BIS Warns (Again) on Strong Dollar’s Impact on Emerging Markets, Deep Dependence on Central banks!

The central bank of central banks, the Bank for International Settlements just can’t get enough from dishing out warnings after warnings on global risk. Obviously they are doing this because the consensus ignores them.

A month ago, I posted here the BIS chief Jaime Caruana’s ‘debt trap’ speech.

Now from the BIS’s December Quarterly Review we read of more warnings.

From BIS chief economist Claudio Borio

On the central bank put during the sharp recovery from the October meltdown: (bold mine)

At the same time, a more sobering interpretation is also possible. To my mind, these events underline the fragility - dare I say growing fragility? - hidden beneath the markets' buoyancy. Small pieces of news can generate outsize effects. This, in turn, can amplify mood swings. And it would be imprudent to ignore that markets did not fully stabilise by themselves. Once again, on the heels of the turbulence, major central banks made soothing statements, suggesting that they might delay normalisation in light of evolving macroeconomic conditions. Recent events, if anything, have highlighted once more the degree to which markets are relying on central banks: the markets' buoyancy hinges on central banks' every word and deed.

The highly abnormal is becoming uncomfortably normal. Central banks and markets have been pushing benchmark sovereign yields to extraordinary lows - unimaginable just a few years back. Three-year government bond yields are well below zero in Germany, around zero in Japan and below 1 per cent in the United States. Moreover, estimates of term premia are pointing south again, with some evolving firmly in negative territory. And as all this is happening, global growth - in inflation-adjusted terms - is close to historical averages. There is something vaguely troubling when the unthinkable becomes routine.

On crashing oil and the strong US dollar.

These developments will be especially important for emerging market economies. The spike in market volatility in October did not centre on these countries, unlike at the time of the taper tantrum in May last year and the subsequent market tensions in January. But the outsize role that commodities and international currencies play there makes them particularly sensitive to the shifting conditions. Commodity exporters could face tough challenges, especially those at the later stages of strong credit and property price booms and those that have eagerly tapped equally eager foreign bond investors for foreign currency financing. Should the US dollar - the dominant international currency - continue its ascent, this could expose currency and funding mismatches, by raising debt burdens. The corresponding tightening of financial conditions could only worsen once interest rates in the United States normalise.

Unfortunately, there are few hard numbers about the size and location of currency mismatches. What we do know is that these mismatches can be substantial and that incentives have been in place for quite some time to incur them. For instance, post-crisis, international banks have continued to increase their cross-border loans to emerging market economies, which amounted to $3.1 trillion in mid-2014, mainly in US dollars. And total international debt securities issued by nationals from these economies stood at $2.6 trillion, of which three quarters was in dollars. A box in the Highlights chapter of the Quarterly Review seeks to cast further light on this question, by considering the securities issuance activities of foreign subsidiaries of non-financial corporations from emerging markets.

Against this backdrop, the post-crisis surge in cross-border bank lending to China has been extraordinary. Since end-2012, the amount outstanding, mostly loans, has more than doubled, to $1.1 trillion at end-June this year, making China the seventh largest borrower worldwide. And Chinese nationals have borrowed more than $360 billion through international debt securities, from both bank and non-bank sources. Contrary to prevailing wisdom, any vulnerabilities in China could have significant effects abroad, also through purely financial channels.

I have been repeatedly saying here that strong US dollar-weak Asian currencies will pose as a significant headwind to the region’s financial assets and economies

As of this writing based on Bloomberg data, Malaysia’s ringgit, Indonesia’s rupiah, Australian dollar and New Zealand dollar are being crushed!

BIS Chief Jaime Caruana Warns of the Three Troubles from Debt and its Outcome: the Debt Trap

In a recent speech by Jaime Caruana, General Manager, Bank for International Settlements at the International Finance Forum 2014 Annual Global Conference in Beijing last 1 November 2014, Mr. Caruana resonating  the admonitions of the Austrian school of economics via the Austrian Business cycle (ABCT), warns AGAIN for the fourth time this year of the risks of debt asset inflation. (hat tip zero hedge)

Let it not be forgotten that the BIS was one of the prescient institutions whom has foreseen and equally warned of the 2008 global crisis.

