Claudio Borio on Financial Stability, the Triffin Dilemma, and International Monetary Policy

Claudio Borio is the director of the monetary and economic department at the Bank for International Settlements (BIS) and has been there in various roles since 1987. Previously, he was an economist with the OECD. Claudio is the author of numerous publications in the field of monetary policy, banking, finance and issues related to financial stability. Claudio joins David on the podcast to discuss his career in monetary policy, banking, and macroprudential regulation. In particular, he and David discuss problems afflicting the Eurozone and how to address massive financial imbalances across the world.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Claudio, welcome to the show.

Claudio Borio: Well, thank you so much for the opportunity.

Beckworth: Oh, I'm glad to have you on. I've read your work through the years as a graduate student, I've read your work. So, I've been following you for many years so it's a real treat to have you on. I want to begin the show by asking the same question I have told my previous guests and that is, how did you get into macroeconomics?

Borio: Well, I was an undergraduate in Oxford, I was doing politics philosophy and economics. Economics was one of the subjects. It was the subject in which I specialized even as an undergraduate. So, I did two additional papers and one of those papers by the way was money. This was in the late '70s and I think that the type of approach or initiation that I had to economics would be unthinkable these days.

Then as a graduate, I was there doing a DCL, equivalent of a PhD and my thesis was on monetary policy and the financial system in Italy... So hence my approach to microeconomics is somewhat tocolytic because I cannot really see how one can properly understand macroeconomics without having a good understanding of money and credit. And on top of that by good, I really mean also having a reasonable, historically rooted perspective. So beyond what the profession has done over the last 15 to 20 years. So, that's basically how I came to the subject.

Beckworth: Yeah. If you read your papers you see that emphasis the credit perspective, money and then history, you always are sure to bring in a lot of rich history into it. So you've been working at the BIS for a number of years. Maybe you can explain to our listeners what the BIS is, what it does. And then also, what is it like typical day of work there?

Borio: The BIS is an institution that is owned by central banks in the world they're 60 shareholders and therefore it serves central banks. We do a number of things. We host some key central bank committees, for example, the Basel Committee or the committee on the global financial system, the committee on payments and markets infrastructure. These are committees that look at various aspects of the global financial system to work on them. And as you know the Basel Committee is a committee that sets banking regulation for much of the world. So, that's one side of what we do. Another thing that we do is to prepare for meetings of senior policymakers, deputy governors to governor level. They meet regularly here, and we prepare the background documents for those meetings.

We also produce statistics and we also produce research and our own publications. I think that's our main mission as the mission statement says on the website is to try and further and help corporation monetary and financial stability among central banks around the world. On top of that, we're also a bank and we manage a significant proportion of world reserves.

Beckworth: So working at the BIS day-to-day, you come in, you do research, you have meetings, you interact with central bankers. That's correct?

Borio: Yes. I mean, that's very much what a typical economist would do here. And then the balance of the work of course, would depend on where you are in the department, where you're more on the secretariats sites. If you're there, of course you do less research. And if on the other hand you're more on some of the other units then you can afford to do more research, but in a way research and a serious analytical work is an input into all the things that we do here.

Beckworth: Okay. Now, I think BIS at least in my mind, my impression was well-known publicly leading up to the Great Recession because the BIS was putting out these warnings, "Look out there's a big credit boom, going on, lookout, something's going to happen." You gave out warnings, the federal reserve needs to be careful, mindful, they're giving rates, what seems really low rates relative to credit growth. So, can you tell us a little bit about that history and maybe in your segue into the first part of our conversation on macroeconomics, what did you see happening leading up to the Great Recession? What were the warning signs and what were the messages you were trying to tell central bankers?

Early Warning Signs Before the Great Recession

Borio: Well, as they lead up to the Great Recession, what's called the great moderation. And I think the basic belief behind that was that price stability was sufficient for macroeconomic stability. The view of the financial system, that financial markets were self equilibrating, which meant that you could exclude them from your analytical frameworks, from your models, from the way that you looked at the world. And here, of course, at the BIS, we were convinced that this was not the right approach maybe that's partly because of the intellectual history of the institution but also because all you had to do was to look at history to see that this was not the case. And you could look at recent history and see what had happened in Japan or in the Asian crisis.

But you could go even further back in history and look at what had happened during the run-up to the Great Depression or even episodes of financial instability crisis during the gold standard. Now, these are all episodes in which appears in which you had price stability, low inflation, stable inflation, and yet at the same time, you had the build up of financial problems in the typical form of very strong credit booms and asset price increases what we tended to call financial imbalances. The very experience of Japan an advanced economy was a regard that at the time, given the who of the time as simply an aberration.

