’ Tweets
in this week’s rundown. And also, spend some time on the BIS website
and start going through some of these papers. The 2002 paper I mentioned is titled Asset
Prices Financial and Monetary Stability. There’s also a great chapter in the BIS quarterly
review from December 2018 titled The Financial Cycle and Recession Risk. And of course, I’ve read the 2019 Annual Report,
and we discuss some of those insights in our overtime, and I’ve extracted and highlighted
portions of it in this week’s rundown. And so, without further ado, here is my conversation
with head of the monetary and economic department at the Bank for International Settlements,
the central bank of central banks, Claudio Borio. Dr. Claudio Borio, welcome to Hidden Forces. Thank you for having me. It’s great having you on. I was telling you that there’s a risk that
this conversation will evolve or devolve into a geek fest. So, I’m going to do my best to try and rein
us in and not get too wonky. That’s my objective here in this conversation. I also told you how much I read of your work,
way more than I expected, and I just kept going, because I ended up having … It was
just super interesting to me. We’re going to try to, I think, in this conversation,
begin with your framework for understanding the economy and perhaps challenging some of
the conventional frameworks, and then we can perhaps try to move forward and apply some
of these into the economy as it is today. But, maybe I can ask you off the top, what’s
been the focus of your research? What are you primarily focused on today? Well, if you take a long-term perspective,
I would say that the primary focus of my research has been to try and understand what the relationship
between finance and the financial system, the monetary aspects of the financial system,
of course the monetary system, the relationship between that and the real economy, which is
something I would say that since the 1990s, at least until recently, faded very much into
the background of the economics profession. So how has central bank, not policy, but the
models that central bankers use and they apply in order to make decisions about how to act
in the economy, how have those evolved since at least the second World War, could you maybe
give us some sense of that? Because I think that’s relevant to our conversation
today. Well, since the second World War, that goes
a long way back, but I would say that after the second World War, and for a long time,
there was a sense that monetary policy didn’t have much impact on the economy, and people
are focusing more on the impact of fiscal policy. That, we should also remember, was the world
in which the financial system, in general, was highly repressed, and as a result of that,
some of the aspects that we have been focusing on for the last, I would say, 10 years or
so, were not really that important. In any case, you had a financial system that
was heavily repressed. Financial factors were not playing a big role. For quite some time, because of the reconstructions
needed after the war, the pent-up demand, pent-up investments, economies did very well. They grew fast. And there wasn’t much inflation. Then, we got to the late ’60s, ’70s, the big
problem for the world economy was high inflation, which by the way, historically, I know we
may come back to this, very high inflation in peace time is the exception as opposed
to the rule. And then at that point, you had the very big
debate between the monetarists and the Keynesians, where the Keynesians would say, “Well, monetary
policy doesn’t really have a very inspecific role,” whereas the monetarists would say,
“Well, monetary policy is the key in order to bring inflation down.” So they were looking at cost push and demand
pull, the Keynesians versus the monetarists, people like Friedman, who said that, “Inflation
is everywhere and always a monetary phenomenon.” Exactly. Exactly. And that was a big debate. I would say that in the end, it was the monetarists
that won, at least when it came also to policy making. Now, a key tenet of the monetarists was that
by controlling the money supply, we would be able to control inflation. Now, in the end, what happened was that central
banks managed to control inflation, but the managed supply didn’t play as big a role as
the monetarists would have liked. And to cut a long story short, that basically
led, over time, to a monetary policy framework in which rather than trying to control inflation
through some kind of intermediate target like monetary targets, you started controlling
inflation … inflation targeting frameworks, simply by saying, “I’m going to aim to get
inflation, and I will the interest rate to whatever extent that’s necessary to do that.” That gained quite a lot of traction during
the 1990s. Now, in the background of all that, there
was the view that as long as inflation was slow and stable, the rest of the economy would
take care of itself so that the economy had strong self-equilibrating properties. Now, what the great financial crisis has shown
is that that assumption was not quite right. In fact, we had inflation that was slow and
stable all the way up to the crisis. And during that phase, what economists called
the Great Moderation, financial imbalances were building up, as a result of changes in
policy frameworks that we can discuss, and then that ended up in the financial crisis. Now, after that, there has been quite a lot
of soul searching about what the role of monetary policy is, what the role of other policies
is supposed to be, including supervisory policy and the like, and we’re still dealing with
those issues. They are still very much with us. What I would say is the key aspect that the
great financial crisis highlighted is that the system does not have a self-equilibrating
properties that people believed it had, and that a key reason for that is what happens
on the financial side. By the way, this is a lesson that, had you
actually looked at history going before the post-war period, even going as far back as
the gold standard, is something that would have been apparent to anyone looking at the
data and looking at the experience of those days. In other words, the post-World War II period
was the anomaly. Let me ask you something else, because this
is super interesting to me. I think these stagflationary period of the
1970s is more important and less remembered than most any other period in recent memory. I think one example of that is the impact
