CLAUDIO BORIO is one of the world’s most provocative and interesting monetary economists. Based at the Bank for International Settlements in Basel, Mr Borio was one of a handful of people who warned of the financial system’s fragility back in 2003. Now he is out with a new working paper called “The financial cycle and macroeconomics: What have we learnt?” This important paper summarises what we know about booms and busts, Mr Borio’s own suggestions for the next research agenda in macroeconomics, and the optimal policy responses to financial crises. What follows is a summary and analysis of the most interesting bits. Those who are interested should read the entire paper.

Mr Borio's thesis is worth quoting in full:

Economists are now trying hard to incorporate financial factors into standard macroeconomic models. However, the prevailing, in fact almost exclusive, strategy is a conservative one. It is to graft additional so-called financial “frictions” on otherwise fully well behaved equilibrium macroeconomic models, built on real-business-cycle foundations and augmented with nominal rigidities. The approach is firmly anchored in the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) paradigm…The main thesis is that macroeconomics without the financial cycle is like Hamlet without the Prince. In the environment that has prevailed for at least three decades now, just as in the one that prevailed in the pre-WW2 years, it is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle. This calls for a rethink of modelling strategies. And it calls for significant adjustments to macroeconomic policies.

What is this "financial cycle"? While "there is no consensus on the definition," according to Mr Borio, it can be understood as a sequence of "self-reinforcing interactions between perceptions of value and risk...which translate into booms followed by busts." This corresponds with large increases and decreases in the amount of private debt relative to income, as well as the prices of assets financed by that debt, such as real estate. For Mr Borio, the financial cycle has several salient features that often cause it to be ignored by mainstream economists. First, it has a much lower frequency than a typical business cycle. Instead of going from peak to trough every 5-7 years, the financial cycle can take decades. Patterns of economic activity on both the upside and downside simply do not make sense unless the high-frequency business cycle is overlaid on top of the slower-moving financial cycle. Second, the amplitude of the financial cycle is very wide compared to the amplitude of the normal business cycle. This combination means that the financial cycle produces sustained booms and deep downturns. Fortunately, Mr Borio points out that we have the analytical tools to observe the financial cycle as it happens. This means that, if we chose to do so, we could erect safeguards against the sort of financial instability that has proved so painful over the past few years:

Financial liberalisation weakens financing constraints, supporting the full self-reinforcing interplay between perceptions of value and risk, risk attitudes and funding conditions. A monetary policy regime narrowly focused on controlling near-term inflation removes the need to tighten policy when financial booms take hold against the backdrop of low and stable inflation. And major positive supply side developments, such as those associated with the globalisation of the real side of the economy, provide plenty of fuel for financial booms: they raise growth potential and hence the scope for credit and asset price booms while at the same time putting downward pressure on inflation, thereby constraining the room for monetary policy tightening…The length and amplitude of the financial cycle has increased markedly since the mid-1980s, a good approximation for the start of the financial liberalisation phase in mature economies. This date is also an approximate proxy for the establishment of monetary regimes more successful in controlling inflation. And the cycle appears to have become especially large and prolonged since the 1990s, following the entry of China and other former communist countries into the global trading system.

Liberalisation, globalisation, and stable inflation are all considered good things. Yet, if Mr Borio is correct—and we would be foolish to dismiss his claims—these seemingly positive developments have some very nasty side effects. The controversial implication is that the peoples of the rich world might have been better off without the reforms of the past several decades.

The next section of Mr Borio’s paper recommends how to rebuild macro models to accommodate the empirical realities of the financial cycle. He has three basic suggestions. First, the cycle has to be inherent in the model, rather than caused by random unexplained “shocks” from the outside. Second, macro models need to account for the ways that debt and excess investment suppress economic activity following a boom. Finally, Mr Borio recommends revising the woolly concept of “potential” output. The conventional view is that this is “what can be produced without leading to inflationary pressures.” However, according to Mr Borio, this measure is unhelpful for policymakers who want to determine a “sustainable” income path because it ignores “the build-up of financial imbalances and the distortions they mask in the real economy.” Mr Borio combines these ideas into a radical departure from conventional macro:

Models should deal with true monetary economies, not with real economies treated as monetary ones, as is sometimes the case. Financial contracts are set in nominal, not in real, terms. More importantly, the banking system does not simply transfer real resources, more or less efficiently, from one sector to another; it generates (nominal) purchasing power. Deposits are not endowments that precede loan formation; it is loans that create deposits. Money is not a “friction” but a necessary ingredient that improves over barter. And while the generation of purchasing power acts as oil for the economic machine, it can, in the process, open the door to instability, when combined with some of the previous elements. Working with better representations of monetary economies should help cast further light on the aggregate and sectoral distortions that arise in the real economy when credit creation becomes unanchored, poorly pinned down by loose perceptions of value and risks. Only then will it be possible to fully understand the role that monetary policy plays in the macroeconomy. And in all probability, this will require us to move away from the heavy focus on equilibrium concepts and methods to analyse business fluctuations and to rediscover the merits of disequilibrium analysis.