So, it was basically just looking at the world through a different lens that made us worry. And from around 2000 onwards, we started doing quite a bit of work in this area. We had already done a little bit before, but I would say that the most important pieces of work were done from 2000 onwards looking into the relationship between monetary and financial stability, looking at the nature of financial booms and busts and with the notion of procedural, fatality, being very prominent. And this basically led to two strands of work, the work on what should monetary policy do about it? How should want to change monetary policy frameworks? And what should regulation of supervision or prudential policy do about it? And the former, as you know is paying more attention to financial stability when trying to prevent the buildup of these problems in the case of monetary policy. And in the case of prudential policy, it was the whole idea of setting up a macro prudential frameworks, frameworks that had a more systemic orientation.

Beckworth: Okay. Well, your work during that time, 2003, 2004 really resonated with me because I had studied under George Selgin and he had really stressed looking at ... activity and it's effect on the price level. And during that period from 2002 to 2004 was the less part of the productivity boom, productivity growth was rapid. It was in the press. People were aware that we're talking of it and all else equal that productivity boom would have implied disinflation and a higher natural interest rate. But the Fed reacted in the opposite direction. They got worried about the low inflation and they pushed rates low. So what you guys were arguing was like, "Hey, you're taking the wrong approach here and you're helping fuel these financial imbalances." So, interestingly it really resonated and the predictions, the warnings you were making came to fruition, unfortunately. And we had-

Borio: Unfortunately, yes.

Beckworth: The Great Recession and in the slow recovery, before I move on one other argument that you made that I've also made, I share the view anyhow, and that deals with the global imbalances prior to the recession. You and a coworker had a 2011 paper, I believe, or 2012 paper, you argued, the standard story is global imbalances result of this excess savings finding it's way to America. But you guys make a different argument. Could you share that with us?

Borio: Well, yes, to try and make the story relatively simple. The macroeconomic profession because it was not paying attention to financial aspects. It was looking at current account imbalances and they saw that as being the root of all evil. We by contrast were approaching the problem from the financial side. So we were concerned about financial imbalances to put it simply this financial booms, the strong credit pros, the strong increase in property prices, signals of very aggressive risk-taking in the market.

So, to the extent that the current account played a role, whether the current account of the United States, or the global configuration current accounts. It was a sideshow in the case of the United States. And more specifically, we thought it was simply a ... of what was going on at home, the financial imbalances that were built up at home.

So we didn't see if you the flip side of that, the current account surplus as the rest of the world as a cause of the lower rates that were had in the United States, we saw that very much as a monetary and financial phenomenon. So to cut a long story short, there are many aspects to it, but we felt that it was very, very important not to focus on current account if we are interested in financial stability issues, not to focus on current account imbalances, which are net capital flows, but at least to focus on growth capital flows, which are much, much, much bigger than that capital flows.

By the way, I'm sure that it didn't escape your notice that the banks that were most exposed to the United States and made the largest losses were the banks in the United Kingdom that had a current account tested and in the Euro area that had a current account surplus, or just to give you a sense of the relative magnitude of what we're talking about. Net capital inflows into the United States fell only marginally during 2008. So their current account position, it changed by 20 billion, but growth inflows decreased by no less than 1.6 trillion, which is a 75% decline. So we're talking 20 billion versus 1.6 trillion. It's no comparison.

Beckworth: So, you missed the whole picture if you focused on, there's the current account, the net flows, you missed the huge changing in gross flows. And that's the thing that's been running through a lot of your research. Let me throw something out there just to get your take on this. So one of the thoughts I had about the global imbalanced discussion leading up to the Great Recession is that it was in part fueled by Federal Reserve policy in the following way, not entirely, but in part. ... something like this, given that a large number of countries peg their currency to the dollar. So, if I'm thinking of China and some of the emerging markets, whenever the Fed began to ease in the early to mid two thousands, those countries had to basically adopt the same policy.

When you peg, as you know, you take on the monetary policy of the country to which you peg. So what they had just maybe the concrete steps is the fed it eases, so China has to go out there and buy up dollars. It does that by creating more of it's own currency. Now it has bought up all these dollars. What does it do with the dollars? It goes and buys treasury securities, mortgage backed securities. So in a sense, the Fed’s easing was being recycled back into the United States via the savings glut. So some part of the savings glut was an endogenous response to the Feds easing, is that a reasonable story?

Borio: It is a very reasonable story. I would not though use the term, quote unquote saving glut because as we... but we don't need to go into this detail, but as we say very clearly in the 2011 paper with PT and in a paper that we produced in 2015, that takes the argument further with also the help of a simple or a Mickey Mouse model to fix ideas. There is no real relationship between saving and financing. And current accounts are about saving and investment balances and financing is a cashflow concept, which is why it's much more related to the gross capital flows and so on. But leaving that aside, leaving that aside, I think you're absolutely right.