it had on policy makers focus, maniacal focus, if you really think about it, on inflation
targeting. What you’re describing, I think, is that throughout
the period of the ’90s and the early 2000s, the central banks were focused on inflation. Low inflation meant, for them, financial stability. And in fact, what you’re suggesting, and through
your work, as well, is that the low inflation, which led central bankers to keeping interest
rates low because they were worried about deflation or they thought, for example, that
they could keep the rates low, was actually a mistake. That, in other words, it led to a buildup
of financial imbalances in the economy. Can you elaborate on that a little bit? Yeah. First of all, I would not say that is a mistake. It could have been a mistake, perhaps. Let me sort of back up. I mentioned the changes in policy regimes,
and I think that that’s important. The way I tend to think about the evolution
of the dynamics of the global economy, the economy in general, is that the early or mid
1980s were a watershed because you had big changes in policy regimes on the monetary
side and the financial side, and later on I would say, particularly in the ’90s, on
the real side of the economy. That changed profoundly the dynamics of business
cycles and their relationship with inflation. Let me sort of elaborate a little bit on that. On the financial side, and this goes back
to what I was saying before, the big change was financial liberalization, which meant
that some of the mechanisms that basically lead the financial side of the economy to
amplify as opposed to dampen economic activity had much more room to play themselves out. The key mechanism there is the interaction
between liquidity constraints or ability to finance itself with asset prices and risk
perceptions. When the economy was highly regulated, the
financial side was highly regulated, these mechanisms were effectively pent up. They couldn’t actually take place. So the basic point here is very, very simple. It has been documented by a lot of research,
and it’s very intuitive. It’s the fact that if you have an expansion
of a credit, an expansion of financing, that allows you to spend not only on real assets
or in current consumption and current investment, but also on other assets, equities and, in
particular, real estate. That tends to raise asset prices. That, in turn, tend to ease financial constraints. And as asset prices increase, and credit increases,
also perceptions of risk tend to change. People think that the economy is on a sustainable
high growth path. At some point, these very strong increases
in credit, and asset prices, particularly property prices, lead to the buildup of these
financial imbalances that at some point have to unwind. So that’s one thing that changed on the financial
side. Before you continue, Dr. Borio, let me try
and summarize that just so I understand where you are. What you’re talking about is the financial
liberalization of the global economy after the end of Bretton Woods and the deregulation
of the 1980s opened up the pathways for credit to begin to build up in the financial system,
so that financial cycles began to become bigger drivers of the business cycle than they used
to be before, and you began to have secular growth in credit and debt globally. Correct. Correct. The second thing that happened, and this leads
to the inflation point that you mentioned earlier, is that inflation became low and
stable, and central banks adopted frameworks whereby they had no incentive to raise interest
rates as long as inflation was low and stable, because that was the key compass in their
policies. Moreover, at the same time, and this goes
back to what I said earlier, they started downplaying the role of monetary, and therefore
also credit aggregates, which tend to be closely associated with what happened. Can you explain that for our audience, the
distinction between the credit aggregates and the inflation number? Like, for example, the feds stopped measuring
M3 I believe in the early 2000s. Yeah, that’s right. I mean, first of all, I mean, credit and money
are not even the same thing. But, the basic point is that, as I mentioned
earlier, the relationship between money and inflation broke down particularly in the early
’80s, and so on. As a result of that, central banks started
paying less attention to that because if they wanted to keep inflation low, if you like,
looking at what was happening to monetary aggregates was more than it was effectively
a destruction. Now, there were differences in terms of how
far countries went and when they moved the way that they moved, but effectively that
was a general trend. In other words, they were able to grow monetary
aggregates without increase in consumer price inflation, for example, but asset price inflation
would grow. Exactly. And that was clearly something that happened
during this phase. So, you’ve had a liberalization. You had changes in the monetary policy regimes. And the third leg, if you like here, the third
element, which we have paid particular attention in our work, which we have stressed, is the
globalization of the real economy. By that, I mean primarily greater trade integration,
greater integration of the global economy, and in particular, the entry of former Communist
countries, the entry of China, the liberalization in emerging market economies, into the global
trading system. And these were countries where costs were
considerably lower than they were in advanced economies, countries that at the same time,
didn’t allow exchange rates to completely offset those costs, which meant that this
put, if you like, persistent downward pressure on inflation. So, what you had was a situation in which
you had these structural forces that were pushing inflation down, and at the same time,
by the way, they would also increase the rate of growth in the global economy because they
worked like a string of positive productivity shots. And therefore, they also meant that people
expected permanent high growth and therefore that was a fertile ground for the buildup
of financial imbalances, quite apart from what was happening on the financial side. Now, as a result, these inflationary pressures
meant that you have even less of a reason to raise interest rates that you had before,
because what you had was low and stable inflation, if anything, disinflationary pressures, while
at the same time you had this buildup of financial imbalances that took place in many countries
around the world. Now, let me sort of summarize that very, very
