The Bank for International Settlements (BIS), the world's oldest international financial institution, launched a stinging critique of central banks, saying the use of ultra-low interest rates to boost economic growth is ineffective and counterproductive because it encourages further debt and eases the pressure on politicians to undertake necessary reforms.
BIS, known as the central banks' bank, said exceptionally low interest rates, unbalanced global economic growth and high debt are symptomatic of the failure of the policy framework used by central banks and threatens to entrench financial instability and chronic economic weakness.
"Persistent exceptionally low rates reflect the central banks' and market participants' response to the unusually weak post-crises recovery as they fumble in the dark in search of new certainties," said Claudio Borio, head of BIS' respected Monetary and Economic Department since late 2013.
In its annual report, Swiss-based BIS argues that the current malaise in the global economy is largely a result of a failure by policymakers to grasp how financial developments, especially debt, interact with economic activity and inflation in a world with closely connected economies.
"Rather than just reflecting the current weakness, low rates may in part have contributed to it by fueling costly financial booms and busts," said BIS, adding: "The result is too much debt, too little growth and excessively low interest rates. In short, low rates beget lower rates."
BIS, a hub of global central bank cooperation, said central banks' obsession with controlling short-term economic output and inflation must be replaced by policies - both national and international - that rely less on demand management and more on structural policies so as to abandon the debt-fuelled growth model that has become a substitute for meaningful reforms.
The recommendations by BIS are hardly new as they echo the message in last year's annual report. But what stands out this year is a much sharper and more coherent analysis of the failings of the prevailing economic paradigm.
This is a tribute to Borio, one of the pioneers in developing the understanding of financial cycles who became known in the early 2000s for arguing that financial imbalances - gauged by looking at the level of credit and property prices - can build up in an environment of low inflation.
Before the financial crises, which BIS warned about repeatedly, central banks were narrowly focused on keeping inflation low and therefore turned a blind eye to the forces that led to the global financial crises in 2008.
To their credit, many central banks have begun to incorporate financial instability into their policy frameworks, but BIS argues it has to be at the core of the debate over economic policy.
Policymakers still remain focused on closing output gaps and use policies that affect demand to eliminate that gap to achieve full employment and stable inflation. Although financial instability is now recognized as something that has to be addressed, the current cure is largely through prudential policy that is separate from monetary policy.
For BIS, financial cycles provides it with a lens through which it becomes easier to understand why economic growth remains to sluggish and unbalanced five years after the end of the global financial cries despite low or even negative real interest rates, and high or growing debt.
In addition to flushing out the elements that must be reflected in a new framework for monetary policy, BIS also puts the spotlight on three risks the countries that were most affected by the global financial crises are still facing.
The first risk relates to the cost of ultra-low interest rates, which can inflict serious damage on a financial system by sapping banks' margins, undermining the profitability of insurance companies and pension funds, and lead to mis-pricing in financial markets.
The second risk relates to the reliance on debt as a substitute for reforms to boost productivity. It's well-documented that high debt is a drag on growth and aging populations make the debt burden much harder to bear. Politically aging populations heighten the temptation for politicians to boost demand temporarily.
The third risk relates to the Greek crises and how it will impact the euro area.
"In some respects, developments in Greece and the euro area more generally, are akin to the broader global challenges but amplified by institutional specificities - a toxic mix of private and public debt and too little commitment to badly needed structural adjustments," said BIS.
To replace the current economic paradigm, BIS calls on three elements in a new policy framework.
First, it must be understood that inflation is not a fully reliable guide to sustainable output, an assertion that is contrary to the prevailing paradigm.
Second, the busts that follow financial booms are deeper and subsequent recoveries are weaker. An economy's potential output is permanently lost as resources in both capital and labour have been misallocated. While over-indebted borrowers take time to pay back debt, misallocated resources cannot respond to authorities' attempts to boost demand.
Debt doesn't come down sufficiently, which means the policy room for maneuver shrinks and the seeds are sown for the next financial cries.
Third, exchange rates respond more readily to expenditures than inflation or output. The international monetary and financial system (IMFS) exacerbates the shortcomings of domestic policies by spreading loose monetary and financial conditions to countries that don't need them.
Ultra-easy monetary policy in advanced economies in the wake of the financial cries resulted in an expansion of U.S. dollar credit in emerging markets, supporting a buildup of financial vulnerability.
Although there is no doubt that many emerging market economies are in much better economic shape than in the 1980s and 1990s, BIS cautioned that foreign exchange exposures are now concentrated in the corporate sector and there are limits to how far official reserves can be mobilized to plug private sector funding liquidity shortfalls.
As emerging economies now account for around half of the world's economic output compared with one-third in the last 1990s, it is clear that any crises in emerging markets no longer stays there.
While policies to keep one's own house in order by managing financial cycles would help to reduce spillovers between countries, BIS called on central banks to take such spillovers more into account, not the least to avoid the effect of their own actions spilling back to them.
"Moving beyond enlightened self-interest would require international cooperation on rules constraining domestic policies," BIS said.
Click to read BIS' 85th annual report