Blanchard: “As the crisis slowly recedes, it’s time for a reassessment of what we know about how to conduct macroeconomic policy.” (photo: IMF)
Interview with Olivier Blanchard
The IMF on February 12 published a paper, “Rethinking Macroeconomic Policy,” part of a series of policy papers prepared by staff of the 186 member international institution that reassesses the macroeconomic and financial policy framework in the wake of the devastating crisis.
Several of the papers will be discussed at a conference to be held in Seoul, Korea, later this month.
IMF Survey online spoke to Olivier Blanchard, one of the authors of Rethinking Macroeconomic Policy, about the reasons for publishing the paper now and what he hopes to achieve. Blanchard, who joined the Fund in 2008 from the Massachusetts Institute of Technology, is Economic Counsellor of the IMF and head of the Research Department.
IMF Survey online: Why are you publishing this paper, which essentially attempts to lay out the contours of a new macroeconomic policy framework, now?
Blanchard: As the crisis slowly recedes, it’s time for a reassessment of what we know about how to conduct macroeconomic policy. It was tempting for macroeconomists and policymakers to take much of the credit for the steady decrease in cyclical fluctuations from the early 1980s on and to conclude that we knew how to conduct macroeconomic policy. We did not resist temptation. The crisis naturally forces us to question our earlier conclusions and that’s what we are trying to do in this paper.
IMF Survey online: So is this a mea culpa by economists?
Blanchard: Well, macroeconomists clearly did not cause this crisis. But we now realize that economists and policymakers alike were lulled into a false sense of security by the apparent success of economic policy ahead of the crisis—a period known as the “Great Moderation” when fluctuations in both output and inflation in most advanced economies were successfully reduced and living standards rose. The crisis has taught us a lot and we want to proactively draw lessons from the “Great Recession.”
Our goal in this piece is to lay out some key questions about the design of macroeconomic policy frameworks. And to develop some ideas on how those frameworks might be strengthened. Looking ahead, we will need to consider in more depth how we should tailor our specific policy advice to advanced, emerging market and developing countries.
IMF Survey online: What are your conclusions so far?
Blanchard: The basic elements of the pre-crisis policy consensus still hold. Keeping output close to potential and inflation low and stable should be the two targets of policy. And controlling inflation remains the primary responsibility of the central bank. But the crisis forces us to think about how these targets can be achieved.
The crisis has made clear, however, that policymakers have to watch many other variables, including the composition of output, the behavior of asset prices, and the leverage of the different participants in the economy. It has also shown that they have potentially many more instruments at their disposal than they used before the crisis. The challenge is to learn how to use these instruments in the best way. The combination of traditional monetary policy and regulatory tools, and the design of better automatic stabilizers for fiscal policy, are two promising routes.
IMF survey online: What do you mean by combining monetary policy and regulatory tools?
Blanchard: Interest rates are a poor tool to deal with excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals. We need a combination of monetary and regulatory tools.
For example, if leverage appears excessive, regulatory capital ratios can be increased; if liquidity appears too low, regulatory liquidity ratios can be increased; to dampen housing prices, loan-to-value ratios can be decreased; to limit stock price increases, margin requirements can be raised. These measures could be to some extent circumvented, but nevertheless are likely to have a more targeted impact than the policy rate on the variables they are trying to affect.
It’s better to use the policy rate primarily in response to aggregate activity and inflation and to use these specific instruments to deal with specific output composition, financing, or asset price issues.
If monetary and regulatory tools are to be combined in this way, it follows that the traditional regulatory and prudential frameworks need to acquire a macroeconomic dimension. The main challenge, here, is to find the right trade-off between a sophisticated system, fine-tuned to each marginal change in systemic risk, and an approach based on simple-to-communicate triggers and easy-to-implement rules.
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. Indeed, the trend toward separation of the two may well have to be reversed.
IMF survey online: You argue that we should understand why, in many countries, central banks care more about the exchange rate than they admit, and we should draw policy conclusions. Can you explain?
Blanchard: In many emerging market countries, while monetary authorities describe themselves as inflation targeters, they clearly care about the exchange rate beyond its effect on inflation.
They probably have good reasons to do so. Isn’t it time to reconcile practice with theory, and to think of monetary policy more broadly, as the joint use of the interest rate and sterilized intervention, to protect inflation targets while reducing the costs associated with excessive exchange rate volatility?
IMF survey online: Central banks have chosen low inflation targets, around 2 percent. In your paper, you argue that maybe we should revisit this target. Why?
Blanchard: The crisis has shown that interest rates can actually hit the zero level, and when this happens it is a severe constraint on monetary policy that ties your hands during times of trouble.
As a matter of logic, higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions. What we need to think about now if whether this could justify setting a higher inflation target in the future.
IMF Survey online: Isn’t that risky?
Blanchard: The crisis has shown that large shocks to the system 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. Maybe policymakers should 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? Is it more difficult to anchor expectations at 4 percent than at 2 percent?
At the same time, it is clear that achieving credible low inflation through central bank independence has been a historic accomplishment, especially in several emerging markets. Thus, answering these questions implies carefully revisiting the list of costs and possible benefits of inflation. Nevertheless, it is worth considering whether these costs are outweighed by the improved policy maneuverability that would be available in times of crisis from having slightly higher inflation.
IMF Survey online: Fiscal policy is back in fashion because of the crisis.
Blanchard: The crisis has returned fiscal policy to center stage as a macroeconomic tool, for two main reasons: first, to the extent that monetary policy, including credit and quantitative easing, had largely reached its limits, policymakers had little choice but to rely on fiscal policy. Second, from its early stages, the recession was expected to be long lasting, so that it was clear that fiscal stimulus would have ample time to yield a beneficial impact despite implementation lags.
It has also shown the importance of having “fiscal space,” again the room to maneuver during times of trouble. Some advanced economies that entered the crisis with high levels of debt and large unfunded liabilities have had limited ability to use fiscal policy, and are now facing difficult adjustments.
Those emerging market economies (some, for example, in Eastern Europe) that ran highly procyclical fiscal policies driven by consumption booms are now forced to cut spending and increase taxes despite unprecedented recessions. By contrast, many other emerging markets entered the crisis with lower levels of debt. This allowed them to use fiscal policy more aggressively without fiscal sustainability being called into question or ensuing sudden stops.
This suggests that we should revisit target debt to GDP ratios. Maybe we should aim for much lower ratios than before the crisis. This is a long way off, given where we start, but this is another issue we must revisit.
IMF Survey Online: Can anything be done to make fiscal policy more effective during a crisis?
Blanchard: Discretionary fiscal policy measures usually come too late to fight the downturn because it takes time to put in place tax cuts or new spending measures. There is, therefore, a strong case for improving what are called the fiscal stabilizers. Our paper argues that we need to look carefully at measures that would automatically kick-in during a downturn and have a significant impact on the economy. For example, one could think of temporary tax policies targeted at low-income households, investment credits, or temporary social transfers that would be triggered by a macroeconomic variable crossing some threshold (the unemployment rate, say, rising above 8 percent).