I will excerpt much of Mr. Caruana’s speech (bold added)

Globally, debt – of households, non-financial corporates and governments combined – has risen from around 210% of GDP at the end of 2007 to around 235% of GDP according to the latest available figures in 2014. That’s a rise of more than 20 percentage points in the course of just over six years. The increase has been faster in emerging market economies, albeit from a lower initial level, but debt has risen in advanced economies as well. 

Not surprisingly, I find myself agreeing with the question posed in the title of a recent Geneva Report – “Deleveraging? What deleveraging?” – though not necessarily with all the policy conclusions drawn by the authors.

Today I would like to share with you a few thoughts about debt and its consequences. I will first take stock of where we are by highlighting a few additional figures on debt and sharing some observations on why the current pattern and dynamics of borrowing do not seem to fully reflect the performance of economically sound functions. I will then reflect on the consequences of higher debt levels. I am tempted to call this section “Debt trouble comes in threes”, paraphrasing the saying “Trouble comes in threes”. In other words, trouble usually doesn’t come alone

Taking stock

How is the 20 percentage point increase in global debt divided between the private and the public sector?

In advanced economies, government debt has risen by close to 40 percentage points of GDP since end-2007 to over 110% of GDP, while private sector debt has fallen by about 10 percentage points.

In emerging market economies, the picture is reversed, with private sector debt growing by more than 40 points during the same period to over 120% of GDP, while government debt has risen only slightly.

The total debt levels in emerging market economies are mostly still significantly lower than those in advanced economies.

In other words, despite a damaging global financial crisis that resulted from excessive leverage, and despite the deleveraging of specific sectors, there really has been little or no deleveraging in aggregate. Some countries – for example, the United States, the United Kingdom and Spain – have managed to reduce excessive household debt since the crisis, but their government debt has increased substantially. Others, especially among the emerging market economies, have kept public sector borrowing largely under control, but borrowing by their firms and households has run rampant 

My comment—This is what I have been warning about too!!! What seems as a present day benefit—low Public sector debt financed by zero bound subsidies via artificially lowered debt servicing charges PLUS inflated tax revenues are not benefits—they are future costs, applied to the Philippines: “The principal cost to attain lower public debt has been to inflate a massive bubble. The current public debt levels have been low because the private sector debt levels, specifically the supply side, have been intensively building.” 

To continue…

The figures I have cited so far refer to the debt taken on by end borrowers. By contrast, leverage among major banks – at least when measured in relation to their equity – has declined since 2007. In particular, banks worldwide have become better capitalised, thanks to stronger regulation and market discipline.

And from a global perspective, aggregate cross-border bank lending, largely driven by the banks most affected by the crisis, has been relatively subdued since then, although it has shown some signs of growth in the past year. These cross-border banking flows are useful for channelling savings to countries that need resources for investment, but research has found that historically they tend to amplify domestic credit booms and busts – on both the upside and the downside. So, given the initial conditions, cross-border banking flows “taking a breather” may on balance be good news – especially since it has stopped adding fuel to those countries that have been experiencing financial booms.

My comment the BIS understands how capital flows are HARDLY the cause of boom bust cycles which are internally generated. Capital or cross border flows only AMPLIFIES on it, as foreign money (mostly financed by carry trades) piggybacks on sentiment in both directions: stampeding inflows during manias, flight during panics.

That said, we see that, at the same time, international bond issuance has hit record highs, especially for emerging market corporates. This development requires some attention.

Let me emphasise that debt, by itself, is not necessarily bad. It performs a useful, indeed vital, economic function. To quote from a 2011 BIS Working Paper by Cecchetti, Mohanty and Zampolli:

“Finance is one of the building blocks of modern society, spurring economies to grow […] individuals can consume even without current income. With debt, businesses can invest when their sales would otherwise not allow it. And, when they are able to borrow, fiscal authorities can play their role in stabilising the macroeconomy.” The authors’ empirical analysis supports the view that, at moderate levels, debt enhances growth, but beyond a certain threshold it becomes a drag on growth – very much in the spirit of the findings by Reinhart and Rogoff as well as some other authors.

My comment: there are productive debt and there are unproductive debt, democratization of debt via zero bound encourages accumulation of unproductive debt.

Mr Caruana’s example: household debt...