There are basically two ways in which the United States has an outsize impact on the rest of the world. The first is what I would call an indirect way. And you described an example of that, which is the fact that US monetary policy easing because of the big role that the United States plays in global financial markets will tend to be resisted to the extent that it is resisted by other economists, because they don't to see the appreciation for whatever reason will then engender easier monetary policy in the rest of the world. And as you know McCain had already written about this many, many years ago in the context, even of flexible exchange rates and the like.

So that's the one channel and it's the channel that you mentioned, and it's indeed a very important channel, probably the most important channel. Then you have an even more direct channel, which is not through the reaction function or the response of other authorities, but occurs directly from the fact that the dollar is a major international currency. It is not just 90% of all transactions or 60% of reserves or indeed 60% of private sector, international assets and liabilities held outside the United States. By the way, just to give an example, there is something like $9.8 trillion lending to non- US non-bank borrowers. So residents outside the United States, 3.3 of that is in emerging market economies. And two thirds two-thirds of that 9.8 trillion, roughly it is financed outside the United States as well. So these dollars never touch you are sure.

So that gives you a sense of how huge the role of the United States is. Then as you know the dollar is also used as a unit of account and a half of global trade. And if you try and see, and this goes back to the reaction functions that we were talking about, to some extent, if you see how currencies move, if you compare the three international currencies, the dollar, and then way, way back the Euro and even have much ... way back. The gravitational pool of the dollar in terms of currency is outside the United States is something 60%. So, 60% of the world is part of what you might call the US dollar zone.

So the fact that you have so many assets and liabilities in particular liabilities in dollars outside the United States means that changes in US monetary policy have a direct impact on financial conditions outside the United States. And this is something which is very important in particular for emerging market economies, which is why tightening of US policy has an out-sized impact on countries outside the United States and in particular in emerging market economy.

Beckworth: I'll come back to the Great Recession. I want to just jump ahead and talk about that right now, since we're on it. So you mentioned your one thing is that there's this big you call dollar zone, or they call it the dollar block, all those countries that basically have to follow the Fed and maintain your peg and all the transactions, but it's incredible. And you guys keep track of this, and I'd recommend my listeners to go to the BIS website look at their statistics. And they have all this data on credit, and also what a currency that credits issued in. But basically what you've said is almost $10 trillion in dollar denominated debt that's issued and used outside the US never touches the shores. So, I think that's a very powerful image and it's tremendously large.

And I think we see the effect of that this year. So the Federal Reserve December, 2015, they raised interest rates for the first time since they hit the zero lower bound. And then soon afterwards we see... in fact actually leading up to it, just the expectation of it. And in late 2015, and then early 2016, we see all these problems in China, talks about recession early in the year. And then you see the FOMC members of the board they become a little more cognizant or more aware that their actions affect the global channel. They become more explicit. There's global repercussions to them raising rates too fast, maybe domestic conditions warrant it but there's this global fallout. So it makes life for the Fed very, very difficult. They have a domestic mandate, but they have a global reach.

Reconciling the Fed’s Domestic Mandate with its Global Reach

Borio: Absolutely, that is clearly one of the concerns that people have about what people call the international monetary and financial system. In fact we have two concerns there, the first one is the one you mentioned the cemeteries that the interest of the dominant country need not coincide with the interest of the rest of the world and the second, which is related, but not quite the same is that the system as a whole does not have a sufficiently strong current monetary and financial anchor. If you asked me and I gave a speech in this mid year, I think, the first is clearly a problem, but it is not obvious to me that a more pluralistic system would necessarily result in a more stable global monetary system, because you could also have competition and I race to the bottom if you like competition in laxity.

And we have seen some signs of that in recent years. So to me the priority, and that's why we're focusing so much on it is to put strong anchors in place in domestic jurisdictions. And then after you've done that to deal with the more global issues. And part of that in our view is to precisely adjust monetary regimes and adjust prudential regimes and possibly even use fiscal policy more cautiously to deal with the financial booms and busts that occur ....

Beckworth: The use of the dollar is the main reserve currency of the world and all the problems that presents that we've been talking about. And it reminds me of the Triffin dilemma. What's ideal for the US is not what's ideal for the world. And it maybe digs in a deeper question and that is, is there a natural tendency for the world to want to have a unit of account, some currency that everything can be denominated. And another words if you started everything over, if you can start earth's history over, would there naturally emerge a currency like the dollar? It was the pound before the dollar now, is there just a natural tendency for the market to work itself to a point where... The world wants some ultimate safe count and we're just going to have to wrestle but the Triffin dilemma is going to be with us no matter what we do, or is there a solution to this?

Borio: Well, let's say that clearly the world, for a number of reasons that I don't need to go into it. There are huge economies of scale in terms of information and so on if you have a single currency. How many currencies you have at the end of the day, it's less of an economic issue and more of a political issue. But so even if you are going to have many ..., many countries in the world and so one, and as I'm sure we will continue to have for many years to come. There is going to be a tendency for international transactions and so on to gravitate towards if you international currencies. And I think this is inevitable. Whether it's going to be one hugely dominant or not, it's less obvious to me, but clearly it's going to be few. There is only one for a few.

