The annual report 2020

Borio (Bis): it is now imperative for the economic policy to regain room of manoeuvre

High debt, porous borders between fiscal and monetary policy, the exiting from extraordinary measures: in an interview the Head of Monetary and Economic Departement at the BIS speaks about the challenges of the recovery.

di Riccardo Sorrentino

11' di lettura

It is imperative to regain room of manoeuvre: fiscal, monetary and prudential policies have to rebuild their “buffers”, and central banks have to maintain their independence and credibility which have proved very useful during the current pandemic crisis. Those are the key messages of the 2020 annual report of the Bank of international settlements (BIS). Claudio Borio, head of the Monetary and Economic Department at the BIS, in an interview with Il Sole 24 Ore, speaks about the more challenging aspects of the recovery.

Covid recession seems to be very peculiar. The economic activity has virtually stopped after a government decision, not because of a cyclical weakness of the economy. What will the recovery look like?
The simple truth is that it is very hard to tell. This is a unique crisis, and a highly uncertain one. To be sure, I have always been quite sceptical of statements like “things are particularly uncertain today” because they are heard far too frequently. But this crisis is uncertain in a very specific sense: its evolution depends on non-economic factors. To the point where a number of central banks haven’t made forecasts; they have just put forward a number of scenarios and carried out policy based on those scenarios.
I can only make some conditional statements.
If there are no further waves of infection, then I think the recovery will be relatively smooth and the problems will remain contained. That’s partly because the so-called “scarring” effects of the crisis will be more manageable: the accumulation of debt – which is a key factor influencing those effects – would be less important.
If we see more waves and containment measures in response, then the crisis will be more protracted and we will be facing more serious issues. First, the crisis is already transitioning from a liquidity phase to a solvency phase. And the severity of the solvency phase depends on how protracted the crisis will be. Second, debt would be higher more generally, and debt overhangs tend to weigh down on growth. Finally, there is an issue with the structural or supply side of the economy: the longer the crisis continues, the greater the necessary sectoral structural adjustments. The pattern of aggregate demand would be changing in more profound ways. Such structural adjustments take time and can be quite disruptive.
So, we have these different scenarios, and which scenario will materialise depends very much on the evolution of the virus.


Private and public debt is rising very rapidly. It will be a heavy burden on the future. How can we deal with this problem?
Again: how high debt will be depends on the length of the crisis. And the level will affect how the debt might be reduced. Historically, there have been three ways of dealing with too much debt, sometimes in combination.
The first way has been through inflation and financial repression. That’s clearly very costly – we’ve been there and don’t want to go back. The central banks’ task is precisely to ensure that we will not return to an inflationary world.
The second way is through debt restructuring.
We will inevitably have some form of private sector debt restructuring; the extent will depend on the extent of the defaults. At that point, the task is to distinguish viable from non-viable enterprises. We know what the mechanisms are: they range from bankruptcy proceedings in the courts to less formal arrangements. At the solvency stage, the public sector’s role is very important, ranging from providing general guidance to buying equity stakes as part of the restructuring of the companies. The important thing here is to be quite selective in terms of which companies to keep alive.
Then, of course, we have public debt. And if we get there, that’s a different kettle of fish, because restructuring public debt is much more costly than private debt. The reason is simple: the public sector is the backstop to the private sector – it plays a key role in the restructuring of private sector debt, be this the debt of companies or, as often in the past, of banks.
But who is the backstop to the government? No one, except the international community. And the likelihood that such debt restructurings may be needed depends on the degree of sustainability of public finances and the room for policy manoeuvre. This room is smaller in a number of emerging market economies (EMEs), but also in some countries that do not have an independent monetary policy.
The third way, which I think is the hardest but at the same time the best one, is to raise growth in a sustainable way. The only way in which that can be done is through structural adjustment. I don’t think there are any shortcuts here. Unfortunately, the experience before this crisis and even going further back is very disappointing. Efforts should focus on carrying out the right structural reforms and on ensuring growth-friendly fiscal policies that keep public finances on a sustainable path.

