The contributions to the macroeconomic theme have addressed several dimensions of the crisis. At one level, some of the contributions have focused on the immediate macroeconomic policy challenges facing the G20 government. In addition, the theme has sought to identify the deeper imbalances that lie behind the crisis and whether these imbalances may cause yet further problems in the future. A recurrent concern across the contributions has been the interactions between macroeconomic policy, policies to resolve the banking crisis, financial regulation and international institutional reform. Accordingly, the contributions from the macroeconomic theme are complementary with those from the other themes in the overall initiative.
The two major macroeconomic policy instruments are monetary and fiscal policies. In view of the dramatic decline in policy interest rates towards zero and the disruption in the traditional credit channel for monetary policy, considerable attention has shifted towards fiscal policy. The contribution of Blanchard et al provides a comprehensive guide to the intricacies of setting fiscal policy during the current crisis. This IMF team calls for an expansionary fiscal approach from those countries (including the major creditor countries) that are in a position to pursue a counter-cyclical strategy. However, its nuanced approach also recognises that ‘one size does not fit all’ with the nature of fiscal expansion taking different forms in different countries (for instance, due to differences in the power of automatic stabilisers across different systems) and funding risk limiting the scope for fiscal expansion for a sizeable group of countries. An important design feature (also shared by the recent VOX contribution from Corsetti et al) is that reversible fiscal interventions are more likely to be effective, in view of the importance of ensuring medium-term fiscal sustainability.
In addition, it is better to pursue a diversified fiscal strategy, since there is considerable uncertainty as to which measures will be most effective. This point is reinforced by the contribution of Richard Clarida; the high level of policy activism in the US reflects a search for the right solution, with little by way of historical guidance to enable confident projections about which interventions will prove to be effective. In similar vein, as is emphasised by Axel Leijonhufvud, the central problem is the imperative by banks, households and firms to restore health to balance sheets means that effectiveness of the usual macroeconomic policy transmission mechanisms is highly uncertain.
Turning to monetary policy, Olivier Jeanne focuses on the importance of avoiding the deflation trap. The current problem is different to that facing Japan in the 1990s, since the deflation risk is not country-specific but global in nature. Jeanne highlights the cross-country spillover effects in fighting deflation, since strategies to commit to the resumption of positive inflation rates in the future are strategic complements. This reinforces the importance of international cooperation in monetary policy, at the very least at the level of multilateral consultations in relation to national policies to address deflation risk.
In addition to their primary role in achieving medium-term price stability, the world’s central banks (in tandem with national treasuries) are also centrally involved in finding mechanisms to unlock the flow of credit and restore the health of banking systems through a range of ‘unconventional’ measures. In a series of contributions, Ricardo Caballero has emphasised that the key problem is the level of uncertainty that faces private investors. The fear of “unknown unknowns” means that the degree of effective risk aversion is very high and a primary goal in designing intervention schemes must be to limit systemic downside risk for private investors.
In addition to dealing with the immediate policy challenges to tackle the acute phase of the global crisis, the macroeconomic policy agenda must include taking steps to minimise the risk of such a crisis recurring in the future. In order to provide an appropriate diagnosis to guide longer-term reforms, this requires an identification of the role played by macroeconomic imbalances in generating the current crisis. While the role played by large current account imbalances as a proximate cause of the current crisis remains hotly contested (see, for example, the recent contribution of Dooley et al), there is little dispute that shifts in the level and composition of gross international capital flows over the last decade have represented a major structural shock that in turn contributed to the accumulation of badly-managed risks in the balance sheets of major financial institutions. In particular, as is discussed in the contributions by Eswar Prasad and Brad Setser, the desire by major emerging market economies (most notably, China) to hold large quantities of dollar bonds contributed to low real interest rates in the credit markets of the major advanced economies and may have prompted excessive risk taking and over-gearing by major financial intermediaries in the search for higher yield (see also the contribution by Richard Portes in the VOX e-book Macroeconomic Stability and Financial Regulation: Key Issues for the G20).
Global imbalances still matter
An important point made by both Prasad and Setser is that the global imbalances issue has not disappeared. In particular, while the safe haven effect has provided important support to the dollar over the last year, this provides no guarantee that a disruptive shift in exchange rates may not occur in a future phase of the crisis. In particular, if the fiscal stimulus in the US means that the US recovers more quickly than its trading partners, then the current account deficit in the US may widen again. In addition, aggressive quantitative easing in the US may further weaken demand for dollar-denominated assets.
In relation to the sustainability of the US external balance sheet, Gian Maria Milesi-Ferretti makes a very important point by highlighting that the US net foreign asset position suffered major capital losses during 2008. After a long sequence of enjoying net capital gains on its external position, the valuation channel went into reverse into 2008 due to the disproportionate exposure of US investors to sharp losses international equity markets, with foreign-currency losses compounded by the appreciation of the dollar. Accordingly, the US net external position likely deteriorated by 15% of GDP during 2008, which may further prompt foreign investors to re-assess the riskiness of holding dollar-denominated assets.
More generally, there is a widespread view that the high demand by emerging market economies for liquid foreign-currency assets in part relates to a desire to self insure against the risk of shifts in domestic and international investor sentiment. This risk is more severe for emerging markets, since domestic financial systems are less well developed and foreign debt liabilities are typically contracted in foreign currencies. In order to guard against the risk that domestic residents seek to convert domestic currency assets into foreign currency alternatives and/or that foreign-currency liabilities are not rolled over, the authorities in these countries have accumulated large volumes of foreign-currency reserves.
However, this strategy is collectively inefficient (see also the contribution by Lane in the VOX e-book Macroeconomic Stability and Financial Regulation: Key Issues for the G20). Moreover, as is pointed out in the contribution by Guillermo Calvo, it is turning out that a high level of reserves does not provide much protection since the depletion of reserves is interpreted as a sign of vulnerability by international markets. Accordingly, Calvo argues that a global lender of last resort is required to restore liquidity. In the short run, this translates into a pressing need to greatly expand the liquidity facilities that can be offered by the IMF and other international institutions to emerging market economies. Accordingly, the expansion of funding for the IMF should be a high priority for the G20, in order to provide confidence to global markets that liquidity crises can be averted.
The stability of the financial systems of emerging markets can be further enhanced if institutional reforms can be implemented that promote local-currency foreign lending to these economies. The contribution by Frank Warnock highlights the advantages of local-currency debt markets for these economies and such innovations may be facilitated by shifts in the financial policies of international financial institutions and in the financial regulations adopted by advanced countries vis-à-vis the treatment of assets held in emerging markets.
Two further points made by Calvo are worth highlighting. First, he emphasises that proposals regarding financial regulation may be counterproductive if the lender of last resort function is not addressed; these issues need to be addressed jointly. Second, he highlights that a global lender of last resort function and greater global regulation of financial flows may be difficult to reconcile with large shifts in exchange rates, in view of the impact of currency shifts on balance sheets. Accordingly, there are also important implications of international institutional reform for the international monetary system.
In this article, I have attempted to provide a tour of some of the main ideas discussed in the contributions to the macroeconomic theme of this project. The bottom line is that fighting the current financial crisis and preventing future crises requires a holistic approach that tackles both short-term macroeconomic policy imperatives and longer-term institutional reforms. It is a false choice to argue that the upcoming summit should focus on one dimension to the exclusion of the other.