Speaking at the Bank for International Settlement’s annual general meeting, BIS general manager Jaime Caruana drew a gloomy picture, saying that “the Great Financial Crisis still casts this long shadow on the world economy.” He sees signs of recovery and reform, and expects global economy growth to return to pre-crisis levels. But he also argues that three transition are necessary to avoid falling back into another crisis in the future: a move to growth that isn’t fueled by debt, normalized monetary policy, and a more reliable financial system.

Global Economy: Non-financial debt has risen against GDP since 2007

For all the talk of deleveraging, non-financial sector debt is now higher relative to GDP in the G20 than it was in 2007, reaching 275% in developed economies. Caruana sees this high level of debt as one of the reasons that companies are holding capex so low; as companies become more leveraged their sensitivity to falling income or rising interest rates increases making them less willing to invest.

“Monetary and fiscal stimulus has won us some breathing space. But it cannot substitute for structural reform,” said Caruana. “Ever rising public debt cannot shore up confidence. Nor can a prolonged extension of ultra-low interest rates. Low rates can certainly increase risk-taking, but it is not evident that this will turn into productive investment.”

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Global Economy: Caruana worried about the QE Trap

Caruana worries that the current near-zero rates could prolong the high debt, low growth environment that we’ve been seeing (what Fed qualitative easing critics call the QE Trap) and wants central banks to move back towards normal monetary policy sooner rather than later. The danger is that if markets assume rates will remain low indefinitely, or that they will drop again to buffer asset prices as necessary, then they put central banks in the position of either matching their expectations or pulling the rug out from under them and watching the securities plummet.

“Markets may be taking more assurance than central banks wish to give, and they may be considering only a very narrow spectrum of potential outcomes. Such overconfidence is dangerous,” he says.

Caruana also says that central banks have a responsibility to consider the international effects of their decisions, particularly on emerging markets, but it’s hard to imagine them doing so. The Federal Reserve for example has a dual mandate to manage inflation and unemployment rates to the best of its ability; defending emerging market economies simply isn’t a part of its mission.

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Global Economy: Capital regulation is a positive, but public confidence needs to be restored

The third transition, towards a more stable financial system, is arguably well underway. US banks face ever stricter stress tests and tier 1 capital requirements, and even the banks that failed this year are in much stronger positions than they were leading up to the financial crisis. Results in Europe are more mixed, but the asset quality reviews, stress tests, and implementation of Basel III is proceeding.

Caruana sees room for improvement, streamlining the modeling assumptions made in stress tests is one, but he also thinks that central banks need to look beyond regulations and work to restore public confidence in the financial system to make sure that it can function when the next crisis hits.