Chapter 8. Making Macroeconomics More Relevant
- Tamim Bayoumi
- Published Date:
- October 2017
The North Atlantic crisis represents a massive failure for macroeconomics and policymakers. Macroeconomics was basically created after the Great Depression so that governments could limit economic cycles. After an unsustainable boom, the North Atlantic crisis generated the deepest global recession since the Great Depression and a tepid subsequent recovery. Talk of a “new mediocre” in growth and the rise in populism and associated rejection of expertise by political systems underlines the degree to which the optimism of the early 2000s has evaporated and been replaced by stagnant economic prospects and associated populist political tensions.
Before the crisis, North Atlantic policymakers missed the growing imbalances and overestimated the potency of policies. This reflected the increasing dominance of a market-based framework in which private sector activity was assumed to be fundamentally stable. As a result, policymakers focused on narrow objectives that provided support for such activity that allowed a series of financial, macroeconomic, and structural strains to fall under the radar. The policy parts did not sum to a whole and an apparently efficient system turned out not to be robust. A deep lesson from the crisis is that a robust economy requires a more integrated approach to policies based on a more realistic view of macroeconomics in which nobody is all-knowing, no institution is all-powerful, and instability can come from many sources, including financial markets.
The immediate response to the crisis in the United States and the Euro area illustrates the advantages of an integrated policy approach. The initial US policy response involved a cohesive mix of rapid monetary easing, fiscal expansion, and effective stress tests on the banks that avoided a repeat of the Great Depression. However, as the crisis has receded the imperative to pursue integrated policies has faded. As policies started to focus on differing goals, the anticipated rapid recovery never materialized and the US economy has settled into modest growth. The story in the Euro area is bleaker. With policy integration constrained by a badly designed monetary union, the initial banking crisis was extended by the revelation of fiscal mismanagement in Greece—a country that represents about 3 percent of Euro area output. The interaction between concerns about banks and government finances generated severe strains in Italy, Spain, Greece, Portugal, and Ireland. Indeed, at one point the crisis threatened the existence of the currency union itself, before a more aggressive stance to preserving the union by the European Central Bank diffused growing negative feedback loops.
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The Way We Were
The pre-crisis macroeconomic orthodoxy had a precise and relatively narrow view of policy challenges. It focused on business cycle fluctuations around a slowly evolving path for underlying output (underlying output was determined by technology and was thus not part of the analysis). These fluctuations were primarily ascribed to wages and prices being sticky in the sense that they responded slowly to changes in economic slack. The challenge for policymakers was to minimize these temporary deviations from a slowly moving baseline.
The central bank of each country was viewed as the main institution responsible for responding to such business cycle fluctuations. Its policies were ideally guided by an inflation target, since an overheating economy would generate upward inflationary pressures while an economy with too much slack would exhibit downward inflationary pressures. Most advanced country central banks tried to keep inflation at around 2 percent, which was seen as low enough to mean that the general public would not worry about the rise in prices (particularly as measured inflation is upwardly biased due to difficulties in measuring technological change) while allowing the nominal interest rate to stay well above its lower bound of zero. If the economy was overheating and inflation was starting to rise, the central bank would raise its short-term policy rate, tightening financial conditions through higher costs of borrowing and by appreciating the exchange rate. This would gradually lower demand and bring the inflation rate back to its target. Symmetrically, if there was too much slack in the economy, the central bank would lower the short-term policy rate and boost demand and inflation.
Fiscal policy was primarily tasked with long-term objectives such as ensuring that government debt was low and sustainable and limiting the size of government. Active use of spending and taxes to dampen the business cycle was discouraged for several reasons. Political interference was thought to make it difficult to reverse any stimulus, leading to a larger government, fiscal deficit, and public debt. In addition, the delay involved in implementing a fiscal package meant that any fiscal stimulus (or consolidation) might occur after the cycle had already turned and end up amplifying fluctuations rather than cushioning them. Rather, automatic stabilizers (the natural increase in the government deficit in a slump as taxes fall and spending on the unemployed increases) were viewed as a more reliable way of stimulating the economy during slumps since its effects were immediate and were automatically reversed in a boom. Finally, economists had doubts about the effectiveness of fiscal deficits in stimulating private spending as tax cuts would lead to higher saving in anticipation of higher future taxes.
