The top economist at the “central bankers’ central bank” on the changing nature of recessions

FILE PHOTO: Flags fly over the Federal Reserve Headquarters on a windy day in Washington, U.S., May 26, 2017. REUTERS/Kevin Lamarque/File Photo/File Photo/File Photo –…
FILE PHOTO: Flags fly over the Federal Reserve Headquarters on a windy day in Washington, U.S., May 26, 2017. REUTERS/Kevin Lamarque/File Photo/File Photo/File Photo –…
Image: REUTERS/Kevin Lamarque
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Known as the “central bankers’ central bank,” the Bank for International Settlements (BIS) provides financial services for the world’s central banks and promotes global monetary and financial stability. The Basel-based organization was founded in 1930, making it the oldest global financial institution. It is also one of the most influential—even though its research increasingly challenges the monetary policy orthodoxy that has seen the central banks in the US, Europe, and Japan embrace low interest rates and unprecedentedly huge bond-buying programs in the last decade. Its top economist, Claudio Borio, has long led this research effort. Quartz caught up with Borio recently to discuss what BIS analysis of “financial cycles” suggests about risks of recession and financial instability around the world.

Quartz: Building on your extensive research into financial cycle dynamics, you and your BIS colleagues recently published an analysis that found that a composite of financial cycle proxies [medium-term changes in real credit, a country’s credit-to-GDP ratio, and real home prices] more reliably predict recessions than yield curve inversions. 1 What does your analysis reveal about the current risk of recession? 

Claudio Borio: It’s important to underline that at the BIS we do not make or publish forecasts. We look more at the balance of risks around the consensus forecast, which are quite public. This is a second important point: [the financial sector proxies] need to be taken with a spoonful of salt because they’re just one piece of information for a more thorough analysis. And it would be overly ambitious to talk about timing.

But the main point [of the analysis] is that the picture that financial sector proxies paint is currently more benign than that of the term spread [i.e. flattened and occasionally inverting yield curves].

You touched on this some already, but can you explain a bit more where in the present global financial cycle we now find ourselves?

The position and the cycles do vary across countries, and they largely depend on whether [a country] suffered a lot during the financial crisis, what we call the Great Financial Crisis, or whether they were left largely unscathed.

Now in those countries [that did experience a financial expansion that peaked before the 2007-2008 crisis], the sectors where leverage was highest have deleveraged to varying degrees. 2 The household sector in the United States or in Ireland—these are typical examples.

In those that have not or did not experience this, the private sector has continued to increase leverage 3 so that the financial cycles have expanded further. And in fact, in some of those economies they have shown signs of turning.

In regard to the US, the 2000 recession is one that our composite indicator4 that brings together credit and property prices would have missed. And the reason for that is precisely that it is designed to capture the most costly recessions, which are associated with a big turn in the financial cycle.

But the most important point is that…the nature of the business cycle has changed and we need to realize that. I would say that it started changing particularly from the early 1980s onwards. So until then, the typical recession was proceeded by a sharp increase in inflation, a consequent monetary policy tightening. 5 And you didn’t really see much in the behavior of credit around, around the turn of the business cycle.

Since then, on the other hand, inflation has been rather quiescent. There has not been much monetary policy tightening precisely because of that. But we have seen a rather strong increase in credit that then reverses and causes economic weakness.

What does your research imply we should be thinking about, in terms of the risk of recession or of a financial crisis?

So there are two notions of risk. One notion of risk, which I think is the one which is embedded in current macro models—I don’t know whether you’re familiar with the [Dynamic Stochastic General Equilibrium]6 models, which are really the benchmark in the academic literature these days—is that risk is low in expansions and high in recessions, which I think sounds very intuitive.

But the notion of risk that we started exploring in the 2000s was turning this on its head and basically saying that risk was building up in expansions, particularly when financial expansions were going strong, and then was materializing in the subsequent bust or recession—so that what you saw in a recession or in a bust was simply the result of what preceded it. And this is precisely the idea that you have cycles.

This idea of a cycle is in contrast to the view that prevails in current models where what happens to the economy is that you get shocks. You get a good shock that brings the economy up and then it moves towards steady state, it returns to equilibrium. Then you get a bad shock that pulls the economy down and then it returns to equilibrium.

But there is no notion of a cycle [i.e. a pattern in which the forces driving an expansion create the source of its reversal] in the way that macroeconomists typically think of the economy these days.

Based simply on one of the graphs in the paper, the US appears to be around the same point in the financial cycle as it was in the early 2000s. So going by that, it doesn’t seem like we’re anywhere near the top, right?

As you know, the past is never a very good guide, or at least not a perfect guide, for the future. But taking it as a guide—I guess we don’t have much else to go with—I would suggest that the US financial cycle in particular has further to run. 7 Interest rates are still quite low to start with and the household sector has deleveraged to a considerable extent.

Now there are issues that…have to do with corporate debt—leveraged loans, the large proportion of BBB debt 8 that is outstanding—which of course makes the corporate sector vulnerable. And that could be a factor that, [while perhaps] not trigger[ing] a recession, could contribute to and amplify an economic slowdown.

But this is a little bit different from the financial cycle itself because you could still have an overall expansion of credit in the household sector 9 and so on. Remember our financial cycles proxies do not capture all recessions. They tend to capture some of the bigger ones.

Of course, the higher US rates go 10, the more pressure they will put on the financial cycles in other economies, including in emerging market economies. And then you have to bring all of that into the picture.