The Future of Macroeconomic Policy: Nine Tentative Conclusions

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The global economic crisis taught us to question our most cherished beliefs about the way we conduct macroeconomic policy. Earlier I had put forward some ideas to help guide conversations as we reexamine these beliefs. I was heartened by the wide online debate and the excellent discussions at a conference on post-crisis macroeconomic policy here in Washington last week. At the end of the conference, I organized my concluding thoughts around nine points. Let me go through them and see whether you agree or not.

1.  We’ve entered a brave new world in the wake of the crisis; a very different world in terms of policy making and we just have to accept it.

2.  In the age-old discussion of the relative roles of markets and the state, the pendulum has swung—at least a bit—toward the state.

3.  The crisis made it clear that there are many distortions relevant for macroeconomics, many more than we thought earlier. We had ignored them, thinking they were the province of the micro-economist. As we integrate finance into macroeconomics, we’re discovering distortions within finance are macro-relevant. Agency theory—about incentives and behavior of entities or "agents"—is needed to explain how financial institutions work or do not work and how decisions are taken. Regulation and agency theory applied to regulators is important. Behavioral economics and its cousin, behavioral finance, are central as well.

4.  Macroeconomic policy has many targets and many instruments (that is, the tools we use or variables to implement policy). There are many examples of this that were discussed at the conference, but here are two.

• Monetary policy has to go beyond inflation stability, adding output and financial stability to the list of targets, and adding macro-prudential measures to the list of instruments.
• Fiscal policy is more than just “G minus T” and an associated "multiplier" (the proportion or factor by which changes in government spending or taxes affect other parts of the economy). There are potentially dozens of instruments, each with their own dynamic effects that depend on the state of the economy and other policies. Bob Solow made the point that reducing discussions about fiscal policy to what is the right multiplier does not do service to the issue.

5.  We may have many policy instruments, but we are not sure how to use them. In many cases, we are uncertain about what they are, how they should be used, and whether or not they will work. Again, many examples came up during the conference.

• We don’t quite know what liquidity is, so a liquidity ratio is one more step into the unknown.
• It was clear that some people believe capital controls work and some don’t.
• Paul Romer made the point that, if you adopt a set of financial regulations and keep them unchanged, the markets will find a way around, and ten years later, you’ll have a financial crisis.
• Mike Spence talked about the relative roles of self-regulation and regulation. Both are needed, but how we combine them is extremely unclear.

6.  While these instruments are potentially useful, their use raises a number of political economy issues.

• Some instruments are politically hard to use. Take cross border flows. Putting in place a multilateral regulatory structure will be very difficult. Even at the domestic level, some macro-prudential tools work by targeting specific sectors, sets of individuals, or firms, and may lead to strong political backlash by those groups.
• Instruments can be misused. The more there are, the more the scope for misuse. It was clear from the discussion that a number of people think that, while there may be an economic case for capital controls, governments could use them instead of choosing the right macroeconomic policies. Dani Rodrik argued for using industrial policy to increase the production of tradables—goods or services that can be traded among countries—without getting a current account surplus. But in practice we know the limits of industrial policy, and they haven’t gone away.

7.  Where do we go from here? In terms of research, the future is exciting. There are many topics on which we should work—namely macro issues with, as Joe Stiglitz said, the right micro foundations.

8.  Things are harder on the policy front. Given we don’t quite know how to use the new tools and they can be misused, how should policymakers proceed? While we have a good sense of where we want to get to, a step-by-step approach is the way to do it.

• Take inflation targeting. We can’t, from one day to the next, just give it up and have, say, a system with five targets and seven instruments. We don’t know how to do it and it would be unwise. We can, however, introduce gradually some macro-prudential tools, testing the water to see how they work.
• Increasing the role of Special Drawing Rights in the international monetary system is another example. If we go in that direction, we can move slowly from, say, creating a market in private SDR bonds to exploring the possibility for the IMF to issue SDR bonds to the private sector and then, if feasible, issuing them to mobilize funds in times of systemic crisis.

Pragmatism is of the essence. This was a general theme that came up, for example, in Andrew Sheng’s discussion of the adaptive Chinese growth model. We have to try things carefully and see how they work.

9.  We have to keep our hopes in check. There are going to be new crises that we have not anticipated. And, despite our best efforts, we could have old-type crises again. That was a theme in Adair Turner’s discussion of credit cycles. Can we, using agency theory and the right regulations, get rid of credit cycles? Or is it basic human nature that, no matter what we do, they will come back in some form?

I was asked whether the conference was "Washington Consensus 2". It was not intended to be and it was not. The conference was the beginning of a conversation, the beginning of an exploration, and we look forward to your contributions.