Financial and structural policies were handled by behind-the-scenes specialists. Financial stability was delegated to regulators who focused on the safety and soundness of individual institutions—so-called micro-prudential supervision. Similarly, the task of maintaining robust underlying growth was delegated to specialists in structural policies aimed at improving the functioning of specific areas of the economy, such as labor markets.
The pre-crisis orthodoxy elegantly compartmentalized policies by assigning specific goals to each institution. Central banks were responsible for taming the business cycle and delivering low and stable inflation, while other policymakers and institutions were primarily responsible for maintaining stability and efficiency in their areas of specialization—fiscal, financial, and structural. Clearly, this highly stylized system was a long way from the reality facing policymakers, even in major advanced countries, let alone the emerging markets that were prone to larger and more varied economic and financial shocks. This stylized vision of macroeconomics did, however, hold an important sway on thinking. This was particularly true for more analytically inclined policymakers such as Ben Bernanke, Chairman of the US Federal Reserve; Timothy Geithner, Head of the US Treasury; Jean-Claude Trichet, President of the European Central Bank; and Mervyn King, Governor of the Bank of England—the first and last being ex-academics, the middle two being trained economists with extensive policy experience.
Crisis and Consequences
The North Atlantic crisis called into question almost every element of this pre-crisis orthodoxy. The major economic shock came from the financial sector, a risk that had been largely discounted in mainstream models. It generated such a large shock that it rapidly overwhelmed the micro-prudential buffers required of individual firms. The resulting recession was so large that policy interest rates in the United States and Europe were rapidly driven down to zero. With no more room to cut rates and the economy still weakening, central banks were forced to experiment with “unconventional” monetary policies such as quantitative easing, in which central banks buy large amounts of assets such as government bonds by printing money. This eased financial conditions by reducing the supply of assets available to private investors, forcing them to either accept a lower interest rate on government bonds or move their money into riskier assets such as equities or foreign paper, thereby lowering long-term interest rates, raising equity prices, and depreciating the exchange rate, all of which supported activity. Tellingly, such policies were dubbed “unconventional” because they were inconsistent with conventional macroeconomic theory which implies that buying and selling assets would have no impact, as investors were assumed to be indifferent about holding different assets, despite the fact that before the crisis central banks controlled short-term interest rates by exactly this mechanism.
In another deviation from pre-crisis orthodoxy, in the immediate aftermath of the crisis the G20 successfully used fiscal stimulus to support activity. This largely reflected the initiative of Dominique Strauss-Kahn, then the head of the International Monetary Fund. At the conclusion of the first-ever G20 leaders meeting in Washington in November 2008, the final communiqué included a relatively innocuous pledge that leaders would “use fiscal measures to stimulate demand to rapid effect, as appropriate, while maintaining a policy framework conducive to fiscal sustainability”. In a press conference later that day, however, Mr. Strauss-Kahn provided a much more concrete vision when he said: “What we’re trying to organize is this coordinated action plan to have a boost in growth starting from a fiscal stimulus of 2 percent [of output]. Some measures have already been taken by some countries, and we are looking for a result of an increase in growth of also 2 percent.”1 In the face of concerns about a new depression, the idea of an internationally coordinated fiscal stimulus rapidly caught on, and the G20 did indeed achieve a fiscal expansion of around 2 percent of output over 2009 and 2010 that boosted growth temporarily.
Finally, the deep global recession and slow recovery (after the fiscal stimulus wore off) have led to an increasing recognition that structural policies can support the recovery by boosting medium-term growth. The key insight here is that the debt burden facing a country depends not only on the level of debt but also on how fast an economy is expected to grow. Debts that were regarded as easily repayable in an era of high growth expectations can become much more problematic in a low growth environment. This creates the risk of a self-reinforcing downward spiral in which it becomes harder to borrow, which constrains future growth, thereby making it still harder to borrow. In an attempt to break this cycle, in 2014 the G20 leaders committed to structural reforms that would add 2 percentage points to global potential over the next five years. Sadly, the effort was half-hearted as most of these commitments were to policies that were already planned.
