The IMF is doing some very interesting (and praiseworthy) rethinking in response to the global crisis, if a new paper co-authored by its chief economist Olivier Blanchard is anything to go by. It’s written by and for economists, so it’s not exactly bedtime reading (unless you’re an insomniac), but here’s the highlights, and my attempts at translation.
Overview: ‘The great moderation lulled macroeconomists and policymakers alike in the belief
All change at the IMF?
that we knew how to conduct macroeconomic policy. The crisis clearly forces us to question that assessment.’
Translation: we thought we knew it all. We don’t. Back to the drawing board.
‘To caricature: we thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job. We thought of fiscal policy as playing a secondary role, with political constraints sharply limiting its de facto usefulness. And we thought of financial regulation as mostly outside the macroeconomic policy framework.’
Translation: We thought all you had to do was keep inflation down, and all you needed to do that was vary interest rates to control prices. Government finances were secondary, and anyway, we didn’t like pesky politicians interfering. We thought regulating financial institutions was irrelevant to overall stability. Whoops.
‘It is clear that the zero nominal interest rate bound has proven costly. Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions.’
Translation: because we kept inflation rates so low, interest rates were also low, so when the crisis hit and we needed to boost the economy, we only had a bit of leeway to lower interest rates (you can’t take them below zero). Instead we had to spend shedloads of cash, and that has left us with a massive fiscal hangover.
‘The crisis has returned fiscal policy to center stage. It has also shown the importance of having “fiscal space”. The aggressive fiscal response has been warranted given the exceptional circumstances, but it has further exposed some drawbacks of discretionary fiscal policy for more “normal” fluctuations—in particular lags in formulating, enacting, and implementing appropriate fiscal measures (often due to an awkward political process).’
Translation: Fiscal policy really matters, and many governments have tried to spend their way out of recession, but getting spending plans through the legislature takes much longer than dropping interest rates, and gets bogged down in pork. In normal times, it’s better to have other options (like more leeway on interest rates).
‘Identifying the flaws of existing policy is (relatively) easy. Defining a new macroeconomic policy framework is much harder. The bad news is that the crisis has made clear that macroeconomic policy must have many targets; the good news is that it has also reminded us that we have in fact many instruments, from “exotic” monetary policy to fiscal instruments, to regulatory instruments. It will take some time, and substantial research, to decide which instruments to allocate to which targets, between monetary, fiscal, and financial policies.’
Translation: Damn, life is more complicated than we thought. Still, lots of work for us researchers….
‘The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Answering these questions implies carefully revisiting the list of benefits and costs of inflation.’
Translation: We think we need to double inflation targets to give governments more room for manoeuvre on interest rates. But hold on a minute, we work for the IMF, so we’d better play safe and pretend we’re merely posing this as a question.
‘If one accepts the notion that, together, monetary policy and regulation provide a large set of cyclical tools, this raises the issue of how coordination is achieved between the monetary and the regulatory authorities, or whether the central bank should be in charge of both. The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators.’
Translation: The economy is just too important to be left to elected politicians. Why not put the Central Bank in charge of everything?
This paper is mainly about policy in the rich countries, but if the change in tone ‘trickles down’ into the Fund’s work in poor countries, it should at least lead to a reduction in its traditional insistence on low inflation at any social cost. Encouraging signs? Further coverage in the FT and on the Vreelander blog.