quickly. In some recent work, we see that there is
a clear break in the mid 1980s in terms of the characteristics of the business cycle. Until then, what you had was that inflation
would go up, monetary policy would tighten, and not much would happen to credit aggregates,
because remember, the economies were highly repressed. That was the typical recession that you would
have until the early or mid 1980s. Since then, the types of recessions that we
have seen, the main recessions that we have seen, those that have been more costly, have
been quite different. We see that nothing much happens to the inflation,
nothing much happens to therefore monetary policy. But, we do see a big expansion in credit and
also asset prices, turning into a contraction. So, the way that we have characterized this
is to say that we have shifted, or at least I have characterized it, is that we have shifted
from what you might call inflation-induced recessions to financial-cycle induced recessions,
with financial cycles being these expansions and contractions in credit and asset prices. Well, is it fair to say that debt has become
a bigger driver of growth in the economy, both in the US and globally, since the mid
1980s, and that this has put, in a sense, downward pressure on interest rates because
raising rates too much would cause a recession because the economy is increasingly dependent
on debt in order to finance growth? I think that’s a possibility. That’s a possibility. It is what, in some of the work we have done,
we referred to us as a debt trap. Clearly a situation in which debt continues
to increase and real interest rates continue, and nominal and real interest rates continue
to fall, can generate a situation in which raising interest rates … It would be harder
for the economy to sustain, to absorb higher interest rates. Yes, that’s indeed a possibility. We don’t exactly know whether that is the
case, but it’s a distinct possibility. Let’s go back to this point about deflation. You made a great point, which is that certain
very large macro forces, one of which was globalization, another one of which was the
information revolution and technology increased productivity worldwide that drove down inflation. And because central banks had these model
that looked at inflation as the primary signal for economic health, seeing a persistent drop
in inflation or disinflation, was not necessarily alarming, but concerning to central bankers. So their concern was not to raise rates, their
focus was, “Let’s keep rates low enough because what we see here is inflation.” And they were completely ignoring the buildup
of risks in the financial system, which goes back to this point about the buildup of credit
and of the dependency also of debt and the long-term impact that that had on the sustainability
of growth, which is to your point about monetary aggregates and their significance. Is that correct? Well, I would say that central banks are fully
aware that if inflation is driven by supply side factors is less costly than if inflation
was driven by weakness in aggregate demand. Sometimes however, distinguishing the two
is quite difficult, particularly in real time. What I would say, more generally, is that
if you look at the historical records, periods of falling prices have not necessarily coincided
with periods of very weak aggregate demand, very slow growth in output and so on. I mean, we have done some work, which was
basically a confirming work done by other academics and before. So, this idea that low inflation, and sometimes
even falling goods prices, is necessarily very harmful for the real economy, is something
that is not borne by the data in the past. So, when we think of possible costs associated
with very low inflation and the possible costs associated with even falling prices for some
time, we need to bear that in mind. Where did that theory come from? Where did it originate from? Was it from the 1929 crash and the Depression
of the 1930s? Is that where we got this concern that deflation
is always and everywhere, a bad thing? No, I would say that it’s something that goes
back even before that. I mean, there are different strands in the
economics profession, some strands that emphasize the cost of falling prices, some strands that
play that down. I think ultimately this is an empirical question. The work that I and others have done suggests
that it is a question that has not received the attention that it deserves. Now, from, I would say, a psychological perspective,
clearly what happened during the Great Depression is something that has been quite important
and has been driving very much of the thinking that we have seen in the post-war period. From that perspective, I would say that the
Great Depression was more an exception than the rule. And if you look at across countries, even
during the Great Depression, you will see that the dispersion in the behavior of prices
is not as large as the dispersion in the behavior of output, therefore the loss says how much
output fell at those countries, and the relationship between the falling output across countries
and the fall in asset prices across countries, is tighter. So, probably what people have underestimated
is the relationship, or the combination of high debt levels with falling asset prices,
as being a key driver across countries of what happened during the Great Depression. Clearly, falling prices for goods and services
played an important role, but I think that the role played by asset prices has probably
not received the attention that it deserves. You’re saying still that’s the case? Or, it was up until the crisis- I think that it’s still the case. That’s interesting. Let’s stay a little bit on this. You mentioned this ultimately an empirical
question. There is a great period that is often cited
and Milton Friedman and Anna Schwartz documented it well in their book, A Monetary History
of the United States, which is the postbellum period, the period after the end of the Civil
War, 30 years, roughly between 1865 and 1895 or thereabouts. For 30 years, for three decades, real GDP
grew at roughly, I believe, 4% a year, and prices throughout that period fell at roughly
2% a year. So we had 30 years of deflation. One is, I’d love for you to maybe tell our
audience a little bit about that period, but also, I’d love to consider for a moment, and
this might bring us into a conversation about the neutral rate and maybe you could give
