Low inflation and rising global debt: just a coincidence?

At first sight, they seem unrelated, says Mr Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements (BIS). After all, why should low inflation and rising debt be linked? True, from the early 1980s inflation declined, and then stayed quite low in much of the world while debt (private plus public) in relation to GDP rose to new peaks. But is this not just a coincidence? Maybe. On reflection, though, the link may be much tighter than we think. To understand why, we need to travel back in time. Not too far, but some distance nonetheless.

Exploring the link
It probably all started some 30 years ago. The change did not come suddenly, but slowly and cumulatively, as events unfolded. It was not a development on the surface, but something much deeper, like the adjustment of tectonic plates. Nor was it a single force, but three that eventually came together. Each of them, taken in isolation, was, and is, highly beneficial. All of them, in isolation and as a package, were, and are, precious and worth safeguarding. Taken together, though, they arguably changed the workings of the world economy in subtle and unexpected ways, throwing up new challenges from unsuspected quarters. And policies did not adjust. The changes engulfed financial, monetary and real-economy regimes.
Financial liberalisation
The first change was financial liberalisation, both domestically and across borders. Financial liberalisation began in earnest in advanced economies in the early 1980s, and by the early 1990s was largely complete around the world. To use Padoa-Schioppa and Saccomanni’s felicitous phrase, liberalisation turned an essentially government-led into a market-led financial system.
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The second change was the adoption of credible anti-inflation monetary policy regimes. Paul Volcker led the way in the early 1980s, and by the 1990s the inflation dragon had been slayed around much of the world. In particular, as the 1990s unfolded, more and more central banks adopted inflation targeting regimes, seeking to steer inflation typically over horizons of one to two years. These frameworks paid little attention to the monetary and credit aggregates that had often guided policy in the early phases of the battle against inflation: these variables had become progressively less useful. And as the frameworks proved successful, they became increasingly ambitious, seeking to steer inflation within narrower margins.
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The third change was the globalisation of the real side of the economy. Globalisation came into its own in the early 1990s and gathered pace in the early 2000s. It followed on the heels of the entry into the world’s trading system of former communist countries and China as well as of the opening-up of emerging market economies (EMEs), notably India. This added something like 1.6 billion people to the global labour force. Alongside the expansion of global value chains, it amounted to a string of positive supply side shocks, which raised the world’s growth potential and sharpened competition.
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All this helps explain the low inflation. But financial cycles, by definition, involve both expansions and contractions. How could this then help explain the increase in global debt, public and private, that we have seen at least since the early 1980s? The answer is a ratchet effect. The effect arises because financial busts, especially if they go hand in hand with banking crises, leave very long-lasting scars on the economy: output may be permanently lower relative to its previous trend. Thus, the impact of financial cycles is not symmetric. More importantly perhaps, policy responses may not be symmetric either. This ratchet effect has arguably reinforced other, better known forces: the turbo-charged financial deepening linked to financial liberalisation and the inherent political difficulties in keeping public finances under control, themselves under growing strain from demographic pressures. Let’s consider the role of policy in more detail.
Fiscal and monetary policy
Fiscal policy has typically been asymmetric. The authorities have failed to recognise that financial booms hugely flatter the fiscal accounts. Potential output and growth are overestimated, financial expansions are revenue-rich, and resources may be needed to repair banking systems when a crisis occurs. The long-lasting impact of the busts on output and productivity does the rest. (…)
Monetary policy has, unwittingly, been somewhat asymmetric too. In the context of low and stable inflation during financial expansions, there has been no reason to tighten. But the financial bust-induced damage, coupled with concerns about a deflation threat, has naturally led to protracted easing to steer the economy back towards full capacity and push inflation up. (…)
Addressing the problem
How can one deal with the debt mountain? Some ways are definitely better than others. A “solution” sometimes put forward is to reduce the debt through higher inflation. The world has already been there, and it was not a pretty sight. It would make little sense to return to an inflationary era after spending so much effort to escape from it. Once the inflation genie is out of the bottle, it is very hard to get it back in. Moreover, in order to have a lasting impact on the debt outstanding, inflation would need to be combined with financial repression. The costs would mount.
Another possibility is debt restructuring. This is only a last resort, to be employed in a crisis once other, more benign alternatives have been exhausted. Restructuring can be very painful, at least when the public sector balance sheet cannot come to the rescue – an option generally highly constrained by the state of public finances and which, in the end, would simply substitute public for private debt. That said, there is scope to further explore orderly restructuring solutions to address targeted problems. It’s better to be ready.
Adopt a policy framework
The best strategy is to adopt a policy framework that explicitly considers the risks to which rising indebtedness gives rise for sustainable economic growth and financial stability. As elaborated in the recent BIS Annual Economic Report, there is a need to develop a more holistic macro-financial stability framework. The framework includes not only macroprudential measures based on solid (microprudentially oriented) regulation and supervision of individual institutions, but also monetary, fiscal and even structural policies. The framework would result in a more balanced policy mix and, in the process, reduce the ratio of debt to GDP.
The elements of the framework are easily summarised. The regulation and supervision of individual institutions help build defences that can cushion the turn of the financial cycle, containing its costs. The active deployment of macroprudential measures during financial expansions can help restrain the development of vulnerabilities and further strengthens the financial system’s resilience. A more financial stability-oriented monetary policy, through both interest rates and foreign exchange intervention, can exploit the room for manoeuvre wherever inflation remains subdued in order to better tackle the build-up of financial risks. A fiscal policy more cognisant of the flattering effect of financial booms, and of the threat posed by high debt, can provide further support. And structural policies can raise sustainable, non-inflationary growth.
Public sector debt
It would make sense to take advantage of the current favourable economic conjuncture to shift in that direction – all the more so since the room for policy manoeuvre has narrowed considerably relative to pre-crisis. Public sector debt is at a peacetime high. And central bank balance sheets are unprecedentedly large while interest rates remain exceptionally low in both nominal and real (inflation-adjusted) terms. Indeed, real rates have never been negative for so long and are negative even as countries are approaching, or may already be above, potential. The need to reload the gun for future battles is evident.
At a deeper level, shifting in the right direction requires placing a higher weight on the long term. Financial cycles, and the associated vulnerabilities, build up slowly. And the costs of high debt may emerge only after a long time. The incentive to kick the can down the road can prove irresistible. But, however distant it may appear, the future eventually becomes today. At which point, it is too late.
You can read the full article on the website of the BIS.
Source: https://www.bis.org/