Do central bankers dare to start raising rates? Photographer: Chris Ratcliffe/Bloomberg
Do central bankers dare to start raising rates? Photographer: Chris Ratcliffe/Bloomberg

Monetary policy should be tighter. Low inflation can be good because it's a consequence of increased competition. Markets are too hung up on regulatory decisions and too heedless of what's going on in the underlying economy. Whether that sounds like common sense depends on your vantage point. If you're above the fight, it does. If you're a regulator with responsibility for a specific country or bloc, it's heresy.

The man spouting this so soon after the European Central Bank caved in to market pressure and lowered its main lending rate to a record-low 0.15 percent is Jaime Caruana, general manager of the Bank for International Settlements. True, he said similar things a year ago, but perhaps it's time people finally listened to him.

As Caruana presented the BIS annual report, he indicated that the world needs to make a transition to a "less debt-driven growth model." Since 2007, Caruana said, G20 economies have increased the ratio of non-financial sector debt to gross domestic product by more than 20 percent. The debt-GDP ratio is currently 275 percent in advanced economies and 175 percent in emerging ones. Big business, however, has been using the extra liquidity to buy back shares, finance mergers and acquisitions, or increase the duration of its debts, not for new plant and equipment. Meanwhile, labor productivity growth has slowed down.

Source: Bank of International Settlements
Source: Bank of International Settlements

In other words, the cheap money floating around the economy only stimulates financial activity -- and drives up asset prices -- rather than fostering real growth. "It is hard to see how additional debt-driven demand can help," Caruana said. "It cannot substitute for structural reform. Ever-rising public debt cannot shore up confidence. ... Low rates can certainly increase risk-taking, but it is not evident that this will turn into productive investment."

The common argument for more monetary stimulus, and the one adopted by the ECB, is that it's needed to prevent deflation. Caruana argues that there may be nothing wrong with low inflation and even some price drops: "There are good reasons to believe that downward pressure on inflation reflects positive supply side effects in the global economy, at least in part. Greater competition in markets for goods and, increasingly, also for services reduces the scope for raising prices, and it may even force them downwards."

In the annual report, the BIS argues that prices may be growing more slowly in part because of globalization, which would explain the remarkable synchronicity between individual countries' inflation rates. As they try to drive up inflation, policymakers such as those at the ECB may be operating in a bygone reality.

The only reasonable motive for trying to drive up inflation and keep money supply abundant is that it benefits over-indebted governments, firms and individual borrowers. That's why Bank of England Governor Mark Carney says the "new normal" interest rates will be lower than the "old normal," around 2.5 percent rather than 5 percent: "Things have changed. Households have a lot of debt, the government is still consolidating is financial position, Europe is weak, the pound is strong and the financial system has been fundamentally changed."

Carney, at least, is talking about raising rates in the foreseeable future, albeit slowly. The U.S. Federal Reserve will only get around to that sometime next year: Right now, it is more concerned with shrinking its bond purchases. The Bank of Japan keeps up its asset-buying efforts. ECB President Mario Draghi is not even raising the possibility of tightening the reins.

It's easy for Caruana to talk: He will not be held responsible for further economic slowdowns, upturns in unemployment or debt crises. Central bank heads do not want the pain associated with tougher policies. That's all the more reason to listen to Caruana, who stops just short of predicting another major crisis unless the root causes of the one that occurred six years ago are finally tackled.

Someday soon, national regulators will have to face up to reality and shut off the running faucets. The later they do it, the harsher the awakening for the governments, companies and households that have been unable to deleverage. If central banks are too slow, the BIS warns, "A vicious circle can develop. In the end, it may be markets that react first, if participants start to see central banks as being behind the curve."

To contact the author of this article: Leonid Bershidsky at lbershidsky@bloomberg.net.

To contact the editor responsible for this article: Zara Kessler at zkessler@bloomberg.net.