Managing macroeconomic risks and protecting the vulnerable

Posted by Anis Chowdhury on 15 August 2010

Managing macroeconomic risks and protecting the vulnerable


Iyanatul Islam and Anis Chowdhury[1]



The manner in which the Great Recession caught most macroeconomists by surprise highlights in a dramatic fashion how relatively long periods of a low inflation environment and short, shallow business cycles as well as the rapid growth of the global economy during 2002-2007 can breed a sense of collective complacency about the future.[2] The community of professional economists and development practitioners now has an obligation to advocate guidelines for improving the management of macroeconomic risks. This note outlines such guidelines that have both prudential and protective dimensions.


Prudential measures to mitigate risks


The objective of a prudential approach is to limit the risk of episodes of financial crises because they produce significant losses of real output and employment. By identifying the common exposures to risks and their systemic nature, a prudential approach would have a better chance of securing financial stability, identifying vulnerabilities and calibrating policy responses than the conventional inflation targeting (IT) approach.


The prudential approach to macroeconomic risk management suggests the following.


  • Install early warning systems that would enable one to track looming macroeconomic crises. Based on the work of Reinhart and Rogoff, one can use a number of relatively robust early warning indicators that could allow central banks and finance ministries to anticipate banking and currency crises triggered by incipient asset price booms.[3] These are: (a) real exchange rate; (b) real housing prices; (c) real stock prices; (d) short-term capital inflows/GDP; (e) current account balance/investment; (f) exports; (g) broad money/reserves. Note that the inadequacy of the IT approach becomes evident because under it the monetary authorities will not monitor, and act on, (b) and (c) or (d) and (f) even if they track (a) or (e) and (g). An additional indicator that needs to be monitored on a regular basis is international commodity price movements. This is relevant for both oil and food importing countries and commodity exporters as this is one of the most common sources of external shocks to developing countries.

  • Invest in data collection and dissemination to support implementation of early warning systems. This is easier said than done. Governments will have to have the political will to invest necessary resources in developing early warning systems. In addition, developing countries will require considerable international financial and technical support. Until such time when data on all the above indicators are not available, there should be interim monitoring indicators such as growth of private sector credit – which may fuel housing or stock bubbles – which are generally available in most countries.  

  • Engage in ‘self-insurance’ during booms and good times that will lead to enhanced fiscal space to deal with downturns.[4]  During boom times and normal periods, resources are plentiful and complacency likely to set in. Self-insurance to enhance fiscal space in such circumstances becomes important. This can occur in many forms, such as setting aside accumulating revenues in a ‘stabilization fund’, paying off debts and building up foreign exchange reserves. These precautionary savings can be used to finance discretionary fiscal interventions during downturns.

  • Temper the pro-cyclical behaviour of financial systems and external capital flows through purpose-built policy instruments.[5] The very act of self-insurance can temper the pro-cyclical behaviour of financial systems and external capital flows, but this can be reinforced by additional purpose-built instruments, such as raising the capital adequacy ratio for financial systems during a boom and implementing unremunerated reserve requirements for capital inflows.[6] More generally, countries should use capital controls as an important component of macroeconomic policy.[7]


Protective measures against macroeconomic risks


Protecting the poor and the vulnerable is crucial in equitably sharing the adjustment costs of macroeconomic crises. This is not just an issue that is germane to only developing and emerging economies. Disaggregated analysis of current unemployment  rates in the US has shown that the global recession has hurt the poor and the near-poor while leaving the affluent largely unaffected.[8] One of the lessons that have been learnt from past crisis episodes is that a well-functioning protective approach to managing macroeconomic risks requires preparedness on the part of governments. This means, in effect, the need to make investments in a social protection system that is both comprehensive and has components that can behave as ‘automatic stabilizers’, with expenditures on social protection rising in a recession and declining in a boom without recourse to discretionary interventions. It is well known that social protection systems in developing countries fall far below this ideal, but even in developed countries key aspects of the social protection system, such as unemployment compensations, are not as comprehensive as they could be.[9] Here is a suggested list of ideas on what needs to be done to implement a well-functioning protective approach to managing macroeconomic risks.

  • Design and implement regular ‘stress tests’ to assess the labour market consequences of macroeconomic crises and whether policy responses can occur quickly and effectively.[10] The idea of regular ‘stress tests’ to gauge financial sector vulnerabilities is now widely accepted. This principle should now be extended beyond the financial sector. The aim is to assess alternative scenarios to simulate the impact of a contraction in output and components of aggregate demand on poverty and labour market indicators both with and without policy responses. If properly designed and carried out, it would alert governments to existing deficiencies in the prevailing policy framework and institutional arrangements.

  • Invest in data collection and dissemination to support implementation of periodic stress tests. A prerequisite for developing and maintaining ‘stress tests’ is to have access to timely and reliable data on the labour market and poverty. Only 20 developing countries have semi-annual labour force surveys (and only one in Africa), while only 17 developing countries have up-to-date unemployment data and no poverty data for 2008 and 2009.[11] This acute paucity of data will need to be addressed with appropriate resources and technical assistance by donors.