In many emerging market economies, the increasing debt stocks reflect, at least in part, progress in the development of their financial systems. Financial deepening contributes to economic well-being and to lower financial and macroeconomic volatility. As more households and businesses gain access to credit, this gives them greater flexibility to smooth out their consumption and to make long-term investments.

In practice, however, debt is often used in ways that don’t seem to correspond to economically sound functions. For example, in some of the countries that were hit hard by the financial crisis, households have tended to extract equity from their homes in good times while paying down their debts in bad times. In other words, the availability of housing finance has reinforced the economic cycle, instead of smoothing it. And a recent study by the Swedish central bank found that, despite high levels of household debt in that country, roughly four out of 10 borrowers are not reducing or amortising their debts.

Mr Caruana’s example Corporate debt…

Corporate borrowers also tend to be procyclical – paying down debt in recessions and borrowing to buy back shares during an upswing. The present cycle seems to be no exception. Corporations in advanced economies hoarded cash during the crisis, and more recently they have been issuing debt in order to buy back shares or to fund leveraged acquisitions. Meanwhile, in many economies, high corporate profitability is not being matched by spending on real investments. 

While some governments have been able to use fiscal policy to counteract demand shortfalls in the aftermath of the crisis, their ability to perform this stabilising function has sooner or later become constrained by the high debt accumulated during the crisis (or even before). The result has been adverse debt dynamics – despite record low interest rates – with government debt stocks not yet returning to a clearly sustainable path. And some countries, especially on the European periphery, have even been forced to cut spending during the downturn.

Three types of debt trouble…

What are some of the implications of excessive debt? In my introduction, I said that the debt trouble comes in threes. At the origin is the build-up of financial imbalances that leads to excessive credit growth. What are the three types of trouble? The first and the most obvious: the build-up of financial imbalances risks a future financial crisis, an impaired financial sector and a debt overhang. 

The leverage that builds up during the boom weakens balance sheets, which reduces borrowers’ capacity to repay and their resiliency to shocks. This vulnerability, in turn, magnifies creditors’  losses, amplifies market participants’ responses and contributes to generating market dynamics that are abrupt and non-linear.

Reliance on debt heightens sensitivity to declines in asset prices..

Relatively small declines in asset prices can force borrowers to cut back their activities, and in some cases default or reschedule their debts, which is costly for lenders and a potential drag on borrowers’ finances. We have seen this type of effect most recently in response to the sharp falls in house prices in countries such as the United States, Spain and Ireland. Similar adverse dynamics can occur if problems hit an overleveraged corporate sector, as several Asian economies learnt in the crises of the 1990s.

This excess sensitivity is just a symptom of the fact that leverage increases procyclicality. Small downside shocks to the economy become transformed, through various channels, into large ones. But the seeds of the problems that materialise in the bust are in fact sown during the boom. There, the procyclicality operates on the upside: borrowers can expand their balance sheets and take on risks too easily, pushing up asset prices and making it easier still to borrow more. The boom sets the stage for the subsequent bust.

Wow. Thoroughly the Austrian Business Cycle from the BIS’ perspective.

Now why emerging markets are faced with high credit risks…

History has taught us that large external debt is correlated with greater vulnerabilities and potentially sudden stops.Indeed, research at the BIS has found that when private sector credit-to-GDP ratios are significantly above their long-term trend, banking strains are likely to follow within three years. And right now, a number of emerging economies, as well as some advanced ones, have reached this point in the financial cycle.  

And the subsequent debt overhang holds back growth. Households and firms seek to pay back what turn out to be excessive debt burdens, built on the illusory promise of permanent prosperity that the boom had fostered. Expansionary aggregate demand policies lose effectiveness. And, unless the financial sector is fixed quickly, it restricts and, more importantly, misallocates credit: reluctance to take losses keeps credit available for the weaker borrowers and curtails or makes it more expensive for the healthier ones. The damage caused by delayed balance sheet repair following the bust of the boom in Japan is well documented. 

Tick tock tick tock.

The second, but less obvious, kind of trouble is that debt accumulation fosters misallocations of real resources.

The GDP and credit growth in the pre-crisis boom years were not evenly spread. They were concentrated disproportionately in specific sectors. For instance, in countries like Spain and Ireland, growth in the boom years was largely propelled by the construction sector as well as finance.

