Two centuries ago, the world was introduced to the concept of the business cycle.
It was the panic of 1825 that jolted observers who once argued economies were inherently smooth unless pushed off course by external shocks such as war. The turbulence backed the emerging view of Swiss-born Jean-Charles Leonard de Sismondi that booms and busts were the norm.
Managing those ups and downs is no longer enough for the state-of-the-art central banker, says the Bank for International Settlements, which was established in May 1930 to oversee the reparations imposed on Germany after World War I and now serves as the central bank for central banks.
Failure to monitor what the BIS calls the financial cycle - - which tracks the interaction of debt, assets and risk-taking with economic growth -- leaves economies prone to fragilities such as overindebted companies and households or bloated financial systems.
“The loose link between business and financial cycles over prolonged periods may tempt policy makers to focus on the former without paying much heed to the latter,” the Basel, Switzerland -based institution said in its annual report published yesterday. “But setting policy without regard to the financial cycle comes at a peril.”
The BIS is already fretting, noting in its report that monetary authorities face a bumpy road to exiting easy policy and shouldn’t delay a withdrawal of emergency measures.
Financial cycles can best be measured by monitoring credit aggregates and property prices, the BIS said. At around 15 to 20 years, they tend to outlast the one to eight years of business cycles. Peaks in financial excess often coincide with banking crises.
Japan and the Nordic countries of the early 1990s and Ireland, Spain, the U.K. and U.S. more recently were victims of a failure to acknowledge the importance of financial flows to economies.
Now, the BIS is concerned by the threat of overheating in Australia, Canada and particularly emerging markets such as China and Turkey, where credit to the private sector has been expanding about 10 percent per year.
The gap between credit as a share of gross domestic product and its long-term trend needs to be monitored, according to the BIS, with any difference beyond 10 percentage points usually followed by banking travails within three years. Switzerland, Brazil, China and Turkey are above that threshold.
For now, the financial cycle of the U.S. seems to have bottomed out and that of the euro area is mainly still in a downswing although the decline in credit and home prices has slowed. That said, the ratio of private-sector debt to GDP in the U.S., U.K. and Spain has fallen only by 20 percentage points from its peak, about half the move seen in previous periods of turmoil and so suggesting some way to fall.
The worry for the BIS is that the current environment of low interest rates has “the perverse effect” of encouraging more debt to be taken on, making an eventual increase in borrowing costs more costly to global growth.
“Output and financial variables can move in different directions for long periods of time, but the link tends to re-establish itself with vengeance when financial booms turn into busts,” it said.
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