In the light of the broad challenges that the crisis posed for the existing orthodoxy, post-crisis changes to macroeconomic thinking have been surprisingly limited. The recognition that financial shocks can be systemic and generate major recessions has been acknowledged by elevating “macrofinancial” policies as a new policy tool. Macrofinancial policies are regulations designed to avoid systemic risks to the financial system, such as capping the amount of debt that a mortgage borrower can assume compared to the value of a house. This reduces financial risks by constraining banks from providing high-risk loans in which the home owner makes little or no downpayment, so that even a small fall in house prices can create defaults and losses for banks. Another example of a macrofinancial policy is to limit the size of the mortgage compared to the borrower’s income, which again seeks to curb banks from providing outsized mortgages which are more likely to be defaulted upon.
Macrofinancial policies are macroeconomic in two senses. First, they focus on the risk to the financial system as a whole, as opposed to the pre-crisis attention on the soundness of individual institutions though rules on capital buffers and the like. In addition, responsibility for macroprudential policies generally involves the central bank either on its own (as in the case of the United Kingdom) or as part of a wider committee (such as in the United States and the Euro area). The logic of linking macroprudential policies to central banks is that systemic financial shocks have major macroeconomic consequences, and hence decisions on macrofinancial policies should include the institution primarily responsible for macroeconomic stability.
In most other respects, however, macroeconomic orthodoxy has reverted to something surprisingly close to its pre-crisis normality as the immediate shock of the crisis has faded. For example, there appears to be an increasing consensus that financial stability and macroeconomic stability should be treated as separate objectives and assigned to separate policies—macro-prudential policies for financial risks and monetary policy for the business cycle. This reflects an evolving belief that monetary policy is too blunt an instrument to support financial stability, which is better left to more focused and specialized policies and policymakers.2 Hence, while macroprudential policies have been elevated to new macroeconomic instrument, the basic pre-crisis assignment that financial regulators should take care of financial risks and that monetary policymakers should focus on stabilizing the business cycle has been largely maintained. Equally strikingly, central banks continue to use inflation targets as their basic framework, even though in the run-up to the crisis it was asset prices and trade deficits rather than inflation that most clearly pointed to overheating in the United States and the Euro area periphery. There are certainly macroeconomists who take a more eclectic view and think that monetary policy should also focus on financial imbalances, most notably in the Bank for International Settlements. But this seems to be becoming a minority view.
A similar reversion to pre-crisis orthodoxy has occurred with fiscal policy. Short-term fiscal stimulus was used by the G20 to boost output in the immediate aftermath of the crisis. In addition, many pundits continue to argue that fiscal stimulus should be used more aggressively to support the recovery given low borrowing costs for funds. However, the reality is that after the G20 boost ended in 2010, fiscal policymakers rapidly switched back to the pre-crisis mode of concentrating on longer-term objectives. These involve either ensuring that debt remains on a smooth and sustainable path, the objective behind the rules in the Euro area and the budget consolidation of President Obama’s administration, or on reducing the tax burden and the reach of government, the motive behind the tax cuts proposed by President Trump’s administration. After a brief flowering over the crisis, the idea that fiscal policy should be used to actively support demand has again fallen out of fashion.
With fiscal policy focusing on longer-term objectives, monetary policy has again become the primary instrument to stabilize the economy. This explains the reliance on “unconventional” monetary policies to boost lackluster economic growth by buying long-term bonds and reducing the short-term policy rate below zero. It also led to calls for central banks to play a wider catalytic role in policymaking, including by encouraging a fiscal boost by promising easy money or even by sending out checks to individuals (so-called “helicopter money”). The desire to use the central bank as a way of inducing a fiscal expansion illustrates the abiding preference of experts for interacting with “technical” independent central banks rather than more “politicized” governments, a preference closely linked to memories of the inflation of the 1970s. More recently, pledges of tax cuts in the United States have led to the Federal Reserve potentially playing its more traditional post-1980 role of offsetting the stimulus to the economy coming from ideologically driven tax cuts, as occurred under the earlier administrations of Presidents Reagan and George W. Bush.
