Seven years since the onset of the global financial crisis, we are still assessing how the crisis should change our views about macroeconomic policy. To take stock, the IMF organized two conferences, the first in 2011, the second in 2013, and published the proceedings in two books, titled “In the Wake of the Crisis” and “What Have We Learned?“.
The time seems right for a third assessment. Research has continued, policies have been tried, and the debates have been intense. But have we truly made much progress? Are we closer to a new framework? To address these questions, Raghuram Rajan, Ken Rogoff, Larry Summers and I are organizing a third conference, “Rethinking Macro Policy III: Progress or Confusion?” that will take place on April 15-16 at the IMF.
Much of the discussion in recent years has centered (rightly) on the policy issues of the day: What measures to take during a financial or sovereign crisis, what to do at the zero lower bound, how to design quantitative easing, at what rate should fiscal consolidation take place?
The focus of our conference will be instead on the architecture of policy when (hopefully) policy rates have become positive again, and most countries are growing and have stabilized debt-to-GDP ratios.
In other words, how will/should macro policy look once the crisis is finally over?
Here are some questions to start the discussion (I hope, in a later blog, to summarize the answers coming out of the conference).
It is now well understood that the financial crisis resulted from the interaction of excessive leverage in the financial system and extensive interconnectedness and complexity of balance sheets of both banks and non banks. In other words, the crisis revealed the presence of large, undetected, systemic risks. Since then, much effort has gone toward improving our understanding and assessment of systemic risk. Questions: Where do we stand? Are some dimensions of systemic risk easier to measure (e.g., leverage in the banking sector vs. interconnectedness of banks and non-banks or risks outside the banking sector)? How should we assess the experience with stress-tests? And have we made enough progress in reducing systemic risk since the crisis, e.g., with Dodd-Frank, the Vickers commission, the Financial Stability Board, etc?
Macro Prudential Policies
Macro prudential tools, that is state-dependent regulations, are the new policy kids on the block. A standard example is maximum loan-to-value ratios, which can be adjusted as a function of the state of the housing market. Properly used, the argument goes, macro prudential tools can be designed and targeted to deal with the many dimensions of financial risk, allowing fiscal and monetary policy to deal with their traditional mandates.
In practice however, the story is much less clean.
Despite increasing experimentation, we are still grappling with which macro prudential tools to develop, how to use them, and the reliability of their effects. Questions: Do we have or can we develop tools to deal with the different types of risk, from high housing prices, to insufficient capital in some financial institutions, to sudden drops in liquidity in some financial markets?
Using these tools in the right way not only requires substantial knowledge, but also raises political economy issues. In a housing boom, increasing the loan to value ratio may be politically difficult. Questions: Given these issues, when should we use macro prudential tools, or should we use tougher, non contingent financial regulation? To be concrete, should we aim for variable capital ratios and decide when to adjust them, or just give up on the variable part, and aim for high but constant capital ratios?
Finally, it is clear that both financial regulation and macro prudential tools are likely to lead financial actors to adjust and explore ways of getting around them. Questions: In this game of cat and mouse, can the macro prudential regulators hope to win? Or will regulation and tools become increasingly complex and possibly counterproductive?
Even before the crisis started, there were sharply different views on whether central banks should have a single mandate (price stability) or a dual mandate (price stability and stable economic activity). The crisis has intensified this debate. Indeed it has led to the suggestion that central banks should have a triple mandate, with financial stability added to the first two. Questions: Under the highly realistic assumption that financial regulation and macroprudential tools do not fully take care of financial stability, should monetary policy take financial stability into account? And if so, how? Can the interest rate or other monetary policy tools reduce financial risk? How should macro prudential tools and monetary policy be coordinated? Should they both be under the responsibility of the central bank? If this is the case, and central banks have tools which can have effects on very specific sectors of the economy, can they retain full independence?
The zero (or as we are now discovering, the slightly negative) lower bound on the interest rate set by central banks was thought to be a theoretical curiosum, unlikely to happen, and, in any case, easy to combat if reached. If reached, central banks could, through announcements of future monetary policy, increase expected inflation and achieve large negative interest rates. We have learned that this was simply wishful thinking. The zero lower bound could be reached, inflation expectations are not easy to manipulate, and it may take a very long time to exit. Questions: What can we do if anything to avoid hitting the zero lower bound again? Are worries about secular stagnation and low or negative equilibrium real interest rates, and thus a higher likelihood of hitting the zero lower bound justified?
