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Halfway through 2015 international financial markets entered an unstable phase that is still being felt now. The slowdown of the Chinese economy and the slump in oil prices triggered tensions that quickly spread throughout all countries and asset types, sometimes becoming quite intense. This is the fourth unstable episode since the great financial crisis of 2008-2009: the major source of instability was in emerging markets in 2014, in the US government bond market in 2013 and affected the euro area between 2010 and 2012. Suspicion is now growing of a common thread linking all these episodes.

Academic economists, economic policymakers and investors are vigorously analysing and debating the origins and consequences of these repeated crises but this is a technically complex area as a wide range of interrelations needs to be taken into account between the variables of the real economy, financial variables and economic policies. It is also a controversial area in political and ideological terms since personal values and preferences determine the relative weight assigned to the costs and benefits of the various public policy alternatives whose effects are not distributed equally among the different socio-economic groups and generations. And this is also, to some extent, a familiar debate as it refers back to the old dichotomy between Keynesian and liberal economists. In fact, two clear bands or currents of thought can be discerned that are openly divergent.

The dominant view is Keynesian in nature.1 This believes that the world economy is suffering from a problem, which has become chronic, of insufficient aggregate demand: households are saving a lot and consuming little, companies are hardly investing and governments are containing their expenditure. As a result GDP growth is slow, resources are under-utilised (high unemployment or low participation rates) and inflation is negligible (and negative in several countries). According to this view there are several reasons for this problem. Some are temporary such as political uncertainty while others are knock-on effects such as the results of heavy borrowing and the hangover from the financial crisis. But the most important reasons have been around for some time and are structural in nature, such as demographics, globalisation and technological changes. The ageing of developed countries has pushed up savings for retirement, in addition to the emergence in international markets of the huge savings carried out by Chinese companies and households (resulting from the absence of social security and public healthcare, among other causes). For their part the new digital sectors are less capital-intensive than traditional industry and construction. This produces a context of high savings and low investment, pushing down the equilibrium real interest rate to clearly negative terrain. But, given that inflation is almost non-existent and the natural lower bound for the nominal rate is around zero percent, the real interest rate in markets is higher than the equilibrium rate, which merely perpetuates the situation of weak demand and under-employment as the natural adjustment or rebalancing mechanism fails to work. In the purest Keynesian tradition the members of this current of thought propose an aggressive use of demand policies (fiscal and monetary, including a whole range of unconventional measures) to get out of this trap as soon as possible. They claim that, with sufficient stimulus, the economy can return to full employment, inflation and inflation expectations can reach the levels desired by central banks, from there on, once again operating relatively normally.

Paradoxically this vision proposes resolving what is considered to be a basic problem of the economy by stimulating one of its very causes: namely raising the levels of debt among agents and inflating the price of financial assets. In fact these channels are expected to be the main ones for monetary stimuli to reach the real economy. According to this view there are three reasons why it is worth running the risk of inflating these financial life jackets. Firstly, if the economy is reactivated and acquires self-sustaining traction, growth in nominal GDP will relieve the burden of debt and justify higher asset prices, at the same time as allowing the stimuli to be withdrawn very gradually. Secondly, the risk of local bubbles forming and of systemic contagion should they burst can be controlled by macroprudential, microprudential and financial regulatory policies. Thirdly, if the two previous arguments fail, this will still not be as bad as the alternative of passively standing by while the economy slumps into a deep hole and extensive layers of society, possibly the most vulnerable, fall into unemployment. According to this school's view, the repeated financial crises of the last few years are therefore indicative of two things. The first and most important indication is that demand policies have been badly designed and have been too timid in terms of their intensity and duration. It therefore comes as no surprise that demands are now being voiced for the Federal Reserve to stop its interest rate hikes and for Japan and the euro area to further push their measures into debt monetisation and negative interest rates. The second, complementary indication is that prudential and regulatory policies have had serious shortcomings.

The alternative view believes that the most important problems affecting the international economy are related to supply and not demand.2 But unfortunately governments try to avoid the short-term electoral costs that tend to be involved in structural reforms and give in to the temptation to patch up the economy via expansionary demand-based policies (even central banks find it difficult to remove themselves from the climate of social and political pressure in spite of their formal independence). This neglect of supply issues naturally reduces potential growth in the long term. And this problem gets even worse when increases in public expenditure and credit are used, due to short-sightedness, haste and the ease of obtaining funds, for relatively unproductive investments that waste resources (real estate bubbles and airports without airplanes are a case in point). In addition, sooner or later and no matter how well-designed the prudential and regulatory policies may be, credit booms end up becoming financial crises that reduce the effectiveness of the economic system even further. The result is an ostensibly worse real economy than at the start of these expansionary demand-based policies with the aggravating factor that it is easy to fall into a vicious circle of slow growth, counterproductive artificial remedies, rising debt, financial crisis and even slower growth.

Those supporting this current of thought propose, as a priority, that society and authorities should adopt a long-term focus to decisively and patiently tackle the structural reforms on the supply side that help to increase potential growth, while recommending fiscal and monetary discipline related to demand policies. In other words they do not rule out applying stimuli when this is justified (as the current situation requires in some countries, in fact) but with moderation, avoiding measures more likely to cause effects contrary to those desired (for example negative interest rates) and with a willingness to put on the brakes once the boom comes. This last point is important as credit booms are not so much the result of stimuli during recessionary phases but rather the absence of restrictive measures in expansionary periods. This asymmetry has perversely distorted investor incentives since the times of the so-called «Greenspan put». Another recommendation from this school of thought in the area of incentives is to accept debt restructuring but only when warranted and carried out selectively and under control. They believe that, with such a system and the complement of a good regulatory and supervisory framework, we would have more functional financial markets that promote economic efficiency and development. In the absence of this, they interpret the chain of financial turmoil in the last few years as risk-off episodes with an initial shock (either fundamental, as in the case of falling oil prices and China's slowdown, or merely in terms of sentiment) that spreads, amplifies and feeds on itself, on top of markets artificially inflated by monetary policies, excessively indebted agents, inadequate incentives and imperfect regulation.

In summary, these are two differing currents of thought in terms of their diagnosis of the problems of the world economy and clearly opposing in terms of how such problems should be resolved (priorities, strategy and specific recommendations). Ironically both are highly critical of economic policy over the last few years, albeit for contrasting reasons (passiveness or hyperactivity). There is, however, one more legitimate point where these two approaches are in agreement: the financial system is of vital importance. The next three articles in this Dossier examine this area in detail given the far-reaching transformations affecting the financial system since the crisis of 2008-2009. Have we gained enough space to sustain additional debt? Are banks and capital markets more stable now than in the past? Are capital and risk more efficiently assigned? Positive answers would be good arguments for those in favour of increasing Keynesian stimuli at least in terms of the balance between potential reward and penalty. Negative answers, however, would warrant greater monetary and fiscal prudence. The current state of the financial world is biased towards the latter of these two views.

Macroeconomics Unit,

Strategic Planning and Research Department, CaixaBank

1. See, for example, Summers, L. (2014) «Reflections on the "New Secular Stagnation Hypothesis"» in the book Secular stagnation: facts, origins and cures, published by Voxeu.org.

2. See, for example, the 2015 Annual Report of the Bank for International Settlements.

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