The story on structural policies is similar to that for fiscal policy, namely an initial burst of enthusiasm followed by a reversion to type. The initial burst of enthusiasm was centered around strengthening financial regulations and involved national initiatives, most notably the Dodd–Frank legislation in the United States, banking union in the Euro area, and tougher international standards, as embodied in revamped Basel 3 regulations. This has not, however, been followed by a wave of broader structural reforms. In most countries, including the United States and Euro area, reforms remain the province of particular departments, with labor reforms being covered by the labor department, product reforms by the commerce departments, tax reforms by finance departments, and so on. Only in Japan has “Abenomics” provided the clear commitment to wide-ranging structural reforms earlier embodied in Thatcherism and Reaganomics, although the recent election of strongly pro-European President Macron in France may change the situation.
A deep lesson from the crisis, however, is that policy compartmentalization runs the risk of tunnel vision and major mistakes. As the 2008 meltdown demonstrated, an environment in which policymakers focus on their own narrow mandates can result in missing threats that can create massive shocks to the system as a whole. A more inclusive view of macroeconomics and macroeconomic policies would be more robust as it would be less prone to such miscalculations. Specifically, a more inclusive view of macroeconomics is needed along three dimensions: Expanding the focus of macroeconomics to include topics such as potential growth as well as financial stability; widening interactions between institutions so macro-economic policies can be decided in a more cooperative manner; and extending the frame of macroeconomic models beyond “homo economicus”, the self-seeking individual at the core of most theories, to acknowledge the importance of group dynamics and rules of thumb.
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Expanding the Focus of Macroeconomics
The rapid switch back to giving central banks the primary responsibility for combatting macroeconomic fluctuations after fiscal stimulus ended in 2010 is particularly striking given the lackluster economic performance subsequently. Over the following years, inflation remained well below US and Euro area targets and growth was substandard. In addition, central banks across the advanced world have yet to start shedding the assets they bought as part of quantitative easing. Equally importantly, assigning macroeconomic stability solely to the central bank is not intuitive. Indeed, before the 1980s the macroeconomic orthodoxy embraced an integrated approach in which monetary and fiscal policies were used simultaneously achieve full employment (“internal balance”) and a desirable trade position (“external balance”). In this macroeconomic scheme there were two objectives (full employment/stable inflation and a sustainable external position) and two instruments (monetary and fiscal policy). Currently, there are four objections—stable inflation/low slack, high underlying growth, low government debt, and financial stability—as well as four instruments—monetary, fiscal, structural, and financial policies. Since there are as many policies as objectives, it is possible (at least in principle) to achieve each objective independently. But there is clearly much more flexibility and many more options if policies assist each other rather than each being assigned to a specific task, just as was done in the 1960s for full employment and the trade balance.
The integrated approach of the 1960s in which monetary and fiscal policies were used to achieve full employment and a desirable trade balance fell out of favor in the wake of the rise in inflation of the 1970s. The loss in monetary control was diagnosed as coming from a slowing in underlying growth that governments and central banks failed to recognize. Politically motivated attempts to push the economy above its new sustainable underlying potential created overheating and inflation. This left an abiding distrust of government attempts to fine-tune the economy, which was part of a wider rejection of a “mixed” economy in which the government had a central role in promoting economic growth and private sector activity. It also left central banks with a strong view that cooperating with more politicized fiscal policymakers could skew their judgment, leading to an increasing belief that central banks should operate completely independently of governments.
