The crisis has forced economists and policymakers to go back to their drawing boards. Where did they go wrong, and what implications does the crisis have for both macroeconomic theory and macroeconomic policy making?
This was the topic of this year’s IMF Jacques Polak Research Conference. The conference was the first since the passing of Jacques Polak, after whom the conference has been named, and to which he came every year until last year. Present at the Fund’s creation and a long time Fund economist, Jacques had been described by the Managing Director as “a leader of critical thought during the post-war evolution of the global economy.” As such, this conference, and its focus on the post-crisis evolution of the global economy, was fitting a fitting tribute to Jacques. We shall miss him.
The twelve papers presented at the conference provided rich fodder for discussion. For two days, researchers and policymakers explored the contours of policy making in the post-crisis world. I want to share with you some of the major themes:
1. The crisis has forced us to pay much more attention to fiscal policy. The rising public debt in advanced economies poses questions on the appropriate scope and timing of fiscal action, be it further stimulus or consolidation. One paper presented a framework for assessing the scope for fiscal maneuver (fiscal space), by comparing current debt levels with what might be the sustainable level of debt based on each country’s track record with fiscal adjustment. Another paper investigated the optimal timing of fiscal consolidation when monetary policy is constrained by the zero lower bound. A commitment to future consolidation can generate an immediate stimulus by lowering the long-run risk premium. The difficulty, as policy makers understand well, is obviously how to make such commitments about the future credible today.
2. Monetary policy can lessen the adverse effects of financial disruptions on the real economy. One paper showed, using a quantitative macroeconomic model, how the negative feedback between the financial sector and real economy resulted in such a deep economic contraction with the 2007-09 crisis. Policy simulations using the model show the macroeconomic benefit of a monetary policy rule that allows the policy rate to respond to changes in financial conditions. Another paper gave evidence that lax monetary policy leads to a decline in risk aversion in financial markets. If present, this effect should be taken into account in designing monetary policy. Whether this should be done through adjustments of the policy rate, or through macro prudential measures, is clearly a central issue of monetary policy today.
3. International capital flows can weaken financial stability. One paper modeled so called “hot money episodes.” When one country experiences a crisis, global investors need to find other destinations for their investments, leading to inflows of hot money into other countries. While the next destination can benefit for some time, all too often these capital inflows are followed by another crisis. Another paper showed that international financial integration—when not accompanied by fiscal integration among countries—can result in an undersupply of safe assets (high-grade sovereign bonds) and spread the financial fragility. The relevance of these papers to capital flows, either to safe havens or to emerging market countries, that we are observing today is an obvious one.
4. Given the critical role of the financial sector in the crisis, regulatory issues and the interplay with the real economy took center stage.
- One theoretical paper examined how the behavior of firms can be less efficient because government bailouts are highly likely in a deep crisis. Regulatory design should take this into account, thereby reducing the distortions due to expected bailouts and facilitating better outcomes. Another paper emphasized the need to strike the right balance between too lax or restrictive regulation. Very light-handed regulation, together with expectations of bailouts, can lead to very risky behaviors and an excessive expansion of the financial sector, while an ‘overregulating’ to prevent crises will stifle economic growth. The link to the problems faced by a number of advanced countries today is, again, an obvious one.
- Macro prudential regulation was also the theme of two major sessions of the conference. For the keynote address of the conference—the Mundell-Fleming lecture—Anil Kashyap (University of Chicago) focused on fire sales—asset sales at an excessive discount—as a source of financial and economic instability, drawing some implications for the design of macro prudential regulation. The same theme was debated among four expert panelists who joined the Economic Forum, the concluding session of the conference.
The conference was an important opportunity to contribute to the post-crisis policy debate. But, it also made clear how much we still have to learn, from the interaction between monetary policy and financial markets, to the meaning of fiscal sustainability, and to the design of macro prudential regulation, to name just a few.