Has the role of central banks and monetary policy changed in the context of crisis management?
Yes. Because of the specific nature of the crisis, central banks have made much bigger efforts to try to cover “the last mile”, ie to ensure that firms get the necessary funding. They have done so mainly by providing backstops for bank loans and buying securities outright, including for riskier firms. In addition, because of the growth in market-based finance, central banks have been moving from their historically traditional lender of last resort function to a dealer or buyer of last resort function. They have been operating much more in markets to make sure that those markets function properly. This shift had already started taking place during the Great Financial Crisis (GFC) in advanced economies, but it has been novel for emerging market economies. Thanks to improvements in the macroeconomic frameworks of EMEs, monetary authorities and central banks there have acquired sufficient credibility to operate directly in domestic currency government bond markets.
As regards the standard macroeconomic stabilisation function of monetary policy, I don’t think there is going to be any fundamental change. Since the GFC, central banks have already broadened the set of tools at their disposal, from employing merely a short-term, in fact an overnight, interest rate to making more active use of their balance sheet and intervening in domestic securities markets. They have always intervened using their balance sheets in foreign currency markets, but interventions in domestic asset markets are another matter. That toolkit is there, so it will continue to be employed. It is important to do so wisely because the more you use the tools and extend the range of action, the less effective the tools become and the more you lose room for policy manoeuvre.
At some point, when conditions allow, a key priority will be to try to regain policy space. That is true also for fiscal policy, and it may be true for prudential policy too.
Indeed, the experience with prudential policy in this crisis has shown just how important policy space and the corresponding buffers are. Prudential policy was very good at rebuilding policy space following the GFC, when we saw the financial reforms and banks had to become better capitalised. Now, precisely because of their greater financial strength, banks have been looked upon as part of the solution as opposed to part of the problem. Prudential authorities have asked them to use the capital buffers they have accumulated to keep credit flowing and to support economic activity to the extent possible. If those buffers are drawn down as we move to the solvency phase, then clearly banks will have to rebuild them.
Thus, because of the sheer scale and scope of this crisis, I think that, going forward, and as macroeconomic conditions allow, it will be very important for the three policies – monetary policy, fiscal policy and prudential policy – to make sure that they have sufficient buffers to deal with any possible contingencies. Far from being a luxury, policy buffers are absolutely essential.

The borders between monetary and fiscal policy have become even more porous. Do you see any problem with the independence and the same effectiveness of central banks?
It is inevitable that in crisis management the borders between monetary and fiscal policies become fuzzier and more porous. Central banks have taken steps to limit this. In particular, they have tried to make crystal-clear the rationale for their interventions and their temporary nature, to make sure they remain accountable and to keep distinct the roles of the two policies, for example through government indemnities. These government indemnities play different roles. They signal that the players are united in dealing with a particular crisis. They help distinguish more clearly real resource transfers – credit losses – which are the domain of fiscal policy, from more lending, which is what central banks can do: central banks lend, they do not spend. In addition, the indemnities help safeguard central banks’ financial, and hence overall, independence. At the end of the day, what matters is that central banks remain in control of what they do and operate within their mandate.
So far, the objectives of central banks and government have coincided, but at some point they may well diverge. You could imagine governments wishing to keep borrowing cost low and central banks needing to raise interest rates because macroeconomic conditions call for that. At that point, the real test will come. At that point, there is the risk that also central banks’ independence might come under pressure. And, as you know, it is very important to preserve it. For example, the meaningful dividing line between monetary financing and standard central bank operations is precisely who is in control and the reasons for the actions. If central banks had to change the stance of monetary policy in order to keep interest rates low, that would indeed be a big problem.
I think it is precisely the hard-earned credibility that central banks have gained which has allowed them to take such extraordinary actions during the crisis, including crossing some previous red lines – doing things that had previously been considered off-limits. If the credibility of monetary institutions ever came into doubt, that would be a very, very high price to pay.