Beckworth: Barry Eichengreen had a book out right before the crisis emerged called the Exorbitant Privilege. And in the book he was making a prediction, well, the dollar is it for now, the dollar is the reserve currency for now, but give a few years, maybe a few decades the euro and the Chinese currency will be there as well. Of course, after that, we had the crisis, people began to question the Euro and then concerns about China.

Borio: As you know it's a mixture of economic size, but above all, also financial size, the depth and breadth of your markets. And then there are a number of issues about contract law, the infrastructure that you have, the trust that you have in a particular jurisdiction and continuing to be there as a jurisdiction, contracts being upheld and so on and so forth. And then of course you have the broader geopolitical considerations that come into it. And it's a mixture of all of these. And unless you have all of these credentials, then you cannot aspire to be a major international currency. And then how many of those that will be then that will depend on the relative merits of each.

Beckworth: All right, you've touched on this already, but let me ask this question. What would you recommend be done to the international monetary system to make it more resilient, more robust so that we don't get these financial imbalances, given that we do have the reserve currency, the dollar, and we have a ... bank with the domestic mandate for the US economy, what can be done to that international monetary system to make it more robust?

Making the International Monetary System More Resilient

Borio: Well, let me mention then four steps. I would say increasing degree of ambition. First and most important one, which again, I think is going to be even quite difficult to put in place is to have adequate strong monetary and financial anchors in national jurisdiction. Now, the question is, what does that mean and what that means depends on it's like in the eye of the beholder. For us at the BIS this means putting price place, what we call macro financial stability frameworks, which are frameworks that succeed in taming this financial booms and busts more successfully than the ones we have now.

And that requires some changes in monetary policy and prudential policy or financial regulation, supervision, and in fiscal policy. I think we have made the most advances on the prudential and regulatory side with this macro prudential frameworks in particular, we're still quite some way, both on the monetary let alone on the fiscal side. And in the annual report over the last two to three years, we have tried to, if you look at the various aspects of what that framework might look like in the latest one, we looked in particular at fiscal policy, but also at monetary policy.

So first of all, you put strong anchors at the domestic level. If you do that, then the likelihood and intensity of what people call negative spillovers to other jurisdictions should decline by quite some bit to consider what extent. Then you can think of how to deal with the interaction of national regimes. And there you have three possible steps. One is we might call it enlightened self-interest, which is a particularly important responsibility for the large jurisdictions that is still in full respect of the national Mondays, because this is something that cannot be avoided.

Try and take into account how other countries react to their policies and what the impact of that on their own country is going to be. In economic terms, one could say try not to behave in a... to behave as a stackable leader. The second step would be occasional coordination in prevention, not just in crisis management. I think particularly central banks are extremely good when it comes to monetary policy in particular to cooperate in crisis management, the less prevention for the reasons that we partly mentioned earlier, the adequacy or inadequacy of domestic policy regimes and the exclusive focus on inflation.

And then of course you could go even one step further, which is to agree on some rules of the game that would help to instill more discipline at the national level. But the problem is that, unless you agree on what the nature of the illness or the problem you're trying to tackle is you will not be able to reach a consensus on the next steps. And there has been agreement on the prudential side, there is no such agreement in particular on the monetary policy side.

Beckworth: Okay. So do you have these steps outlined in a paper or is there a menu for improving-

Borio: They are discussed but not spelled out in a tremendous amount of detail in a number of places including the speech that I mentioned earlier, some speeches that were given by our general manager in ... in the annual report as well. For example, to be more precise, we had eight chapters, not this year, the previous year in the annual report the international monetary and financial system, and it goes into some detail on ....

Beckworth: Great. All right, I'm going to move back now to the Great Recession talk. We were discussing what led up to it and we went into it and it's been seven, eight years since the bottom of it, it's now well over. And you had an article in the Kiddo journal, a talk that you gave at the conference there. The conference was late 2015, that came out in the journal this year. And it was interesting because the title of the article was “Revisiting the Three Intellectual Pillars of Monetary Policy.” And I want to just read a few excerpts from it and turn it over to you. And maybe you can elaborate.

Three Intellectual Pillars of Monetary Policy

Beckworth: "You know that the great financial crisis has triggered much soul searching within the economics profession and the policy-making community." And that's true. I know I've rethought some of my views and I've learned a lot since then. But you go on and say, "But has this soul-searching gone far enough?" And you put, "I shall argue that it has not." And so you go on and say, there's three areas in mainstream macro economics, mainstream monetary policy analysis that need to be updated, or change the thinking. And I was hoping you could touch on those and tell us where do we need to go as a profession?

Borio: Okay, well, that's a very long story.