  • Move away from fine targeting and a fragmented approach to the notion of a social protection floor. The targeted social protection or poverty reduction programmes are inadequate in coping with macroeconomic crises. Furthermore, the need to build political support for progressive social policies requires a broader conceptualization of poverty that focus not just on the currently poor, but also the near-poor and the interests of the burgeoning middle class in developing countries who often lack economic security.[12] In addition, the limitations of a fragmented approach to social protection which highlights specific policy instruments, such as conditional cash transfers or employment guarantee schemes, rather than the importance of adopting a system-wide approach, are also increasingly being recognized in the post-crisis era. Hence, the notion of the UN-supported ‘social protection floor’ initiative that argues that all citizens in the developing world are entitled to minimal social protection coverage entailing both labour market and other social assistance and social insurance programs. ILO estimates have shown that even low-income countries can afford a social protection floor with transitional donor assistance.[13] The challenge is to harness the necessary resources to invest in the social protection floor initiative and to ensure that it acts as an automatic stabilizer to temper the consequences of economic volatility.



Concluding remarks


In the current re-thinking on macroeconomics that is underway, there is a growing recognition that the low inflation/fiscal prudence approach has underperformed in anticipating gathering financial storms and their long-lived, deleterious effects on the real economy, especially on employment. The most recent estimates show that, based on past crises episodes, it can take 5.5 years for employment to return to pre-crisis levels in developed countries and about 3 years in developing countries to achieve the same outcome. Furthermore, in the case of developing countries, informal employment often increases during crisis episodes. Such increases can take years to reverse.[14] Therefore, much greater attention needs to be given to the management of macroeconomic risks by harnessing a combination of prudential and protective tools. This means installing early warning systems, periodic ‘stress tests’, complementary investments in data collection and dissemination, the use of self-insurance schemes and counter-cyclical policy instruments during booms and normal periods, and the adoption of the agenda of a global social protection floor.


[1] Iyanatul Islam, ILO, Geneva and Griffith University, Australia. Anis Chowdhury, UN-DESA, New York and University of Western Sydney, Australia. The views expressed here are strictly personal and do not necessarily reflect the views of the United Nations or the ILO.

[2] The complacency is captured in the so-called ‘Great Moderation’ hypothesis. Blanchard et al acknowledge this. See See Blanchard, O, Giovanni, D and Mauro, P (2010) ‘Rethinking Macroeconomic Policy’, IMF Staff Position Note (SPN/10/03).See also Bernanke, B (2004) ‘Remarks by Governor Ben S.Bernanke: The Great Moderation’, Speech made at the meetings of the Eastern Economic Association’, Washington D.C, February 20.

[3] Reinhart, C and Rogoff, R (2009) This Time is Different: Eight Centuries of Financial Folly, Princeton and Oxford: Princeton University Press

[4] Blanchard et al support the need to for ‘building fiscal capacity in good times’. See also Ocampo, J.A  (2010) ‘Symposium: The Return of Counter-cyclical Policy- Editorial Preface’, Journal of Globalization and Development, 1(1), Article 10.

[5] Ocampo (op.cit)

[6] The IMF has now recognised the importance of prudent capital account management. See Ostry, J.D et al (2010) ‘Capital Inflows: The Role of Controls’, IMF Staff Position Note (SPN/10/04), February 19 and the Global Monitoring Report 2009.

[7] See Cordero, J.A and Montecino, J.A (2010) ‘Capital Controls and Monetary Policy in Developing Countries’, April, Washington D.C: Center for Economic and Policy Research.


[8] Sum, A and Khaiwada, I  and Palma, S (2010) ‘Labor Market Underutilization Problems of US Workers Across Household Income Groups at the End of the Great Recession’, February, Center for Labour Market Studies, BostonUniversity

[9] See ESCAP (2010) ‘Strengthening Social Protection Systems in Asia and the Pacific in the Aftermath of the Global Financial Crisis’, Macroeconomic Policy Brief No.3, June. For  a sample of 30 countries in the region, the median coverage rate by programme (labour market programmes, assistance to the elderly, health care, social assistance, access to micro-credit, assistance to disabled, children’s protection) varies from 57% (social assistance) to 5 per cent (health care). The ILO’s global database for social security shows that unemployment benefits reach less than 60 per cent of the eligible population even in high income countries.

[10] This point is emphasised by Cavallo, E and Izquierdo, A (2009: chapter 1) Dealing with an International Credit Crunch: Policy Responses to Sudden Stops in Latin America, Washington D.C: Inter-American Development Bank. They call it the need to engage in ‘fire drills’.

[11] Department of Statistics, ILO, Geneva.

[12] Kanbur, R (2010) ‘Macro Crises and Targeting Transfers to the Poor,’ Journal of Globalization and Development: Vol. 1, Issue 1, Article 9 explores the traditional theory of targeting and highlights its limitations. He argues for the case of a more comprehensive approach to social protection.  See also Commission on Growth and Development (2010) Special Report, Part 5, WashingtonD.C.  The vulnerability of the developing world’s ‘middle class’ (those above USD 2 a day) is analysed in Ravallion, M (2009) ‘The Developing World’s Bulging (but Vulnerable) Middle Class’, World Bank Policy Research Working Paper No.4816. Birdsall, N (2010) ‘The (Indispensable’) Middle Class in Developing Countries’, Working Paper No.207, March, Washington D.C: Center for Global Development, provides new evidence on the middle class using higher standards than the conventional US 2 a day.

[13] ILO (2009) ‘Social Security for All’, Social Security Policy Briefing No.7, Geneva:ILO

[14] International Institute of Labour Studies  and ILO (2009; chapter 1) The World of Work Report, Geneva