our audience a definition of what that is. I’d like to consider theorizing what would
have happened if we had today’s central banks with today’s models, or let’s say, pre-2008
models, being applied to that environment, to that economic environment during that time. What would have happened? And of course then we didn’t have central
banks. We had the National Banking Act, but we didn’t
have even a fed at that time. Those are my two questions. We could take them, maybe first with the period,
you could describe it for our listeners. Well, first of all, the relationship between
falling prices of goods and services and GDP, as I mentioned, this is not just something
that we have seen in the United States. It’s something that one can see more generally,
and that is that the relationship is rather weak. We should remember that until the gold standard,
until roughly 1896, if I remember correctly, prices were falling gently. And after that, they started rising gently
and through the first World War. Of course, there was quite a bit of volatility
because the price index and the role of commodities and food in the price index was higher than
it is today. The role of services was less important and
so on. But that is the key fact to bear in mind. And during those years, you saw output going
up, output coming down, and so on, and sometimes growing fast, sometimes growing more slowly. But that’s what I mean by the relationship
not being that close. Now, why should that be the case? That’s a very interesting question, but presumably,
presumably, the answer is that if inflation is driven by improvements on what economists
call the supply side, such as technology, such as competition, such as globalization
as I was mentioning early, you can think of that … You can think of that as an outward
shift in the production possibility of an economy. Now, if that is what is driving lower prices,
then clearly, it’s likely to be the case that you’re going to see growth associated with
falling price of goods and services. If, on the other hand, the primary reason
why you have falling prices is that you have a big shortfall of aggregate demand in the
economy, then of course, what you will be seeing there is weakness in economic activity
and falling prices of goods and services. And I think this is the key aspect to bear
in mind. So, what we saw in the United States during
the period that you’ve correctly highlighted, is something that was not just a characteristic
of the United States, but was something that was much broader across the world. So, your point is it matters what’s causing
the disinflation. You can’t simply look at the inflationary
number. You have to dissect it and understand what
is driving that. Is it a lack of demand? Or is it that there are productivity gains
in the economy that are driving down prices? Productivity and other types of gain in the
economy that are basically driving prices down. For example, you were mentioning before, technology
and the impact of technology on the economy and on prices, technology in terms of reducing
the cost of production, technology in terms of allowing some winners, if you like, some
companies that are ahead of the pack, to reduce prices. Like, think of the Amazons of this world. And in the process, to put pressure on other
firms to reduce their prices, as well. So you can have aspects that work on the labor
market, and you have aspects that work more on the goods markets. Yes, that’s definitely the case. Let me just give you an example, a very concrete
example, and that’s the case of the country where we’re living, which is Switzerland. Now, Switzerland saw falling prices for a
few years in a row, but it didn’t see weakening growth. Actually the growth performance was quite
good. Now, at the same time, because interests rates
have, or at least in part because interest rates have been as low as they have been,
what we have seen is a buildup of problems on the financial side. We’ve had very strong credit growth. We have had very strong increases in property
prices, which of course have been a source of concern, both for the supervisory authorities
and also for the central bank. Now, imagine this thought experiment. Imagine that you have strong disinflationary
pressures as a result of positive supply side developments. Imagine that because of that, monetary policy
is held … is very, very easy. Imagine that you don’t have sufficient safeguards
on the prudential regulatory side to try and restrain the buildup of credit and property
prices. Then at some point, what might happen is that
the financial word we call the financial cycle expansion turns from an expansion into a contraction,
and that of course will be a strong drag in aggregate demand. On top of that, if policy has been very, very
easy, it means that the room for maneuver would not be as high as it would otherwise
be. So, on the one hand, you’re going to have
weak economic activity. That could actually put downward pressure
on prices, so good disinflation would turn into bad disinflation because we would have
a switch from positive supply side forces to negative demand side forces. In a context in which the room for maneuver
for monetary policy would not be as great as- Can I ask you something there to see if I’m
following you completely? You’re saying that good disinflation, in other
words, the fall of cost of input costs driving the price of consumer goods and other services
down, being misunderstood by central banks as bad disinflation, dropped interest rates
during the period which led to buildup of financial instability, a growth in credit,
which led to secular deflationary forces that would later arrive, and that would be what
you called bad disinflation. Did I get that correctly? Well, I think you’re pushing it very, very
far. What I would say is that in the context of
those three forces that I mentioned, financial liberalization, the establishment of this
monetary policy regime focused on near-term inflation, by the way, financial liberalization,
I should stress, without sufficient strengthening of the prudential safeguards, remember that
the idea at the time was that the financial system would be largely self-equilibrating,
and on top of that, the globalization of the real side of the economy, these three forces
that are, in and of themselves, taken in isolation good forces for a global economy. Not just in isolation, but taken in combination,
those forces changed the nature of the risks that policy makers were facing in a way that