Leverage can distort investment decision-making, giving incentives to put resources into projects that promise quick, measurable returns, rather than into longer-term ventures with less certain but potentially more valuable rewards. Such incentives are arguably stronger when leverage is cheap.

The consequence of this association between debt accumulation and real resource misallocation is important. When boom turns to bust, the bloated sectors will have to shrink. Reviving growth in this kind of recession requires flexibility and capacity in the economy to reallocate resources efficiently from less productive to more productive sectors.

As I recently noted applied to the Philippines: A fifth major cost is that resources channeled to the bubble sectors are resources that should have been used by the market for real productive growth. Much of these resources are now awaiting reappraisal from the marketplace via a shift in consumer’s preferences which will render much of these misallocated capital as consumed capital.

Also: And since the current credit boom translates to intensive leveraging of the balance sheets of entities with access to the formal banking system and to the capital markets, the current BSP actions eventually shifts the risk equation from inflation to levered balance sheets…In short, there is concentration of credit risk from mostly heavily levered firms.

Third, financial booms mask deficiencies in the real economy.

Credit booms can act as a smokescreen. They tend to mask the sectoral misallocations that I just described, making it difficult to detect and prevent these misallocations in time. Boom times also tend to hide other slow-moving forms of deterioration in real growth potential. One such example is the trend decline in productivity growth in the advanced economies that started decades ago. Arresting this decline is crucial to achieving sustainable economic growth. Additional examples are adverse demographics and the secular decline of job reallocation rates. What appears fantastically harmonious on the way up thanks to the flattering effect of the credit-driven boom becomes cacophony and fragmentation on the way down

My comment: credit booms, which are seen by the public as this time is different, are illusory. The greater the boom, the more harrowing the crash. Let me paraphrase Newton’s third law of motion; for every boom, there is a near proportional and opposite bust.

Mr Caruana’s conclusion…

And so that’s why I said debt trouble comes in threes. The combination of these three types of debt-related phenomenon together with policies that neglect the power of financial cycles can give rise to serious risks in the long term. A sequence of such boom-bust cycles can sap strength from the global economy. And policies–fiscal, monetary and prudential –that do not lean sufficiently against the build-up of the financial booms but ease aggressively and persistently against the bust risk entrenching instability and chronic weakness: policy ammunition is progressively eroded while debt levels fail to adjust. A debt trap looms large.

Moving away from the debt-driven growth model of the last few decades is in my view essential in order for the global economy to truly recover from the crisis. This will require efforts from the public and the private sector alike to restore the resilience and reliability of the financial system. But no less importantly, it will require a rebalancing of economic policies so as to support greater flexibility and productivity in the real economy. In other words, a wider but country -specific reform agenda is needed.

Every crisis has been sown from the seeds of artificial booms. There is now way out now except to let the markets clear.

But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances.—Ludwig von Mises

BIS Official: Loose Central Bank Policies Looking Increasingly Dangerous

The chief of the central bank of global central banks, the Bank of International Settlements, has warned of unintended consequences of prolonged easy money policies

From the Wall Street Journal Real Times Economics Blog: (bold mine)

The latest to take up the refrain is Jaime Caruana, general manager of the Bank for International Settlements, who warned in an unusually frank speech in London that, while the ultra-low interest rates and ultra-easy monetary policy adopted by advanced economy central banks might have been the right response to the crisis when it broke, they are looking increasingly dangerous the longer they last.

“A vicious circle can develop, with a widening gap between what central banks are expected to deliver and what they actually can deliver,” Mr. Caruana said. “This may ultimately undermine their credibility and, with it, their legitimacy and effectiveness.”

Low rates may have helped keep banks alive and keep a roof over the heads of overextended borrowers—but they are threatening the ability of insurance and pension funds to meet their commitments, and tempting them into all kinds of wrong investment decisions in the meantime. Although he didn’t spell it out, he painted a picture of a massive and stealthy transfer of wealth from savers to borrowers.

Perhaps Mr. Caruana may have noticed of the growing disparity between asset markets and the real economy and how such policies have been failing to generate the much anticipated results.

Importantly, Mr. Caruana notes of the ethical inequities from  the “massive and stealthy transfer of wealth” which in reality is taken from society (those not politically connected) and transferred to the political class and politically privileged banksters and other cronies.