When they encountered the zero lower bound, central banks extended the set of assets they were willing to purchase, these operations being known generically as Quantitative Easing, or QE. They have both changed the composition and vastly increased the size of their balance sheets. Questions: If and when economic conditions turn more favorable, and it is time to exit from the zero lower bound, should central banks eventually return to the traditional mode of intervening at the short end of the market, or should they continue to buy and sell longer maturity sovereign or corporate bonds? Should the balance sheets of central banks return to their pre-crisis size, or remain permanently larger? If the central bank intervenes along the yield curve, how should monetary policy and debt management by the Treasury be combined?
Last but not least, central banks ended up providing liquidity to many agents at the height of the crisis, not only to banks but also to non-deposit taking institutions and (directly and indirectly) to sovereigns. Questions: Should central banks continue to provide such an extended lender-of-last resort role in tranquil times or should a narrower focus be retained?
When the financial system froze, and monetary policy no longer worked, most advanced economies relied on fiscal policy to limit the decrease in demand, and in turn on output. The result of the combined drop in output and fiscal stimulus was a dramatic increase in the debt- to-GDP ratio. Since then, the focus has been on the rate at which this ratio should be first stabilized and then decreased. Turning to future policy, this story raises a number of issues.
While the acute phase of “fiscal austerity’’ has passed, many issues will remain for decades to come. Questions: What is a dangerous level of debt? How do we think about fiscal space? Should fiscal accounting rely more on stochastic debt sustainability analysis? What are the multipliers associated with fiscal consolidation? What do we know about confidence effects? The rules governing fiscal policy in the European Union are widely perceived as too complex and suboptimal. Can one design better rules? Should the old idea of the fiscal golden rule, the separation of a current and of a capital account, be resurrected? Or is the potential for abuse just too large? If we have truly entered a period of secular stagnation, with an excess of saving leading to a negative real rate, doesn’t it make sense for governments to run larger deficits and increase public investment?
Most observers agree that the fiscal stimulus early in the crisis was instrumental in limiting the decrease in output. Questions: Doesn’t this suggest that we should take more seriously the role of fiscal policy as a macro policy tool? Most countries allow for automatic stabilizers to dampen demand fluctuations, but these so-called stabilizers were never designed with stabilization in mind. Could they be improved—and why has there been so little thinking about it?
Capital inflows, exchange rate management and capital controls
The crisis has reinforced the notion that international capital flows can be very volatile, with emerging markets being particularly vulnerable. Policy makers have responded with a panoply of tools, from capital controls, to macro prudential measures aimed at shaping flows, and FX intervention. Questions: What have we learned? Do these tools work? When should they be used, and how should they be articulated with the rest of the macro toolbox? Are there important differences in how advanced economies and emerging markets use (and should use) these tools? And what does the experience since the crisis say about the optimal opening of the capital account, even in the long run?
The International Monetary and Financial System
The financial crisis played out on a global scale, and the international monetary system was tested as never before. Central banks had to extend swap lines. The IMF created programs to provide liquidity. Large capital flows, and large changes in exchange rates, triggered talk of currency wars. Questions: Can we live with the existing system? Can it be improved going forward? If domestic financial regulation is hard to design, cross border regulation is even harder; can we design and achieve cross-border financial regulation and limit the risks of international arbitrage? Can the hybrid system of international liquidity provision through swaps by central banks and liquidity provision by the IMF be improved? Should we reexamine the rules of the game for exchange rates? How can we improve on the process of sovereign debt restructuring? What should be the role of international forums such as the G20?
As you can see, there is no shortage of questions to answer. While the conference is by invitation only due to space constraints, the sessions will be webcast. To follow it, and get more information please visit the conference website. And, as I promised above, I shall try, in a post conference blog, to summarize at least some of the wisdom coming out the conference, and give tentative answers to at least some of the questions listed above.