was not fully taken into account in policy. I’m not just talking about monetary policy. I’m also talking about prudential policy. I guess what I’m trying to get at, or maybe
what I’m expressing, is that there’s been a view that central banks are holding rates
low, but I wonder if, instead, it is closer … What’s really happening is that central
bank policy, in conjunction with other forces as we described here, but if interest rates
having fallen below the natural rate over the last few decades, maybe not every year,
but on average let’s say, were actually a driver of credit growth that is now causing
downward pressure on interest rates. In other words, I’m really trying to focus
in on this issue of credit and debt because it seems to me that this is the fundamental
problem, and perhaps I’m overstepping, but it seems to me that this is the fundamental
driver of the low-growth environment that we are living in today, even more so than,
let’s say, structural demographics or other issues. How important is this buildup of credit and
the reliance on debt financing for growth that we’ve seen over the last few decades? Let me stand back and basically say I think
that there is, when it comes to sustainable, and let me stress sustainable growth in domestic
economy, in the global economy, I think that there is no substitute for getting the structural
side of the economy right, putting in place policies that are pro-growth, in terms of
the competitiveness of goods markets, in terms of the competitiveness of labor markets, in
terms of the ability to absorb technology, in terms of generating an environment that
is conducive to investment and the like. What we have seen over the last, I would say,
decade or so in particular, is that those types of policies, despite all the things
that I mentioned earlier, those type of policies have not been receiving the attention that
they deserve. This is basically what we mentioned, highlight,
in the annual report this year, and what we have highlighted in the annual report in previous
years. Is that what you mean in the report when you
talk about macro prudential policies? Well, now we’re getting a little bit technical,
but macro prudential policies is basically financial supervisory policy, banking supervision
and regulation. The focus is not so much on individual institutions
on a standalone basis, but considers the system as a whole, calibrates instruments with respect
to what happens in the system as a whole, and in particular, takes into account these
financial expansions and contractions that I mentioned earlier. Okay? Mm-hmm (affirmative). That’s what we mean by macro prudential policies. We can come back to that later. But, the main point I want to make here, which
is sort of consistent with some of the things that you are saying, is that yes, the world
economy has relied not so much on supply side policies, but on debt in order to grow. And every time that the economy was slowing,
you had a big push to increase the debt of the economy, be that private debt or be that
public debt, and that the relationship between those two depends on the circumstances. So, yes, the world economy has been directly
or indirectly, whether that was deliberate or not, I think that was largely not deliberate,
has had to rely too much on debt in order to grow. And longer term, I think that the bigger risk
for the global economy is precisely the fact that we have quite a lot of debt, be that
public or private, and that will depend on the countries that one is talking about, too
much debt around. We should recall that debt was, for the reasons
that we mentioned, at the heart of the global financial crisis. And now, if we looked around the world, the
ratio of global debt to GDP is higher than it was before the crisis. That doesn’t mean that we are in for a crisis. That’s not what I’m trying to say. Sure. Sure. What I am trying to say is that this proved
very, very hard for the global economy to move away from the debt-fueled growth model
that seems to have been, at least evidence indicates, has been operating for so long. So this is super interesting to me, and I
want to stay on it a little bit because it’s kind of like a who-done-it question. Again, it goes back to your point about the
… After the end of Bretton Woods and the deregulation of the ’80s, as well as the experience
of the stagflation and the focus of central bankers on inflation as the measure of economic
health, it seems to me that these forces have brought us to this place we are today where
some people, like Richard Koo and others, have called it a liquidity trap. Is it fair to say that central banks are caught
in a liquidity trap where they can’t raise interest rates too much because the debt has
grown so out of control since the early ’80s? On account of the things that we discussed,
is that fair? I think that’s taking it too far. We don’t know whether we are in a debt trap
or not. And clearly, what we can say is, of course,
that a higher debt levels, all else equal, would imply less room for maneuver. And what we can also say is that, of course,
if interest rates are very, very low, and if balance sheets are very large, the margin
of effectiveness of monetary policy and the room for maneuver is not as high as it was
in the past. Going back to, I would say, just the post-crisis
experience because I think that’s very important to bear in mind, what happened then? I mean, we have to recognize that central
banks and the actions that central banks took during the crisis were the key reason why
the problems didn’t get out of hand. That stabilized the economy. That avoided another Great Depression. Regardless of whether you think, or whatever
causes of the Great Depression could have been, clearly the fact that this financial
system was imploding partly under the weight of debt, partly under some of the … the
fact that the financial system didn’t have enough capital built in, was the major threat
to the economy. Point number one. Point number two, we should also bear in mind
that the key reason why we are where we are in terms of growth, and so on, is because
central banks have supported the economic recovery of the global economy. At the same time, what is clear is that the
recovery from the great financial crisis has been imbalanced because we have relied too
much on monetary policy, and in particular, we have relied too little on structural policies. And if we want to move away from the debt-fueled
model that, de facto, we seem to have in the world, we need to move away from a situation