The article suggest the BIS’s view should be heeded because “the BIS is one of the few international financial institutions (some say the only one) to see the financial crisis coming and to issue clear warnings ahead of time.”

This represents that cognitive bias called anchoring. In reality, past performance does not assure of future outcomes. Correct prediction by the BIS in the recent past doesn’t necessarily hold that they will be as accurate in the future.

What makes the BIS council worthwhile is the economic and the epistemological reasoning behind the analysis of current du jour easy money policies.

For instance, Mr. Caruana implicitly points to the moral hazard as consequence from such policies, noting that instead of real reforms, politicians have used central bankers as instruments to maintain the status quo.

From the same article:

Like many central bankers, Mr. Caruana put a good deal of the blame for the current mess on governments for failing to address the root causes of unemployment and low growth. “After five years of buying time, one has to ask whether that time has been – or will be – used wisely,” he said.

Likewise he warns of the anchoring bias applied to looking at inflation risks…

But he reserved a decent measure of criticism for central banks too, warning that they can’t just shut their eyes to the risks they are creating just because a certain measure of domestic consumer inflation is within its official target range.

…and of bubble cycles:

“If you don’t get financial stability, you will not be able to get price stability,” he said in follow-up comments to his speech, making clear that he understood financial stability as something to be defined globally, not just in a single country or region. That’s a problem because no central bank in the world is mandated to give a hoot about what effects its policy causes outside its jurisdiction. With an eye on the huge cross-border capital flows triggered by radical central bank action, he warned his audience how easy it is, in a globalized world, for distortions created in one country to spill over into other countries before returning “like a boomerang” to haunt the originating country.

So very apropos. 

Seems like Mr. Carauana, a telcom engineer by education, has revealed tinges of influence from Austrian economics. 

The BIS has been no stranger to the Austrian school. Canadian economist, William R. White, former manager in the monetary and economic department has been reputed as one of the Austrian school influenced economist in the BIS. In fact, it was Mr. White's paper in 2006, during his tenure, that accurately predicted the crisis of 2007-2008, from which the reputation of the above article rests on.

The Impact of Financialization on Economic Growth and the Austrian Business Cycle

Great stuff from the Bank of International International Settlements (BIS), where they come up with a study on the diminishing returns from the financial sector.

Stephen G Cecchetti and Enisse Kharroubi of the BIS concludes, (bold emphasis mine)

In this paper, we study the complex real effects of financial development and come to two important conclusions. First, financial sector size has an inverted U-shaped effect on productivity growth. That is, there comes a point where further enlargement of the financial system can reduce real growth. Second, financial sector growth is found to be a drag on productivity growth. Our interpretation is that because the financial sector competes with the rest of the economy for scarce resources, financial booms are not, in general, growth enhancing. This evidence, together with recent experience during the financial crisis, leads us to conclude that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems. More finance is definitely not always better

In my view this BIS study exhibits tight relevance to, if not provides proof of the Austrian Business Cycle theory (ABCT)…

From the great Professor Murray N. Rothbard [Economic Depressions: Their Causes and Cure] (bold my comments)

The Ricardian analysis of the business cycle went something as follows: The natural moneys emerging as such on the world free market are useful commodities, generally gold and silver. If money were confined simply to these commodities, then the economy would work in the aggregate as it does in particular markets: a smooth adjustment of supply and demand, and therefore no cycles of boom and bust. But the injection of bank credit adds another crucial and disruptive element. For the banks expand credit and therefore bank money in the form of notes or deposits which are theoretically redeemable on demand in gold, but in practice clearly are not…

The banks, then, happily begin to expand credit, for the more they expand credit the greater will be their profits. This results in the expansion of the money supply within a country, say England. As the supply of paper and bank money in England increases, the money incomes and expenditures of Englishmen rise, and the increased money bids up prices of English goods. The result is inflation and a boom within the country.