The new paradigm in the 1980s emphasized a market-orientated approach in which the role of the government was to provide a stable backdrop against which the private sector could flourish. This approach, associated with the pro-market philosophy of Prime Minister Margaret Thatcher of the United Kingdom and President Reagan of the United States, envisaged a limited role for government policies. The desire to get the government out of the way of private enterprise meant that independent central banks limited themselves to achieving the narrow objective of an inflation target. Similarly, other policy instruments were focused on providing a predictable environment in their own areas of expertise—government debt, financial stability, and potential growth.
The North Atlantic crisis challenged this paradigm as a lightly regulated private sector turned out to be at least as capable of generating macroeconomic crises as government activism. If the economic instability and low growth of the 1970s was a product of overly active government policies, then the even more destructive crisis that erupted in 2008 was a product of too much confidence in the self-stabilizing properties of private financial markets. The immediate response has been a renewed interest in active financial policies comprising stricter regulation and a new willingness to use macroprudential policies to reduce signs of financial overheating.
The early response to the crisis also involved a healthy dose of policy integration. In 2009 and 2010 the G20 provided concerted fiscal stimulus to support monetary easing at the same time that the most affected financial sectors were stabilized with government backing. The mix worked, as global growth climbed from zero in 2009 to over 5 percent in 2010. It then gradually slowed to its current rate of slightly over 3 percent as fiscal policymakers refocused on reducing the ratio of government debt to output and structural policies remained on the sidelines. With unconventional monetary policies unable to revive demand on their own, the North Atlantic saw a prolonged period of mediocre growth and low inflation.
This pattern is similar to the pre-crisis experience of Japan. After the bursting of a major property price bubble in the early 2000s, Japan fell into a prolonged depression characterized by a gradual fall in prices accompanied by low growth and serial recessions. All of this occurred despite policy rates that remained stuck at zero and various bouts of central bank asset purchases and fiscal stimulus, the latter increasing government debt to a precarious level. The conventional wisdom at the time was that this inability to revive the Japanese economy reflected insufficiently robust macroeconomic policy implementation and that more consistent monetary and fiscal stimulus could have raised the economy out of the doldrums. The North Atlantic crisis is causing this to be reassessed given the similarities between the problems of Japan and the post-crisis experience of other parts of the world, most notably the Euro area where growth forecasts remain lackluster, inflation stubbornly below target despite monetary stimulus, and debt high.
Meanwhile, Japan is experimenting with a more integrated policy approach to resuscitate its economy. In late 2014, Prime Minister Shinzo Abe was elected on a platform based on reviving the economy through a combination of monetary and fiscal stimulus as well as structural reforms to raise potential output. This approach, dubbed “Abenomics”, had initial success as monetary and fiscal stimulus pushed inflation towards the central bank’s target of 2 percentage points and supported output. However, the limited focus on structural reforms meant that the economy relapsed after the initial macroeconomic stimulus wore off.
The Abenomics approach in which monetary, fiscal, and structural reforms are (in theory) being marshaled in reviving activity and inflation is a welcome departure from prevailing macroeconomic orthodoxy. It embodies a more integrated view of macroeconomic challenges, as several policies are used to support a recovery rather than the usual and inefficient approach of assigning each target to a specific policy. This allows much more firepower to be used on pressing policy needs, such as the desire to reinvigorate the Japanese economy after twenty years in the doldrums, resume growth and convergence in incomes in the Euro area, and recharge US economic vitality.
Despite its attractions, however, transferring the integrated Abenomics policy philosophy to the North Atlantic region will not be easy. The constraints on greater policy integration are particularly evident in the Euro area, where the European Central Bank remains committed to pursuing low and steady inflation, fiscal policies are the preserve of national governments, Stability and Growth Pact rules limit the degree of fiscal flexibility, and structural policies are also decided at the national level. The result has been a disjointed policy response that has been unable to overcome low growth and substandard inflation. While some crisis countries such as Spain and Ireland have successfully used structural reforms of labor markets and banks, respectively, to help overcome their macroeconomic misery, other crisis countries such as Italy, Portugal, and Greece remain mired in low growth.