in which growth ends up being so dependent on monetary policy. Well, what seems really interesting, and I
want to pose this question to you, it seems to me that we went from a period where monetary
policy was primarily focused on achieving the optimal growth rates while keeping prices
stable, to now being a tool of managing the de-leveraging. What I mean is that it seems to me that, as
I remember it also anecdotally during the ’90s in particular, the focus really was,
you mentioned, the Great Moderation, this idea that central banks had really nailed
it and the interest rate was a tool of achieving optimal growth. The conversation now around interest rates
since the crisis, and maybe a little even before that, but certainly since the crisis,
has been really about — it’s felt like the conversation: is how do we keep rates low
enough that we don’t spiral back into deflation. It seems that that is the narrative that’s
being discussed in Western economies, and perhaps, that was already the narrative that
developed in Japan, for example. And to what extent, perhaps, are we following
in the footsteps of Japan, does that resonate? Or is that incorrect? How would you respond to that? I would basically say that since the financial
crisis, there is a clear recognition, a clear recognition within the central banking community,
that this economy is not self-equilibrating, that stable inflation doesn’t mean that may
not have problems building up on the financial side. But the problems of the financial side are
quite insidious. They take a long time to build up. Once these financial expansions finish and
the imbalances unwind, they can create serious problems for the real economy. All of this is an important step forward. What is at stake is the question of how much
you should deal with this problem by the mix of monetary policy and what I mentioned earlier,
prudential policies, because there is also a recognition that very low interest rates
for very long tend to generate risk taking and can, of course, induce a further buildup
of debt, which goes back to the imbalance recovery that I was mentioning earlier. So the key question, the key policy question
is what is the best mix of policies that you need to have in order to try and make sure
that you have growth that is sustainable, and that is a combination of structural policies,
monetary policies, regulation supervision of financial institutions, of the financial
system. So, what is the right combination? What we have been arguing in our publications
is that monetary policy cannot be regarded as the engine for sustainable growth, that
in order for that to occur, going back to what I said earlier, you do need structural
policies. And there is a big role to be played by a
regulation supervision of the financial system. Secondly, you need all these policies to work
together, and you also need fiscal policy that is sustainable longer term. So, that is what we, and I’m sorry if I used
some technical terms, that is what we mean by a macro financial stability framework. Sustainable growth with price and financial
stability requires a balanced mix between all of these policies. And the one that I would stress as the key
policy to make sure that you have sustainable non-inflationary growth is structural policies. Unfortunately, since 2011, rather than stepping
those policies up, countries around the world have actually reduced efforts in that direction. And I think that a key reason there is that
there never seems to be a good time to carry out structural policies. You know, when the economy is doing well,
people say, “Well, why should we do anything?” When the economy is doing badly, that, of
course, is a bad time to [crosstalk] structural reforms. To engage in austerity and other regulatory
measures. But sometimes that’s the only time when you
will do it because you have your back against the wall. So this is really great. I’d like to separate these two because I’d
sort of generally label what you just were describing as regulation, for general listeners. Is that fair to describe it in that way? Yeah. If we are talking about regulation, it depends
which bit. Of the financial system. Maybe you can be a little bit more precise. What will you cover under the heading of regulation? Well, I guess what I’m getting at is that
the Bretton Woods period of fixed exchange rates, after we went off of Bretton Woods,
the regulatory frameworks that Western economies had in place weren’t really appropriate, I
would say, and perhaps you can comment on this. They weren’t appropriate for the type of financial
system that developed out of that. And so we had the deregulation in the US beginning,
I think, with the Monetary Control Act under Carter, and then through the ’80s with Reagan. But we didn’t have, let’s say, a re-regulation. We didn’t introduce new regulations to try
and … that would be more appropriate for a free-floating exchange rate fiat global
monetary system. Is that right? Well, I would say that maybe rephrase what
you said, is that the key challenge that financial regulators have is to ensure that the financial
systems is a source of strength as opposed to weakness for the economy. Sure. Now, the type of regulation that you had in
the post-war period is more like financial repression. It did not have as its specific objective
to ensure the stability in the financial system, and you had many other objectives including
credit collocation, keeping the cost of funding low and so on so forth. I mean, that varies from country to country. But, it was a form of financial repression. Now, the problem with financial repression
of that kind is that it’s not, in fact, conducive to good allocation of resources and the like,
and that led to the financial liberalization that we later saw. It was one reason why we had the financial
liberalization that we saw. Now, because the system had been repressed
for so long, it meant that prudential regulation, which is precisely designed to ensure that
the financial system is strong … I’m thinking, for example, of capital requirements, for
minimum capital requirements for banks and so on so forth, had actually taken very much
… was in the back burner, was in the background. So, it took quite some time for that is what
I call prudential regulation, regulation with a financial stability objective explicitly
in mind, to be put in place. And that was a key reason why the system failed
to perform well during the contraction of these financial expansions that I was mentioning