But this inflationary boom, while it proceeds on its merry way, sows the seeds of its own demise. For as English money supply and incomes increase, Englishmen proceed to purchase more goods from abroad. Furthermore, as English prices go up, English goods begin to lose their competitiveness with the products of other countries which have not inflated, or have been inflating to a lesser degree. Englishmen begin to buy less at home and more abroad, while foreigners buy less in England and more at home; the result is a deficit in the English balance of payments, with English exports falling sharply behind imports. But if imports exceed exports, this means that money must flow out of England to foreign countries. And what money will this be? Surely not English bank notes or deposits, for Frenchmen or Germans or Italians have little or no interest in keeping their funds locked up in English banks. These foreigners will therefore take their bank notes and deposits and present them to the English banks for redemption in gold — and gold will be the type of money that will tend to flow persistently out of the country as the English inflation proceeds on its way. But this means that English bank credit money will be, more and more, pyramiding on top of a dwindling gold base in the English bank vaults. As the boom proceeds, our hypothetical bank will expand its warehouse receipts issued from, say 2,500 ounces to 4,000 ounces, while its gold base dwindles to, say, 800. As this process intensifies, the banks will eventually become frightened. For the banks, after all, are obligated to redeem their liabilities in cash, and their cash is flowing out rapidly as their liabilities pile up. Hence, the banks will eventually lose their nerve, stop their credit expansion, and in order to save themselves, contract their bank loans outstanding. Often, this retreat is precipitated by bankrupting runs on the banks touched off by the public, who had also been getting increasingly nervous about the ever more shaky condition of the nation's banks.

The bank contraction reverses the economic picture; contraction and bust follow boom. The banks pull in their horns, and businesses suffer as the pressure mounts for debt repayment and contraction. The fall in the supply of bank money, in turn, leads to a general fall in English prices. As money supply and incomes fall, and English prices collapse, English goods become relatively more attractive in terms of foreign products, and the balance of payments reverses itself, with exports exceeding imports. As gold flows into the country, and as bank money contracts on top of an expanding gold base, the condition of the banks becomes much sounder. [the boom is followed by a bust which extrapolates to the financial sector size has having an inverted U-shaped effect on productivity growth. Boom initially drives up productivity and eventually contracts when the bust appears, hence the U-shape effect—my comment].

This, then, is the meaning of the depression phase of the business cycle. Note that it is a phase that comes out of, and inevitably comes out of, the preceding expansionary boom. It is the preceding inflation that makes the depression phase necessary. We can see, for example, that the depression is the process by which the market economy adjusts, throws off the excesses and distortions of the previous inflationary boom, and reestablishes a sound economic condition. The depression is the unpleasant but necessary reaction to the distortions and excesses of the previous boom. [the boom which is followed by a bust shows that “financial sector growth is found to be a drag on productivity growth”. Whatever temporary gains acquired from the boom are lost through capital consumption thus “financial booms are not, in general, growth enhancing”—my comment]

BIS: The Difference of Great Depression and the 2008 Crisis is Central Bank Inflationism

What’s the fundamental difference between the crisis of the Great Depression in 1931 and that of the US Mortgage crisis of 2008?

The Bank of International Settlement (BIS) gives an answer: central banking inflationism

Here’s the concluding remarks of William A Allen and Richhild Moessner from their recently published paper:

We have suggested a number of ways in which the financial crisis of 2008 was propagated internationally. We argue that the collateral squeeze in the United States, which became intense after the failure of Lehman Brothers created doubts about the stability of other financial companies in the United States, was an important propagator. The provision of large-scale swap lines by the Federal Reserve relieved many of the financial stresses in other countries that had followed Lehman Brothers’ failure. The unwinding of carry trades, particularly yen carry trades, is also likely to have transmitted market volatility to the countries that had been the destination of the carry trades when they were first put in place. It seems likely that, at the time of writing, there is still a large quantity of yen carry trades to be unwound.

In both crises, deposit outflows were not the only important sources of liquidity pressure on banks: in 1931, the central European acceptances of the London merchant banks were a serious problem, as, in 2008, were the liquidity commitments that commercial banks had provided to shadow banks. And in both crises, the behaviour of creditors towards debtors and the valuation of assets by creditors, were all very important. Flight to liquidity and safety was an important common feature of the crises of 1931 and 2008. In both episodes, the management of central banks’ international reserves appears to have had pro-cyclical effects.

However, there was a crucial difference, in that the supply of assets that were regarded as liquid and safe in 1931 was inelastic and became narrower with the passage of time, whereas in 2008, it could be, and was, expanded quickly in such as way as to contain the effects of the crisis. The understanding that the role of governments and central banks in a crisis is to enable such assets to be supplied was perhaps the most important lesson of 1931, and the experience of 2008 showed that it had been learned.