In the United States, an initial burst of policy coordination in the immediate aftermath of the crisis seems to have faded. In response to the economic and financial crisis, stimulus was jointly applied by the central bank and the fiscal authorities using emergency funding. In addition, a combination of easy financial conditions, government support, and tough stress tests encouraged banks to raise their capital buffers. These additional funds allowed banks to deal with their bad loans, most notably through a wave of foreclosures on mortgages that was accompanied by considerable short-term macro-economic and financial stress. The final result has been a stronger recovery than in the Euro area, where nonperforming loans have not been fully written down. Over time, however, interest in monetary and fiscal cooperation has dwindled. While the new Trump Administration advocates fiscal stimulus, this reflects ideology (a desire to boost growth through lower taxes and a smaller government) rather than a plan to provide an integrated approach to reviving growth.
Only at the international level have policymakers been happy to support an integrated approach to reviving growth and inflation. At a meeting in Chengdu, China in July 2016, the G20 finance minsters reiterated their
determination to use all policy tools – monetary, fiscal and structural – individually and collectively to achieve our goal of strong, sustainable, balanced and inclusive growth. Monetary policy will continue to support economic activity and ensure price stability, consistent with central banks’ mandates, but monetary policy alone cannot lead to balanced growth. Underscoring the essential role of structural reforms, we emphasize that our fiscal strategies are equally important to support our common growth objectives … while enhancing resilience and ensuring debt as a share of GDP is on a sustainable path.3
Sadly, the admittedly short history of the G20 suggests that this lofty rhetoric is unlikely to significantly alter domestic policy priorities. Part of this skepticism reflects the inclusion of caveats such as “consistent with central banks’ mandates” and “ensuring debt as a share of GDP is on a sustainable path”. In addition, however, earlier and more ambitious attempts at policy cooperation through the G20 have failed. In particular, a wide-ranging G20 initiative aimed at broad policy cooperation through constructive cross-country surveillance, called the Mutual Assessment Process (MAP), was launched by the United States at the 2009 G20 leaders’ summit in Pittsburg.4 With the global economy mired in a new mediocre level of growth, the idea was that countries would make policy commitments that would be enforced through common oversight. In reality, however, G20 policymakers generally proposed policies that were already planned and then adopted a non-aggression pact in which country A would not criticize country B for not delivering on its commitments for fear of the reverse occurring. A later attempt by the Australian presidency in 2014 to revive the MAP as a more narrowly focused initiative aimed at boosting output by 2 percent over the next five years through structural reforms also failed to gain traction. These experiences are consistent with earlier patterns whereby international policy cooperation erodes after the immediate crisis fades. A good example of this is the contrast between the success of the Plaza Accord in 1985, agreed at a time when the overvalued dollar was a clear concern, and the failure of the 1987 Louvre Accord after the dollar had depreciated to more normal levels. The same loss of coherence has happened in the wake of the North Atlantic crisis as fears of a new global depression faded.
What is needed is a more integrated approach to domestic policies of the type that has been articulated in Japan. It is difficult to see how the international policy cooperation advocated by the G20 can work in the absence of effective domestic cooperation that uses a combination of monetary, fiscal, financial, and structural policies to generate inclusive and robust growth and bring inflation back to target. Such an approach will involve much greater cooperation between the central bank and the finance ministry, as well as with the other parts of the government responsible for structural reforms and financial stability, than has been typical since the generalized move to independent central banks in the 1980s. But how can this be arranged without forsaking the advantages of an independent central bank that is not under the sway of politicians?
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Strengthening Domestic Policy Cooperation
It is striking and surprising that the attempts at reviving international policy cooperation has not led to a broader discussion on how to improve domestic policy integration. If it is appropriate to advocate a combination of monetary, fiscal, and structural policies to revive global growth, then surely it makes equal sense to push for the domestic equivalent. The complication here is the lingering distrust of policy integration as a result of the inflation of the 1970s and the focus on central bank independence that this engendered.