Some economists and many policymakers advocate monetary financing. Do you think it is a viable proposal?
There has been a lot of talk about monetary financing, but I think this debate is somewhat confusing. There is a technical aspect to all this: purchasing government securities is part and parcel of monetary policy implementation. So, to speak of it as “monetary financing” is rather odd: why didn’t we speak of monetary financing before if that is the case? We always had fiscal deficits and we always had central banks purchasing government debt.
As I have just said, I think that the important economic dividing line between monetary financing and normal monetary policy has to do with who is in control and the reasons for the actions taken. As long as central banks are in control of what they do and as long as what they do is in line with their mandates, the issue of monetary financing is not particularly relevant; it is more rhetoric than anything else.Central bank’s balance sheets are very large now. Can they create any problem?

Central banks' balance sheets and, correlatively, excess reserves have become very large. Can they create any problem?
Having large balance sheets does create a set of issues of its own. The issues depend on which assets the central bank buys.
If the central bank buys government paper and issues central bank liabilities against it (eg bank reserves), it ends up doing the equivalent of a very large debt management operation. If you consider the public sector balance sheet as a whole, it is as if the government bought back some of its debt and issued very short-term liabilities – in fact, overnight debt. Governments don’t quite issue at that maturity, but they come close in economic terms. So you’re entering a sort of fuzzy area. But the bigger questions concern the political economy of the operations – the fact that the central bank risks incurring losses. These can create risks for central bank independence as well as the perception of monetary financing, regardless of circumstances. We have seen that already.
If, on the other hand, the central bank buys private sector assets, then it would extend its involvement in the market economy and, one way or the other, end up making allocation decisions, which is not so much its role.
Moreover, in either case – buying government or private paper – exit is harder. It is easier to change interest rates than to sell securities outright. We saw this in the run-up to this crisis, but it is true historically more generally.
These issues aside, the impact on aggregate demand and inflation depends much more on the level of interest rates than on the size of central bank balance sheets per se. In particular, having large excess reserves in the system is not the issue in this context. Interest rates matter so much because, in effect, they set the universal price of leverage in a particular monetary area. And this can have a major impact on price and financial stability, regardless of the size of reserves (“money”) in the system. As long as you can control interest rates, reserve size is not an issue. That’s why central banks pay interest on excess reserves: precisely in order to retain control over the interest rate. The idea that there is a mechanical link between (excess) reserves and inflation was never right and it will never be.

How hard will it be exiting from the current emergency measures?
Clearly, exit has proved hard, and central banks are fully aware of this. They are also aware that exiting from emergency measures is going to be critical. This is why a number of the measures they have taken are self-liquidating, because of the interest rate charged on them, the maturities and other terms. But the real issues are not so much technical but economic. For that reason, the normalisation of policy was a key challenge pre-crisis, and I think it will continue to be a challenge post-crisis.

Is inflation targeting dead, in the current environment of even lower inflation?
Price stability will rightly continue to be a key objective. I think that, subject to ensuring price stability, it is important to pursue inflation targeting in a flexible way. This is to allow other considerations that have to do with longer-term macroeconomic stability, not least financial stability, to be incorporated.
A key such consideration is that interest rates that are very low for a long time do contribute to financial vulnerabilities, which can then undermine financial and hence macroeconomic stability. For instance, a number of financial vulnerabilities that were present when this crisis started have added to its severity – although the crisis would have been very bad anyway. To cite just one example: in a number of countries, including in the United States, the corporate sector was already overstretched before this crisis. This was part of a broader picture of high private sector debt and aggressive risk-taking in financial markets.
Flexibility in pursuing an inflation target is also important for regaining the necessary room for policy manoeuvre.
This implies having a horizon that is long enough in order to be able to accommodate these other considerations. And, of course, it also implies having other policies play a complementary role. If the primary risk is a risk to financial stability, the onus is on prudential policy; if the risk is that of fiscal dominance, public sector finances must remain on a sustainable path. So, in general, it is the whole package that matters.

Central banks have a very rich toolkit, now. Are there any new tools they can use if the economy outlook worsened?
If the economy needs to be supported, I am sure that central banks will show as much innovative spirit as they have in the past and that they will be able to deliver. Of course, this will inevitably imply a further loss of room for policy manoeuvre. This highlights a point I mentioned earlier: as soon as conditions allow, it is important to regain that room.

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