Beckworth: Let's do one piece at a time. Let's start with the equilibrium natural interest rate. Tell us about that.

Borio: Okay. Well, the notion of equilibrium on natural rates that is I would say mainstream these days goes back to vixel and it's basically a more than modern incarnation of the actual story. And it basically says that it's a real rate that equates output, that potential and makes the inflation stable, the two things being equivalent. Now what's interesting is that this notion of the natural rate has also given a rise to the view, which I'm sure you have come across that the natural rate is very, very low, possibly even negative.

And that rate, that equilibrium natural rate is at the same time, the cause of major financial instability. And this is a view that for example Summers has put forward in his secular stagnation hypothesis. Now, I think that this is almost a contradiction in terms, because it's hard to think how you can have an equilibrium or natural rate, which generates the very problems that you are supposed to try and avoid, which is huge macroeconomic costs and huge instability and to my mind, this goes back to what I was saying earlier. It's more a symptom of the incompleteness of the models that we use to understand how the macro economy works. There's models that don't really have financial potential for financial instability as one of their ingredients. And therefore the play down, the potential destabilizing role, the financial system and monetary policy can play.

So this, in a nutshell is the story about the natural rate. I think that we have to have a concept of a natural rate that is not just ensuring that output is a potential, that inflation is stable and so on and so forth but also that it is consistent with sustainable economic expansions and therefore with as some notion of financial equilibrium. And indeed in a recent paper that we produced in July, we try to go at least one step further in that direction by calculating what something like that might be, by deviating as little as possible from traditional models, but allowing for this possibility of financial booms and busts and into the system.

And we show that if one does it that way, even by making relatively simple changes to the basic assumptions and encompassing the traditional model, you get natural rates that are higher than the current estimates, you get natural rates that have declined by less. And in particular, if monetary policy was to try to deal with the financial booms and busts in a more systematic way, then you would be able to have a higher natural rates as well.

Beckworth: Okay. So if I can summarize your view and correct me if I'm wrong here, but what I took away from that article, that part of the natural interest rate discussion is that the accelerant traditional view is that first, we don't observe this natural interest rate that one of the key things. It's a latent variable, but it's important given the standard new Keynesian view of the world, monetary policy is done in such a way that needs to align it's target interest rate with this market clearing natural interest rate value. And one way we know we're not doing that is as inflation starts to take off, if inflation takes off, it must be the case according to the standard view that we've purchased interest rates below the natural rate, we've pushed interest rates below the market clearing the stabilizing value.

And what you argue is that's not sufficient, right? You argue that you could have low inflation and still have the interest rate below the natural rate. And one sign of that would be a buildup of financial imbalances, is that right?

Borio: Absolutely. Yeah, that's right. Which is basically just repeating what we had said about the problems that were building up before the financial crisis, inflation was low and unstable but low interest rates were contributing to the buildup of financial imbalances that were then creating major problems down the road for the real economy. So the notion of the natural rates should also incorporate some sense of equilibrium stability in the financial system because that financial system and the real economy are inextricably linked and problems in one create big promise for the other.

Beckworth: I agree with you, I take a slightly different route in reaching that conclusion though. And that is in the natural rate has embedded in it productivity growth, right? If you do basic growth model, one of the terms is, some would say the trend growth, but deeper down is the productivity growth rates. So, we talked about the pre 2008 period that the credit boom. So we had low inflation =but productivity, as I mentioned before, it took off during this period, it really grew rapidly and all else equal is this standard macro model will tell you the natural rate had gone up. So, in my view, it seems the Fed by failing to recognize that, rates were below the natural rate during the pre 2008 period, and because there were below, they fueled the financial imbalances. So that makes complete sense.

So here's where I struggle. Maybe you can help me understand. So since 2008 and we've been in a slump, Larry Summers has his explanation for it. One thing we haven't had since 2008 is rapid productivity growth. In fact, there's a debate on whether we're measuring it properly, but we'll put that through the side. Well we haven't had rapid productivity growth, so I'm having a hard time understanding, are we creating potential imbalances now? Your measure would suggest we are based on the fact that rates are still below the natural rate, others measures would say, they're not. But one thing that does seem clear to me is that productivity is not booming and therefore not creating a destabilizing role, maybe that it did prior to the crisis.

Borio: Well, I think that the key question that you're raising and at the end of the day, it is an empirical question is whether it is the behavior of productivity or the behavior of, what do we call financial imbalances in the behavior of credit property prices and whatever that gives you a better sense of whether the problems might arise. Having said that, what is happening is if you take this argument over different business and financial cycles, what happens is that you get a situation in which symmetric monetary policies over successive cycles tend to lead to what we call a debt trap and might actually over time tend to reduce any reasonable measure of the natural rate as well, because what they basically do is that, so they failed to lean against the booms and bust then that creates the bust.