earlier … bigger financial expansions and contractions, and a financial system that
was not really able to absorb them. Because prudential regulation had been left
a little bit on the side, people had not focused on it as much as they should have. And in some cases, even when measures were
taken, the fact that those measures were not sufficient of the awareness of that was not
there. It’s not just regulation versus no regulation. It’s more a question of the type of regulation
that one is thinking about. So that’s one side of the equation, and I
feel like that’s a well-understood and well-articulated view, and it’s often shared here in the US. I want to suggest, or make a more controversial
suggestion. You may disagree with it, so I’d love to hear
your view on it. It has to do with the interest rate side of
this equation. One, of course, is the regulatory side, and
the other one is central bank policy. Right? Specifically interest rate policy. And I spent some time researching this, the
history of monetary policy, not as an academic, but as a sort of pseudo-academic. The Paul Volcker period, his administration,
from ’79 to I think it was ’87, I found that extremely educational, particularly in 1979,
his Saturday night special, when Volcker, instead of focusing on interest rates, pinned
the money supply and allowed interest rates to fluctuate. Basically, he introduced volatility in the
price of credit. And I found that extremely interesting as
a historical experience because I think, and this is sort of a way of asking, have we created,
through central bank policy, a misperception of risk to the downside because market participants
feel too comfortable with their ability to A, to expect central bank intervention and
keeping rates low, but also the lack of volatility in interest rates, the fact that market participants
feel a certain sense of ease around the availability of credit? Maybe I need to articulate it better. Does that make sense as a question? I think that central banks are fully aware
that’s something that they need to avoid. It’s precisely the sense that they will always
be there to deal with any market jitters, if you like, or any market disruptions that
take place. I think the key compass in this context is
the extent to which those disruptions, those changes, have an impact on the real economy
and an impact on inflation. So, depending on their specific mandate, all
of them, there are maybe different weights on output relative to inflation, but inflation
is a key objective with central banks. What they want to make sure is that whenever
they react to financial market developments, they react to them because of their impact
on economic activity, because of their impact on inflation. Now, that of course, sometimes if very difficult
to work out, and therefore, sometimes it’s hard to tell whether a central bank is responding
to financial markets because financial markets have changed, or we feel like over and above
the impact of financial markets on the real economy and on inflation. And that may misleadingly generate the impression
within, among financial market participants, that the central bank is responding purely
to financial market developments because of the financial market developments, regardless
of their impact on the real economy and inflation. And this perception is something that the
central banks know can be a problem, and they try to the best of their ability, to avoid. What I’m actually saying, I think is a bit
more controversial than that. I talk about it in terms of interest rate
volatility. I often say interest rate volatility, to me,
seems to be inversely correlated with financial stability, in the same way that, let’s say,
electoral volatility is inversely correlated to political stability. In other words, a country like Saudi Arabia
has low electoral volatility and high political instability, whereas, let’s say, a country
like Italy has high electoral volatility and low political instability, or high political
stability, if I got my words mixed up. What I’m trying to suggest here is that the
low volatility of interest rates is a source of financial instability in the way that it- I would not go as far as that. You should recall that the reason why Volcker
allows such high volatility in interest rates was not because he was trying to get interest
rates to be volatile, per se. I mean, he was trying to allow interest rates
to go as high as they needed to go in order to bring inflation down. But wasn’t it also about creating accountability
in credit markets? I mean, obviously it was the fact that they
weren’t able to raise their way into a disinflationary environment, so they had to try something
else, but the fact that they pinned the money supply, and interest rates began to fluctuate,
it broke markets’ ability to use expectations to beat inflation, in other words. I’m not sure whether I would characterize
it like that. I characterize this saying, you needed a compass
to help you understand how far interest rates would need to go up. The compass, if you like, the benchmark that
was used at the time was a monetary aggregate, and that’s basically what happened. I think that the volatility of interest rates,
per se, was more an outcome, as a byproduct of this, as opposed to something that was
an objective in itself. But at least that’s my interpretation. What you had to do was to break inflation’s
back, and in order to do that, you have to allow interest rates to go up quite a lot,
given the inflationary mentality of the day. All right, I may ask you one more question. I’m almost confident you’ll disagree with
me, but I want to throw it out there. It’s a question I asked the former vice chairman
of the fed, Alan Blinder, on my old television show. It is essentially this, why do central banks
need to set interest rates? I understand the reason for the monetary backstop. I understand the need to provide liquidity
during periods of seasonal illiquidity. I understand those. And this brings us to a question about the
natural rate again. Why is it that the central banks, the contention
is, that are better at targeting the optimal rate, as opposed to credit markets? What is the argument there for the need for
a central authority to set interest rates, to set the price of credit? I would basically suggest to you that it would
be very, very hard for markets, in and of themselves, technically, to set the price
of credit these days. And in fact, central banks have been a key
