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July 2, 2006
David Warsh, Proprietor


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Would You Like a Belt with Those Suspenders?

I’ve been reading the annual report of the Bank for International Settlements.  Economic Principals generally steers away from international economics, since there are plenty of excellent professional journalists who cover the field. This is one newspaper beat that isn’t understaffed.

But there’s always something so reassuring about the BIS report, whose appearance coincides with the organization’s annual meeting in Basel, Switzerland, during last week of June. It is evidence that serious people on the BIS staff — central bankers, mostly, but of a temperament that goes well beyond the narrow meaning of constrained independence — are thinking carefully and deeply about the stability of the global economic system.  I read it every year.  More to the point, so does the international financial community.

Plans for the BIS were fashioned by international bankers in the halcyon summer of 1929, adopting a plan developed by a committee led by economist Allyn Young.  The ostensible purpose was to channel German reparations payments from World War I to England and France. The broader charter was to serve as a clearinghouse for international capital flows under extreme conditions –”a private and eclectic Central Banks’ Ôclub,’ small at first, large in the future,” in the words of Bank of England governor Montagu Norman, who had first broached the possibility in 1925.

After the October stock market crash, the banking community moved swiftly to establish the BIS — it was chartered at a conference at The Hague in January 1930, and given the twin protections of treaty status and incorporation under Swiss Law in Basel, the cosmopolitan little city on the bend of the Rhine in the heart of Europe where the France, Germany and Switzerland intersect. But of course the infant organization was powerless to counter the collapse of international financial cooperation that ensued, producing a Great Depression of unparalleled severity and length. Not surprisingly, coordination has been a major theme with the BIS ever since.

That the BIS was able to function throughout World War II owed to the flexibility and insulation from political interference that its founders had bestowed.  The original members of the “club” — Germany’s Reichsbank, the Bank of England and the Federal Reserve Bank of New York — tended to trust one another more than they trusted their governments, according to Gianni Tonilio, whose superb 700-page history of the bank appeared last year.

Not that the bank’s conduct was unblemished; but the deposits of looted gold that it accepted from the Nazis (including small amounts of “victim gold”) were dwarfed by those that passed into the hands of “neutral: central banks in Sweden and Switzerland.  And so in 1944 the BIS survived an attempt by an angry US Treasury to forces its liquidation in the course of the conference at Bretton Woods, N.H. that mapped out an international financial system for the post-war world. (The Americans felt the bank had tilted towards Germany; the Europeans felt that fifteen years experience maintaining its independence was more important.)

Starting in 1946, then, the quiet little organization mapped smoothly into the Bretton Woods system as a behind-the-scenes lender of last resort — “the central bankers’ central bank” — whose principal goal was to avoid being needed. It paid increasing attention over the years to the junctures at which national policies affect one another:  banking supervision, financial markets infrastructure, payment systems, exchange rate regimes, and macroeconomic monetary and fiscal policies.  It helped lay the groundwork for the European Monetary Union.

Today, the BIS describes itself as “a forum for discussion, policy analysis and information-sharing among central banks and within the international financial and supervisory community.”  A committee on banking supervision negotiates international bank capital requirements; another appraises market innovations as they arise (and meets four times a year to assess risk); another inspects payment systems infrastructure; still another monitors currency markets and the counterfeit-deterrence group develops ways to protect paper currency.  Every two months, central bank governors from around the world travel to Basel to compare notes.

The staffers of the Monetary and Economic Department regularly brief their board, produce the annual report, and otherwise keep a weather eye on the world economy.  Much of what they have to say this year will be familiar to anyone who follows the news.

The Japanese economy is growing again, after most of a decade in the doldrums. So is the German economy, and indeed, most of the rest of Europe.   Some global imbalances have been lessened thereby; others have grown. There is no consensus as to whether they can be expected to resolve in the “bang” of a currency crisis or a “whimper” of slow growth over an extended period of time, or, best of all, a smooth rebalancing through market processes. The rapid growth of the Chinese and Indian economies have added to the complexity of the situation, moving the benchmarks used by central bankers to gauge whether their policies are tight or loose. Concerns about inflationary pressures have increased. Puzzles abound. And yet the global economy has grown steadily for the last couple of years.

“Everyone would hope that, by this time next year, we will be as satisfied with the performance of the global economy as we are today,” the BIS report concludes. But after reasoning-through of the macro-conundrum known as “global imbalances,” the authors close by proposing a series of modest but concrete steps.  Lines of communication could be hardened among financial firms, their supervisors and central banks. Scripts could be written, detailing who is expected to do what in a pinch. Burden-sharing could be discussed in advance of the matter.  Whether it is deposit insurance, emergency lending to stem a panic, or the rapid restructuring of an international bank, the cost of the next bailout will be substantial.

Indeed, it is fair to say that the crises most on the mind of the BIS authorities this year are those that have involved “bubbles” of one sort or another — the Mexican financial crisis of 1994, the Asian crisis of 1997, the Russian debt default (and the events surrounding the failure of Long Term Capital Management, a bond trading firm, in 1998, and the collapse of the market for tech stocks of 2001. Clearly, a sound policy against inflation is not enough to avoid an occasional crisis. The sudden rush of capital into new pockets of opportunity can produce major problems, too, feeding back into monetary policy.

Hence “the current conventional approach to price stability might need refinement,” the authors suggest. The simple year-or-two ahead forecast used by most central banks to chart monetary policy has had remarkable success in recent years, they acknowledge, by firmly taking expecations of inflation into account.  (For a lucid discussion of how the best-known such rule came to be, see the new interview with Stanford’s John Taylor in the current issue of the Minneapolis Federal Reserve Bank’s The Region magazine.) But a “much richer set of indicators” may be needed to identify various “boom-bust” situations before they get out of hand and necessitate a heavier hand on the throttle than otherwise would have been the case — a belt to go with the suspenders of the Taylor Rule, in which the notion of an “output gap” (the difference between actual and potential gross domestic product) is the key.

More hands-on regulation might also do the trick, the authors note, but a big change in the political climate would have to happen first. Otherwise, only by lengthening the period by which the relative success of monetary policy is gauged can the full effect of undershooting or overshooting the inflation target be seen.

Was monetary policy too loose in the late 1990s?  Is it too tight today?  I don’t know. As I say, it’s not my department. But I’m glad that the regulators at the Bank for International Settlements are on the case.  The BIS regulators are not always right. The most moving passage in this year’s report reminds readers of the central disagreement over economic policy of the last thirty years:

Policymakers in the 1960s and 1970s were generally of the view that the unemployment costs of reducing inflation would be both large and long-lasting, substantially outweighing the benefits. They were wrong. New analytical insights highlighted the role of inflation expectations, and how credible policies could ratchet those expectations down, and keep them down, at much lower cost than initially expected.  The generally excellent performance of the industrial countries over the last 20 to 30 years confirms the wisdom of those who decided to put that insight to the test.

A climate of low inflation, however, is not the end of history. The supervisors of the BIS are genuinely independent and they take a long view, heirs to the fair-minded men who built the international financial system with the Bretton Woods treaty, the Marshall Plan and the General Agreement on Tariffs and Trade. Given their 1930 start-date, they are their predecessors as well — the world’s oldest international financial institution. They still have the best interests of citizens of the global economy at heart.

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