The bust causes long-term economic damage, including by the way, persistent low productivity growth. And this is something that we have shown in another paper that we have. I don't know whether you have seen that we released, I think at of the beginning of the year, we could talk about that. But I actually mentioned, I think in the cut off speech. Then policy response very aggressively and persistently to the best. So in the ... of the next problem, but over time, what this does, it imparts a downward bias to interest rates. And then up put bias to debt, which we actually are seeing. So that at some point it's very hard for you to raise interest rates without creating the very problems you're trying to avoid, because there's too much debt out there and the economy simply cannot take it. So over time, you're running out of policy ammunition because your interest rates are falling and falling, and it becomes harder to raise them without creating problems.

So this is what we call a debt trap. So that over sufficiently long horizons, low interest rates in the past are a reason why you see such low rates or even lower rates today. So that's the same thing, which we talk about too low rates be getting lower rates. So then what policymakers take us given as exogenous as economists would say at a particular point in time is in fact in part the result of that past policy decisions, and this is something which is very important to bear in mind. And the main mechanism is through the accumulation or destabilizing accumulation of stock.

Beckworth: So how do we get out of the debt trap, this burden we've created, how do we put ourselves in the right path?

Borio: Well, I think it's not easy. It's obviously not easy. You know what the typical ways are, one is through growth, if you can get it mainly through structural measures and the like. The other is through restructuring or during the restructuring of the debt where it is excessive and a lot has and should be done in, for example, in the case of the banking sector. And the other possibility economists would tell you is, well, basically just higher inflation, but it's not just higher inflation it's higher inflation in the context of financial repression. And it's not obvious to me that that type of inflation would also be any inflation that would help generate growth. So that is a very tricky line to follow.

Beckworth: Well, let me continue on, the other context we were discussing was your Kiddo journal article, you're revisiting the three pillars of monetary policy. We've covered the first one, reconsidering how we think about the natural interest rate. And I'm going to skip the second one, because we've really discussed that already. And that is money neutrality, this whole debt cycle, low rates, beget other low rates.

So I want to move to the last one, and this is one that's been near and dear to my heart. I've actually worked on that. And as I mentioned, George Salesmen was my professor. So, I've thought about this too. And this is the idea of deflation always being a bad thing everywhere and always. And you make the case... Well, not so not so fast. It's conditional upon the state of the economy and what's driving it. So can you just talk about that?

Borio: Yes. Well, I think that the general view these days is that there is a very tight, logical link between deflation and recession. It's a blowgun reaction. Whenever you mentioned the term deflation, people who think, "Oh, it must be terrible. There must be a bad recession, depression or whatever." And alongside that, you have concerns with downward spirals. So the idea here is the price of full monetary policy hits the zero lower bound. You do much that leads to further folding prices and the contractions in demand either because households tend to postpone consumption, they always are equation, or because the real value of debt increases depressing demand further.

Now people tend to forget that weather falls... Let's be more technical, falls or persistent falls in the price level are bad or are associated with contractions or not is ultimately an empirical question. Just to simplify, if prices fall because of decreases in demand then money is likely to see lower prices and lower output and therefore defeat deflations being quote unquote contr actionary if they fall, because there are increases in supply on the area. On the other hand, think of the aggregate supply curve and the simple model one would tend to see lower prices, but higher output then therefore expansionary.

And this is really the origin of the distinction between good and bad deflations that goes back to quite a number of years ago. Now the historical evidence that we have seen, and some of which we have produced is not really consistent with the view of the deflation is always costly. So in theory, collaborators had already put forward the distinction good and bad deflations. We've taken some steps further by also looking at the relationship with asset prices and we basically find three findings.

The first is we confirm previous work and we find that there's a weak link between deflations and output growth. The second finding is that the link arises largely from the Great Depression, the experience of the thirties, and even that link disappears once the behavior of asset prices is taken into account. And we find no evidence of the cost of the interaction between debt and deflation, if you share in that deflation, but we find evidence of such an interaction between debt and property prices, especially house prices. And of course, what happened most recently is an example of that.

So the results are consistent with the notion that many inflations are supply-driven or at least benign, and that concerns with spirals are over done. And there are many factors that may help to drive prices down, including technological change, globalization, the entry of former communist countries into the global trading system since the 1990s and more recently. And even the example of Japan, which is often quoted as how things can go wrong when you have deflation upon closer examination does not really support that view.

Beckworth: Yeah. This view here, I think helps us understand what happened early, mid two thousands. Again, going back to that productivity boom, I keep talking about that was driven, there's technological reasons for that productivity boom, but also the opening up of Asia, I think was a big part of that massive labor supply shocks, technological supply shocks. And had the Fed been less fearful of this inflationary or even deflationary pressures during that time, they may have been sooner to raise interest rates than they did, and may have stalled some of the excess of boom and credit creation during that time. But it's this fear, right? It's this knee jerk response, this inbred fear, deflation must always be avoided as opposed to what is the source of it? And I've looked at the postbellum period in the US so after the civil war up until the late 18 hundreds, I know you have as well and a number of authors have.

