Reorienting macroeconomic policy

What's at stake: The IMF, at the forefront in recommending the policy response to the global economic crisis, has entered the debate about how macroeconomic policy should be adjusted in the future, drawing lessons from the worst global recession in 60 years. Olivier Blanchard, the IMF's chief economist, and a couple of other Fund economists released a paper on Friday about how macroeconomic policy might be reoriented.

Drawing lessons from the Great Recession

Olivier Blanchard says economists and policymakers alike were lulled into a false sense of security by the apparent success of economic policy ahead of the crisis. In the piece, Blanchard and co. lay out some key questions about the design of macroeconomic policy frameworks and also develop some ideas on how those frameworks might be strengthened. 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 that policymakers have to watch many other variables, including the composition of output, the behaviour 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.

Free exchange notes the contrast between this paper and his “state of macro” paper from August 2008 is striking. The assessment of the former paper was that, "the state of macro is good." Interestingly, the older paper is not among the list of references in the new one. Blanchard and co.'s list of the oversights and mistakes of "Great Moderation" macroeconomics makes it harder to see why, a month before Lehman Brothers collapsed, Blanchard was saying that the state of academic macroeconomics was good.

Olivier Coibion and Yuriy Gorodnichenko argue that it is misleading to consider the dramatic end to the Great Moderation as particularly damning for “good policy” explanations of the Great Moderation. The authors argue that the current recession, while clearly severe by historical standards, does not seem to imply a return to the levels of volatility observed in the 1970s and that good policy does deserve credit for the decrease in inflation levels.

The case for higher inflation

Eurointelligence notes that the most surprising conclusion is the idea that central banks have been setting their inflation targets too low. Policy would have been more optimal if we started to cut interest rates from a higher nominal rate. To achieve this you need higher inflation. Blanchard says the 2% inflation targets most central banks seem to have opted for have no reason in theory. If this had to be done over again, he would advocate an inflation target of 4%. He says there is not much between 2 and 4% in terms of price stability, but it gives the central banks more room for manoeuvre to cut interest rates during a crisis.

Paul Krugman very much agrees with Blanchard. He even goes further and writes that there’s another case for a higher inflation rate – an argument made most forcefully by Akerlof, Dickens, and Perry. It goes like this: even in the long run, it’s really, really hard to cut nominal wages. Yet when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts. So having a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis. This point is especially important in the European context as the period 2000-2008 saw a huge divergence in price levels between the capital-inflow nations of the European periphery and the European core. Almost surely, that divergence now has to be reduced. Yet with a low overall inflation rate for the eurozone, that means large-scale deflation in the overvalued economies if convergence is to happen any time in, say, the next 5-10 years. The task would be a lot easier if the eurozone had 4 percent inflation instead of 2.

Georges Soros’ initiative

Not directly linked but somewhat telling about the current mood in macroeconomic thinking is the veteran investor call for a change in how economics is taught in academic institutions, with the emphasis moving away from the widely accepted mantra that markets are always efficient. He has set up the Institute for New Economic Thinking with a $50 million pledge, to explore why prevailing economic theory failed to predict the financial crisis. The advisory board includes George Akerlof, Alexander Mirrlees, Michael Spence, Joseph Stiglitz, Willem Buiter, Simon Johnson, Kenneth Rogoff and Jeffrey D. Sachs amongst others.

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