Many academics across the world have worked (and are working) on these ideas. Hyman Minsky, the late American economist, thought that it was more helpful to divide economic actors by the way they financed themselves rather than what they did in the "real" economy. The late Wynne Godley co-wrote a textbook on how to model the economy as a monetary and credit system with Marc Lavoie, a professor in Canada. Agent-based modelling rejects equilibrium solutions in favor of enormous computer simulations, where representations of actual people, firms, and banks can interact and alter their environment. Scholars in Europe have built sophisticated models of the EU economy using this technology, while others have used it to improve our understanding of financial markets. Steve Keen, an Australian economist, has long argued that macro needs to incorporate these ideas, and has developed a prototype of a computer program, called "Minsky," that can be used to model economies as monetary systems. So while most economists have not embraced Mr Borio's agenda for the reformation of macro, some have. That is encouraging news.

The final section of Mr Borio’s paper is devoted to policy, particularly how governments should deal with the downside of the financial cycle. He frames the discussion by comparing the Nordic countries’ response to their financial crisis in the early 1990s with Japan’s response to its crisis during the same period. The Nordic countries addressed the underlying problems that caused their crises (by restructuring their banks) while buoyed by short-term stimulus measures (currency devaluations and large budget deficits). By contrast, according to Mr Borio, the Japanese hoped that their structural problems (bad banks) would simply go away even as they failed to support their economy’s adjustment with sufficient monetary and fiscal stimulus during the first several years of the downturn.

America and Europe arguably did a better job than the Japanese of addressing their economies’ short-term needs, but did a far worse job than the Nordic nations of restructuring their enormous debt overhangs. This failure might help explain the slow pace of the recovery in America, and the non-recovery in much of Europe. To be fair, the Nordic nations had a significant advantage: their tiny size made it easy for them to earn large current account surpluses after devaluing their currencies. America and Europe are simply too large to do this without dramatically upsetting the global trading system. Moreover, both economies engage in relatively little trade with the rest of the world. (The nations of the euro area individually are very open but they mostly trade with each other and are therefore unable to devalue against their most important partners.) Also, while America, Britain, Ireland, and Spain all suffered from private sector debt bubbles, this did not occur in Italy, Portugal, or Greece, although those nations did have very large stocks of public debt denominated in a currency they could not print.

Mr Borio recommends that governments should focus on private debt relief in the aftermath of a crisis. This means providing cash to households and businesses so that they can repay their debts, rather than wasteful spending on bridges to nowhere. Conveniently, this policy does not depend on any assumptions about the “multiplier” of government spending. That concept comes from the belief that different types of fiscal transfers are more or less desirable according to whether the cash is saved or spent immediately. In a balance sheet recession, however, the point of fiscal stimulus is not to goose spending per se but to provide the private sector with the income it needs to repay its debts and rebuild its stock of savings without having to cut its spending in a downward spiral of debt-deflation. Thus, the policy's effectiveness can be determined by observing the changes in private balance sheets, rather than any complicated calculation attributing dollars of additional private spending to dollars of government spending. Once the debt is cleared off, growth can then resume at a more sustainable pace without the government's help. That, at least, is the theory, according to Mr Borio.

But while fiscal policy can be very helpful at the trough of the financial cycle, monetary policy is much less likely to be successful:

Monetary policy typically operates by encouraging borrowing, boosting asset prices and risk-taking. But initial conditions already include too much debt, too-high asset prices (property) and too much risk-taking. There is an inevitable tension between how policy works and the direction the economy needs to take.

Moreover, stimulative monetary policy is more likely to have negative side effects (such as “going-for-broke” behaviour by financial firms) following a crisis, according to Mr Borio. This is worth considering in light of the most recent news emanating from the rich world’s central banks. It also jives with warnings from sophisticated macro investors like Ray Dalio (disclosure: a former employer of your correspondent) that risk premia have gotten too small.

It seems unlikely that Mr Borio’s thoughtful and dense new paper will affect the consensus. When he and William White, his colleague at the BIS, warned the world that a credit bubble was inflating back in 2003, they were roundly ignored by the academic and policy establishments. Yet they were right. (A few other observers, includingthispublication, were also convinced of the danger.) The world would be wise to heed them this time.