But it's striking because during that period, and there were a few bad episodes, but on average, the real GDP grew almost 4% from about mid 1860s and mid 1990s, almost 4% real GDP growth complimented by almost 2% deflation. So that's 30 years where on average prices fell 2% a year and the real GDP grew about 4% a year. So, it's a completely foreign world to anyone today. If you told someone, "Hey, you know over the next 30 years, prices will fall on average 2% a year." Mind would blow, it seems so different.

Borio: This is of course, one of the episodes which is included in the cross-country analysis, that we did looking at many countries over many, many, many years, but even if you look at more recent examples, China has seen over the last decades significant episodes of periods of deflation in the traditional sense. And yes, of course it has been growing very, very fast, but even if you go beyond China, if you look at the recent experience of Sweden, you will see that that country has got quite strong growth but consistent, but at the same time falling prices. And even the country where I live in, which is Switzerland, is a country in which we have had falling prices for quite some time, but not stellar, but quite solid GDP growth and very low unemployment.

But of course, a number of these countries, not all of them, but a number of these countries, well, at least the three that I mentioned have definitely seen at the same time, which is quite worrying strong increases in credit and strong increases in property prices that have been a source of concern for the policymakers. So the irony in all this is that as we have discussed in a number of papers number of years ago, actually strongly against the good deflation may paradoxically lead to bad deflation for the down the road, if you have a big part in the economy and construction in demand. And if, as a result of that construction of aggregate demand, and there is downward pressure on prices.

Beckworth: So embrace the good deflation today, or face the bad deflation tomorrow, is the lesson ....

Borio: There is a trade-off, and I think the important policy implication of old days is to look very closely at the sources of falling prices before calibrating a policy response. And the other implication of course, is to perhaps pay less attention to fine tuning inflation numbers and more attention to what happens on the financial side, the financial cycles, if financial booms and bust.

Beckworth: Okay, let me switch to the time we have left, we're getting near the end of the show here, but let me switch to a paper you just put out, you co-authored. I believe it came out in July of this year where you and your co-author go back and you... It's a great paper, because you go back and summarize the literature on unconventional, monetary policies. You called a reappraisal. So you go back and you look at all the QEs that's been done all the different Ford guidance, the use of the balance sheets. Tell us about that paper and what did you find by going back and studying the literature on unconventional monetary policy.

Reappraisal of Unconventional Monetary Policy

Borio: Well, what do we basically find by looking the evidence is that there is clearly plenty of evidence that the various unconventional monetary policies have had a major impact on yields and on asset prices. I think that there is no question about that. The evidence is clear. I think all you have to do is to watch out of the window or more precisely just look at the TV and hear how financial market participants are responding to these policies.

Beckworth: When you say major... I want to ask actual magnitude, let's do, for example, the US, US since let's go back 2007, ten-year treasury yield was about almost five and a quarter percent, and now it's one and a half. So are you saying most of that decline is due to QE or just a meaningful amount?

Borio: No, I would say a meaningful amount of that, I would not say ... I don't have the numbers. I couldn't say off the top of my head, but in the paper we have some review of the various estimates and provide some figures, but as a significant, a sizable amount of that would be attributed to the policies followed by the central banks. So it's not just QE for guidance and so on and so forth. And then there are many aspects, many aspects to this. But of course much harder is clear evidence of an impact on an inflation because unfortunately there's nothing you can really do about this, much of that has to rely on extrapolations from previous relationships. Some of which are highly dubious, going from the size and structure of a central bank balance sheet to economic activity.

And in fact, one should not expect to have seen much of a relationship at all on conceptual grounds or trying to go from the same size and structure of the central bank balance sheets to some synthetic or shadow rates or shadow yields and so on. So, I'd say it's very difficult to get a good solid empirical evidence of the relationship between those policies and inflation and I'll put on the other on the other hand. But of course and this is really in that part of the work we really go beyond what the empirical evidence can suggest, but I think there are reasons to believe that those past relationships also need not hold. One has to do with economic context and it's the idea that over indebted agents tend to retrench and repair the balance sheet when they've realized that they've taken on more debt than they can repay.

And of course in broken financial systems failed to transmit policy adequately. This is what typically happens during a financial bust. Now, some countries have dealt with those problems better than others. But they're also reasons to believe that there might be different returns because of the intrinsic nature of these policies, because there are of course limits to how far risk premial can be compressed or expectations guided or interest rates and rates pushed into negative territory.