The difference has been Central Bank's asset-purchasing program or termed as credit easing policies a.k.a Quantitative Easing.

The BIS gets it.

The deflation camp based on premises of “aggregate demand” does not.

Perhaps a little more elaboration from the great Murray N. Rothbard who presciently wrote (What has Government Done To Our Money), [emphasis added]

But the central Bank, by pumping reserves into all the banks, can make sure that they can all expand together, and at a uniform rate. If all banks are expanding, then there is no redemption problem of one bank upon another, and each bank finds bank expansion of one bank upon another, and each bank finds that its clientele is really the whole country. In short, the limits on bank expansion are immeasurably widened, from the clientele of each bank to that of the whole banking system. Of course, this means that no bank can expand further than the Central Bank desires. Thus, the government has finally achieved the power to control and direct the inflation of the banking system.

In addition to removing the checks on inflation, the act of establishing a Central Bank has a direct inflationary impact. Before the Central Bank began, banks kept their reserves in gold; now gold flows into the Central Bank in exchange for deposits with the Bank, which are now reserves for the commercial banks. But the Bank itself keeps only a fractional reserve of gold to its own liabilities! Therefore, the act of establishing a Central Bank greatly multiplies the inflationary potential of the country.

The essence is, an inflationary or deflationary outcome depends largely on central bank directives.

Inflation expands the power of central banks, deflation does not. Guess which route central bankers are likely to chose? (Of course, this assumes that the market can still bear with the effects of central bank policies)

The US dollar's Vitality Stems From Debt Deflation Prompted US Dollar Shortage

We have long argued that the recent strength of the US dollar, which was seen almost across most major currencies, have been mainly a function of the US dollar's role as an international currency serve. [see latest Asian Currencies Fall On CEE To South Korean Won Contagion]

Apparently the Bank of International Settlements in its Quarterly Review has a similar perspective.

The chart according to the BIS "examines cross-currency funding, or the extent to which banks invest in one currency and fund in another. This requires a breakdown by currency of banks’ gross foreign positions, where positive (negative) positions represent foreign claims (liabilities).

``For some European banking systems, foreign claims are primarily denominated in the home country (or “domestic”) currency, representing intra-euro area crossborder positions (eg Belgian, Dutch, French and German banks). For others (eg Japanese, Swiss and UK banks), foreign claims are predominantly in foreign currencies, mainly US dollars. These foreign currency claims often exceed the extent of funding in the same currency. (bold emphasis mine)

So how did the shortage come about? From the unraveling debt deflation process...

Again from the BIS (bold emphasis mine),

``European banks’ funding pressures were compounded by instability in the non-bank sources of funds on which they had come to rely. Dollar money market funds, facing large redemptions following the failure of Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks (see Baba et al in this issue). Less abruptly, a portion of the US dollarforeign exchange reserves that central banks had placed with commercial banks was withdrawn during the course of the crisis. In particular, some monetary authorities in emerging markets reportedly withdrew placements in support of their own banking systems in need of US dollars.

``Market conditions made it difficult for banks to respond to these funding pressures by reducing their US dollar assets. While European banks held a sizeable share of their net US dollar investments as (liquid) US government securities, other claims on non-bank entities – such as structured finance products – were harder to sell into illiquid markets without realising large losses. Other factors also hampered deleveraging of US dollar assets: prearranged credit commitments were drawn, and banks brought off-balance sheet vehicles back onto their balance sheets...

``The frequency of rollovers required to support European banks’ US dollar investments in non-banks thus became difficult to maintain as suppliers of funds withdrew from the market. The effective holding period of assets lengthened just as the maturity of funding shortened. This endogenous rise in maturity mismatch, difficult to hedge ex ante, generated the US dollar shortage."

Despite the tremendous amount of financing generated by the US Federal Reserve, the losses in the US banking system compounded by the pressures on the European Banking system has been far greater in reducing supply of US dollars in the global financial system. Nonetheless, all these reveals of the inherent privileges of the world's currency reserve.

In short, the factors of demand and supply of currencies dictate on relative currency values, with special emphasis over the short term, more than just economic conditions.