In particular, central banks have jealously guarded an extreme definition of independence. They have been reluctant to suggest appropriate fiscal and structural policies for fear that governments will respond by openly questioning monetary policy decisions. This careful approach may have made sense in the 1980s and 1990s when central banks were involved in the economically painful and politically unpopular business of wringing excess inflation out of the economy. Faced with such a difficult environment, it was understandable that central banks, who were often newly independent, would react by emphasizing the importance of ensuring that their decisions were technical and independent from the government.
However, low inflation was achieved in most advanced economies by the end of the 1990s and its economic benefits are by now widely accepted, so that there is little risk of undermining this consensus. In addition, rather than the narrow monetary issue of lowering excess inflation that confronted central banks in the 1980s and 1990s, the current policy challenges involve low underlying growth, lackluster inflation, and high debts that are unlikely to be solved using monetary policy alone. Meanwhile, the potential for a long period of low inflation and growth is real. Mild deflation was the pressing problem of the late nineteenth century as a lack of gold caused a gradual fall in prices after 1870; this period is now generally referred to as the Long Depression but at the time was labeled the Great Depression. Indeed, it was in response to persistent deflation that the US presidential candidate William Jennings-Bryan in 1896 made his famous pledge allow silver to be part of the US money supply so as not to be “crucified on a cross of gold”.5
Central bank independence does not necessarily imply that the banks cannot cooperate with finance ministers or engage in a debate over the appropriate mix of monetary, fiscal, financial, and structural policies. Indeed, in the 1960s and 1970s the independent US Federal Reserve and German Bundesbank accepted the prevailing orthodoxy that monetary and fiscal policy should be cooperative. This suggests that the fundamental issue is less about whether the central bank is independent and more about the receptiveness of central banks to the inevitable to-and-fro on the appropriate monetary stance that a more cooperative approach to policies implies.
The need to revive growth through multiple policy channels suggests the importance of an organized process in which the options for different macroeconomic mixes are discussed.6 Such an arrangement would replace the current compartmentalized approach to policies in which each institution focuses on its own assigned policy goal. It would encompass not simply monetary and fiscal policies but also financial and structural ones. This is a sensible response to the current “new mediocre” in global growth. Over time, however, policy integration is likely to become the new orthodoxy as the limitations of the compartmentalized approach is more fully recognized.
Such integration can be organized through regular meetings of the main domestic macroeconomic decision makers. These should include the head of the central bank, the finance ministry, the financial regulator, and those responsible for structural reforms (an added bonus from such as approach could be centralizing responsibility for structural reforms under one minister). The exact membership would likely vary by country depending on the institutional arrangements and (possibly) the economic challenges. The existence and timing of the meetings of these “economic all-stars” would be made public. Attendees and other experts such as outside commentators, institutions, and ex-policymakers would be encouraged to submit analysis on the appropriate mix of policies. All contributors would be asked to analyze the entire range of policies, rather than focusing on their own specific areas of expertise, so as to ensure that there was an informed debate about the appropriate joint settings for monetary, fiscal, structural, and financial policies.
The discussion between the top policymakers would be behind closed doors, to allow an appropriate level of frankness, but minutes would be made public as is currently the norm for central bank committees. This would include a summary of any agreements and disagreements about the appropriate mix of policies. While there would need to be a chairperson to ensure an orderly discussion, the outcome would not be binding on participants. In particular, although attendance at the all-star meeting would be mandatory so as to encourage a wider policy discussion, independent central banks would be allowed to make their own monetary policy decisions. The arrangements would thus respect institutional responsibilities and expertise. Policy integration would come organically out of the existence of a well-defined platform in which differing views on policies and their impact on the economy would be debated in an organized manner and the pros and cons of different policies analyzed. In terms of timing, the meetings would need to be sufficiently seldom that macroeconomic conditions would be likely to have altered but often enough to respond to new challenges. At least in current circumstances, in which macroeconomic instability is high, meetings might occur once every six months with the option for additional emergency meetings if circumstances warranted. For example, the unexpected vote for the United Kingdom to exit the European Union would likely have justified an emergency meeting.
