Rewriting the Macroeconomists' Playbook in the Wake of the Crisis

IMF Blog, March 4, 2011

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Canonical URL: Rewriting the Macroeconomists' Playbook in the Wake of the Crisis

Author: Olivier Blanchard
Date: March 4, 2011
Context: Reflection on how the global economic crisis necessitates rethinking mainstream macroeconomic policy frameworks developed before the crisis.

Pre-crisis consensus (caricatured):
- The essential goal of monetary policy was low and stable inflation.
- The best way to achieve it was to follow an interest rate rule that delivered stable inflation and output close to potential.
- Setting a key policy rate would affect term structure of interest rates, asset prices, and aggregate demand; details of financial intermediation could be largely ignored.
- Financial regulation was outside the macroeconomic policy framework.
- On exchange rates, countries could float with inflation targeting or choose a hard peg; with inflation targeting there was no reason to worry about the level of the exchange rate or the current account balance.
- Capital controls were undesirable; multilateral coordination was not required.
- Fiscal policy had a limited role in the short run; automatic stabilizers suffice; discretionary policy was likely to be misused; focus should be on medium run fiscal sustainability.
Result: These principles appeared to work during the “Great Moderation” from the early 1980s, but the crisis revealed large hidden imbalances and costly vulnerabilities.

Findings:
- Stable inflation did not guarantee stable output.
- Steady output growth and stable inflation masked growing imbalances in the composition of output, balance sheets of households, firms, and financial institutions, and misalignments of asset prices.
- These imbalances were very costly when the crisis hit.
Key questions:
- Should macroeconomic policy be organized around three legs—monetary, fiscal, and financial—each with separate authorities?
- Or should monetary policy’s mandate and toolset be extended to cover both output and financial stability?
- If monetary policy is extended, what tools exist and how should they be used?

Observations:
- Central banks cut policy rates early in the crisis until they reached their lower bound, namely zero.
- Once at the lower bound, interest rate policy could not prop up aggregate demand, prompting use of credit and quantitative easing.
Key questions:
- Would higher nominal interest rates before the crisis have given central banks more room to maneuver?
- Should we revisit the low inflation targets and associated low average nominal interest rates adopted pre-crisis?
- Are credit and quantitative easing policies only for exceptional times, or do they also make sense in tranquil times?

Observations:
- When interest rates hit the lower bound, fiscal policy returned to prominence.
- Most countries adopted fiscal stimulus programs beyond automatic stabilizers to boost aggregate demand.
- Debates about the size and sign of fiscal multipliers highlighted how little work had been done on fiscal policy design.
- The large increase in debt since the beginning of the crisis is overwhelmingly due to the loss of output and implied loss in revenues rather than to fiscal stimulus programs themselves.
Key questions:
- What levels of public debt should countries aim for given the large post-crisis increases?
- Are old rules of thumb, such as trying to keep the debt to GDP ratio below 60 percent in advanced countries, still reliable?

Observations:
- The crisis triggered very large capital flows, often driven by foreign financial institutions’ needs to repatriate funds rather than by conditions in the originating country.
- Capital later flowed back to emerging markets, sometimes provoking complaints of ‘currency wars’ and intense discussion about capital account management.
Key questions:
- How should countries react to large capital inflows?
- When should countries build up reserves and when should they use capital controls to mute inflows?
- Should countries be free to decide their own responses, or should international rules of good behavior govern capital account measures?

Observations:
- The crisis raises both old and new questions about international monetary coordination and rules.
- Some emerging market countries relied on low exchange rates and export-led growth before the crisis; as these countries grow larger, their competitiveness effects on others become more visible.
Key questions:
- Should benign neglect govern coordination of monetary policies across countries?
- Should there be international rules on capital controls, reserve management, and monetary policy?
- Should countries be free to run the current account deficits or surpluses they prefer, or should there be restrictions?

Observations:
- The great recession showed that advanced countries can suffer sudden stops.
- During the crisis, foreign liquidity was provided mostly through swap lines from major central banks.
- Since then, the IMF has created two new liquidity windows.
Key question:
- Is the problem of international liquidity provision solved, or is more needed?

The crisis requires a wholesale reexamination of pre-crisis macroeconomic principles.
Research and policy work needed on:
- Integrating financial stability concerns into macro policy frameworks and mandates.
- Reassessing inflation targets and nominal interest rate policy in light of lower bound risks.
- Deepening understanding of fiscal multipliers and appropriate public debt targets.
- Designing rules or guidelines for capital flow management, reserve accumulation, and international monetary cooperation.
- Evaluating the adequacy of international liquidity facilities and the role of the IMF.

A conference organized by David Romer, Michael Spence, Joseph Stiglitz, and Olivier Blanchard will take place on March 7 and 8 at the IMF.
The conference is by invitation only due to space constraints but will be webcast live.
After the conference, a discussion site will be opened to continue the discussion online.

Source: Olivier Blanchard, March 4, 2011.