to setting that interest rate for many, many … going back to their creation. And even when they were not there, there were
institutions that performed very much almost the function of, for many years, the functions
in central banks and setting interest rates. Setting interest rates, it ends up being,
in the absence of central banks, too, and this is my personal view by the way. I think it’s mentioned in the paper that I
said about my credit trust in central banking and so on. There is a strong conventional element in
it. What central banks do is … The reason why
central banks are setting interest rates is precisely because they have a clear objective
in terms of the longer-term economic performance of the economy, and they try to move it in
the correct direction. Unless you have an institution that does that,
there is no reason why the interest rate would even move in the right direction. So, I think that we need a mechanism to set
interest rates, and we need a mechanism to set interest rates in accordance with the
needs for the economy. And whether we like it or not, we cannot shy
away from that. I would put it to you that having central
banks doing this, compared with any other system, is an improvement. This is great, and I want to make one more
suggestion, and then we can perhaps move forward to a few other points before we get into a
larger discussion about the current economy. But this brings us back to the postbellum
period, and something I was suggesting, which was what would have happened during that period
if we had a federal reserve? Which period, sorry? The postbellum period, the 30 years of disinflation,
of 2% disinflation, averaged annually, with 4% growth, when we were building out the railroads,
and we had really the meat of the industrial revolution, a very productive time in America. Back then, of course, we didn’t have a central
bank so credit was set by the market- Well, I mean, I wouldn’t say that it was set
by the market. Remember, I mean, it was set by other central
banks. You’re saying foreign central banks, you’re
saying? Right. I mean, because [crosstalk 00:58:48]- Like the UK, the Bank of England? … relationships between the interest rates
that are set, particularly in the UK and other countries, and interest rates that are set
in the periphery of the world, whether you have a central bank or not. And I think that was a key factor. So, it’s not that you didn’t have central
banks. You already had central banks, de facto, setting
interest rates globally. No, that’s a fair point. That’s a very good point. Okay, so I mean, that was really great. I wanted to get to that point. I want to move onto the current economic environment,
which is basically your annual BIS report that came out June 29th of this year. Before we do that, I have one more question
that’s related to a very popular theory that’s taken hold here in the US. A lot of the more progressive candidates on
the Democratic side are kind of echoing some of the sentiments, and that is modern monetary
theory. I don’t know to what extent you’re familiar
with the theory, and I don’t know to what extent you want to comment on it, but it seems
to me that the work that you’ve done in terms of particularly your point about inflation
being not a particularly good signal for determining interest rate policy, for modern monetary
theorists, their idea is that the central bank and the Treasury should merge, essentially. There shouldn’t be two separate entities. But the major point is that the government
is not constrained when it comes to spending. It should be able to spend as much as it likes. And that the only constraint on spending is
inflation. I wonder how would you respond to that sort
of a theory that we want to target full employment, we should spend as much as possible, and the
only constraint on that is when we see inflation rising. Well, as I mentioned earlier, I mean, inflation
is an important gauge for what is going on in the economy, and I think it is important
to try and to make sure that inflation remains low and stable and within certain bounds. That’s absolutely critical because what we
do want over time is an economy which is growing at a steady pace, is growing as high pace
as the structure of the real economy, its real growth potential is. But we want it with price stability, because
we know that without price stability, you have real big problems in the real economy. So that is something that we want to preserve. At the same time, it is, indeed, true that
we should not expect that if we have price stability everything else is going to be okay. You do have to pay a lot of attention to what
happens on the financial side, in particular, the way the financial side interacts with
the real economy, in terms of the allocation of resources, in terms to the possibility
of having serious financial strains, in terms of the possibility of the economy to deal
with big, high debt levels that may be generated. And therefore, just using inflation as the
gauge for the whole of your policy frameworks would be a mistake. Well, Dr. Borio, I really appreciate you being
on the program. We’re going to go into the overtime now. There are a number of things I want to talk
to you about on the overtime, including, and most of this comes from your report, the state
of the banking sector, emerging market economies, collateralized loan obligations, leveraged
loans, basically debt in the corporate sector, and some of the forces you also describe in
the BIS annual report. These are things I want to talk to you about
in the overtime. For regular listeners, you know the drill. If you’re new to the program, head over to
hiddenforces.io/subscribe, or patreon.com/hiddenforces, where you can subscribe to our audio file,
autodidact, or super nerd tiers for access to this week’s overtime, as well as a transcript
to my conversation with Dr. Borio, as well as this week’s rundown, which is full of detailed
information related to this week’s episode including hyperlinks and citations to papers
that Dr. Borio has written, in which I relied upon for this conversation. Dr. Borio, thank you so much and stick around. We’ll talk on the other end of this one. It was a pleasure. Thank you. Today’s episode of Hidden Forces was recorded
at Creative Media Design Studio in New York City. For more information about this week’s episode,
or if you want easy access to related programing, visit our website at hiddenforces.io, and
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