The future of macroeconomic policy: Nine tentative conclusions

The global economic crisis forces us to question our most cherished beliefs about the way we conduct macroeconomic policy. With this in mind, I have just organised, together with David Romer, Joe Stiglitz, and Michael Spence, a conference at the IMF on "Rethinking macroeconomic policy”.

Before the conference, I put forward some ideas to help guide the conversation (if you go to the conference site, you can view the proceedings as well as read the various contributions). At the end of the conference I organised my concluding remarks around nine points. Here they are:

1. We’ve entered a brave new world, a very different world in terms of macroeconomic policymaking.

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. There are many distortions relevant for macroeconomics, many more than we thought was the case earlier. We had largely ignored them, thinking they were the province of the microeconomist. As we integrate finance into macroeconomics, we’re discovering that distortions within finance are macro-relevant. Agency theory – about incentives and behaviour 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 themselves is important. Behavioural economics and its cousin, behavioural 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). Many examples were discussed at the conference. 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.
• Michael Spence talked about the relative roles of self-regulation and regulation. Both are needed, but how we combine them is 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. 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 tradable goods 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 suggests, 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 probably the way to go.

• 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 (SDRs) 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 mobilise 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.