And as those limits are hit or reached then the policy effectiveness tends to worsen. Now another example of all this has to do with the impact of the rates through the financial system, which again is not something that is easily embedded into models, but low rates tend to... as a very flat term stretch it and to undermine bank profitability, which can turn then reduce incentives and ability to lend. They put insurance companies and pension funds under strain because the maturity of their liabilities is longer than that of their assets. They may inhibit the ability of shift resources from low productivity firms to higher productivity firms.

The story of the zombie banks and the zombie companies. And then there are also broader questions about confidence. There are some perverse effects here because sometimes in order to convince markets that you will keep interest rates for low, for very long, for example, you have to paint a rather bleak picture of the macroeconomic outlook. And although that might get markets to pricing those rates, it may be create problems for the confidence of the people that you really want to reach, the businessmen and households.

And there is a broader question of even people understanding what's going on. I think for example, when you start shifting into negative interest rates, it's very, very hard to communicate to the average person, why those rates are as low as they are. And that can really backfire in terms of confidence. And then of course, a number of political economy considerations that have to be taken into account, which are quite important in terms of what all this could do to the credibility and independence of central banks going forward. So these policies used to be seen as a free lunch. Now it's clear that they're no longer perceived so easily. I know, so clearly as a free lunch, central banks are very, very aware of the possible collateral damage that this policies might create. But then of course there is a question of balance of benefits and costs and it's here where different assessments can be made.

Beckworth: Yeah, well, I know in the case of the US the hopes and claims of Fed officials were for much greater outcome than actually happened, QE was supposed to boost the recovery, ... demand growth. And they might argue in some do argue that it, maybe it did put a floor under the economy, but it definitely didn't live up to the expectations and the hopes.

Borio: Clearly also one has to make a very, very sharp distinction between what I would call the crisis management phase and the crisis resolution phase, the crisis management phase that you have to put out all the stops and so on. And clearly quantitative, these types of measures can be seen as more in line with the traditional lender of last resort policies, but in a much broader sense.

In crisis resolution, the key is to try and repair balance sheets and the like, and this is something that monetary policy is not particularly effective. If anything, it could actually delay some cases adjustment, for example, when it comes to the bank, since we have ..., because it's much easier to keep providing credit to the companies that are not in very good shape, partly because you don't want to recognize losses.

And then that would mean that if you have some kind of capital constraints, you would be reducing the credit supply or enraging the price for the better customers. The bottom line is that during financial tasks, deleveraging is a necessary... and we have quite a lot of empirical evidence to that effect. Deleveraging is a necessary condition for a self-sustained and a strong recovery. And some of these policies rather than helping it may actually hinder it.

Beckworth: Okay. I still think that the results of QE have not been very firm in terms of real recovery, inflation growth, part of the objective of doing them. I also have some skepticism about how effective it has been, even in changing yields. I know you take a different view. But there's some folks who argue a lot of the evidence for even the effect on the yield is based on events studies and how much does it really get to permanent change in yields? And really, I guess this goes back to the question of where is the natural rate, are rates low because central banks have been intervening or rates low because we've been in a slump?

And even in the latter case, even if rates are low, because we've been in a slump or a weak recovery, I think you could argue and go back and say, "Well, okay, sure." But that goes back to the debt cycle, right? It goes back to previous, previous mistakes that were made, but it's a fascinating conversation. And one that we will continue to discuss as time goes on. Now we have just a few minutes left, and I want to turn over to you in closing all this experience behind you and your work in the field, what would you recommend to a budding young macroeconomist someone who's going into this field. What would you tell them, how do make the most of this career? What would you recommend to them?

Borio: Well, I think that it depends very much what they want to do there is a serious problem with incentives. I think if they want to try and find their own way in economics, I would suggest to them not to stop at whatever they learn in university and to try and look at a bit more how the history of the evolution of economic thinking has been over the year. So the history of economic thought, and I think came out quite clearly from our conversation or for economic history. I think that there is a lot that can be learned from that. It provides a lot of perspective that would otherwise be very difficult to pin. And by the way, let me say that even when I was at university, I didn't actually do this.

Delving more into history was something that I did after I left and I don't regret having done it. So that, for me, it's important. The second thing that I think is very important is, don't be afraid of questioning sometimes conventional wisdom and be curious and try and read as I mentioned earlier, a broad range of views, as opposed to just focusing on the model. The key problem there very often is that sometimes the questions that we ask are constrained by the tools that we can use. And I think that's very bad.

I think modeling is extremely important to clarify one's thinking. But we should not be too constrained by the fashion the fashion of the day when asking particular questions. And I think that's part of the problem that exists in the profession aware of course you have to publish at all costs. And in order to publish the full costs the incentives are structured in such a way as to do minor adjustments to the existing body of work, as opposed to try and think a little bit more free.

Beckworth: Well, those are great recommendations to end the show on. Our guest today has been Claudio Barrio. Claudio, thank you so much for being on the show.

Borio: Thank you so much for having me.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.