Regular readers know that your humble blogger has been saying that monetary stimulus won't work since the beginning of the financial crisis (several months before Anna Schwartz, the pre-eminent economist on the Great Depression and Milton Friedman's co-author, made her observation in an interview with the Wall Street Journal).
The problem we face is bank solvency. Specifically, the unwillingness of policymakers and financial regulators like the Fed to admit that the banks are insolvent and that they need to absorb upfront the losses on the excess public and private debt in the financial system.
As I predicted in late 2007, the underlying path for the real economy is a downward spiral until such time as the banks perform the function for which they are designed and absorb the losses on the excess debt.
The failure to use the banks as they are designed hurts both the real economy and the social contract.
The real economy is hurt because capital that is needed for growth and reinvestment is diverted to debt service on the excess debt. In addition, capital is misallocated due to the distortion in prices caused by regulatory forbearance that lets assets continue to be tied up in 'zombie' loans.
The social contract is hurt because governments cut back on benefit programs to offset their increasing debt service burdens.
Fortunately, there is an answer to the bank solvency problem we face. The answer is the Swedish Model. Implementing this model was built into the global financial system during the Great Depression.
Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt. This protects the real economy and the social programs.
Banks are able to absorb these losses and continue operating because of the combination of deposit insurance and access to central bank funding. When banks have low or negative book capital levels, deposit insurance effectively makes the taxpayers the banks' silent equity partner.
The Guardian's summary of the BIS report,
Central banks have done as much as they safely can to rebuild the world economy, and the onus is now on politicians to create the conditions for a stronger recovery, according to the Bank for International Settlements, the central bankers' club.
In its annual report, published on Sunday, the bank, based in Basle, Switzerland, warns that with unprecedented stimulus already in place, fresh action from central banks to kick-start growth may do more harm than good, by distorting financial markets and jeopardising stability.
"Unfortunately, central banks cannot do more without compounding the risks they have already created. Monetary stimulus alone cannot put economies on a path to robust, self-sustaining growth, because the roots of the problem preventing such growth are not monetary," said Stephen Cecchetti, head of the bank's monetary and economic department, presenting the report.
The bank's intervention comes at a critical time, as the Federal Reserveis preparing the US public for the end of the quantitative easingprogramme under which it bought $85bn (£55bn) of bonds every month. In total, central banks in the world's major economies, including the US, UK and Japan, now own assets worth 25% of those countries' GDP.
Stock and bond prices plunged across the world last week after Ben Bernanke, chairman of the Federal Reserve, announced that he planned to begin "tapering" quantitative easing by the end of the year.
The regulating bank in Basle believes it is the right time for central banks to reconsider their role. "We are past the height of the crisis, and the goal of policy has changed – to return still sluggish economies to strong and sustainable growth. Can central banks now really do 'whatever it takes' to achieve that goal? As each day goes by, it seems less and less likely."
Instead of more central bank stimulus, the bank would like to see governments take immediate action to repair public finances, finish the job of re-regulating the fragile banking sector and make markets work better.
It warns that record low interest rates and quantitative easing on a huge scale have dulled the imperative for politicians to act. "After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change," the report says.
However, the bank does express concern about the knock-on effects of central banks withdrawing their emergency measures, including on emerging market economies, many of which have seen their currencies appreciate and their stock markets boom as investors have used the cheap money to invest in riskier assets.
As the stimulus is withdrawn, and bond prices start to fall, interest rates – which move in the opposite direction – could jump. "An outsize increase in interest rates could lead to volatile capital flows and exchange rates, with corresponding adverse implications for global macroeconomic and financial stability," the report warns.
The International Monetary Fund also expressed fears in a recent paper that interest rates could rocket as quantitative easing comes to an end if investors "run for the door".