One objection to such an arrangement is that key policymakers already meet regularly on an informal basis and that the policy mix is part of such tête-a-têtes. This objection, however, is unconvincing. First, it is difficult to believe that such discussions involve the detailed analysis of macroeconomic outcomes envisaged in the meetings of the “economic all stars”. In addition, such meetings are generally between two institutions rather than a broader group. Perhaps the most compelling argument, however, is that such meetings do not involve or incorporate the insights from outside commentators, institutions, and ex-policymakers who have informed opinions on the appropriate policy mix. A wider and more formal discussion of the correct combination of policies has a much better chance of producing a carefully considered outcome.
Another objection is that monetary policy is the most flexible of policies and hence that intransigence by (say) fiscal policymakers could force the central bank into policies it would rather not follow. In terms of game theory, fiscal policymakers could end up using their inability to change plans quickly to force monetary policymakers to respond to facts on the ground. However, this is already the case in that fiscal policy is set less often than monetary policy, and hence monetary policy generally has to respond given a fiscal stance that has already been announced. It is difficult to see why organized policy discussion, in which the central bank could voice concerns about any problems created by fiscal and other policies, would not improve matters. Indeed, the logic of the all-stars meetings is to put pressure on institutions not to compete with each other, but rather to discover a mutually agreeable approach.
This line of reasoning also ignores the fact that the greater flexibility in changing monetary versus fiscal policy has to be put against the fact that fiscal policy feeds through into the economy faster. Budgets need prior planning and are generally implemented once a year (although emergency budgets can be organized more quickly), while most monetary policy committees meet every six weeks or so. But this faster implementation of monetary policy has to be set against the fact that changes in taxes or government spending boost output almost immediately while interest rate changes are generally believed to take around nine months to feed through to activity. It is thus far from clear that monetary policy delivers support for the economy faster than fiscal policy, a point that central banks could make in an organized discussion.
A final argument for insulating the independent central bank from wider discussion is that monetary policy is technical and that central bankers understand the macroeconomy better than others. Over the 1990s and 2000s there was an increasing belief in the science of central banking. The logic of this scientific approach was that monetary policy was best left to the august technicians housed in central banks who had the expertise to examine the tea-leaves of the economy and made far-sighted decisions that ensured macroeconomic stability. While there is no doubt that central banks have a lot of expertise, the North Atlantic crisis demonstrates that independent central banks are sufficiently fallible that they can allow major economic strains to fester and lead to economic collapse. The crisis exploded the myth of the omnipotent central bank should be left to make its own decisions rather than a more fluid and cooperative approach to macroeconomic policies in which the pros and cons of different policies are given a wider discussion.
The strongest case for considering this change in macroeconomic arrangements to allow more policy integration is the failure of current policies to deliver an acceptable outcome. When each institution focuses narrowly on its own narrow mandate the overall picture gets lost, strains go unresolved, and the economy becomes more brittle. Despite the best efforts of central banks, the North Atlantic crisis happened and the post-crisis period has seen low growth, low inflation, and chronic macroeconomic and political instability. Faced with the failure of the current myopic approach, it is essential to move to a more inclusive and cooperative one. A similarly eclectic approach is needed for macroeconomic theory.
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A More Inclusive Approach to Macroeconomic Theory
The more market-orientated approach to macroeconomic policies, developed in response to the inflation of the 1970s, put an emphasis on economic theory. The failure of central banks to control inflation in the 1970s was ascribed to a mistaken belief that you could push unemployment ever lower without sparking an acceleration in inflation. In reality, however, attempts to drive unemployment down led to a destructive inflation spiral. In order to avoid future policy mistakes based on (apparently stable) empirical links that subsequently turned out to be malleable, macroeconomics increasingly moved to models based on microeconomic theory in which individuals maximized pleasure and firms maximize profits. This is exemplified by the increased use of dynamic stochastic general equilibrium (DSGE) models, in which the macroeconomy is seen as an amalgam of microeconomic theories for households and firms with policy rules defining the responses of central banks and fiscal policymakers.
The backbone of the microeconomic theories is “homo economicus”. Homo economicus is an individual (“agent” is the preferred term) who maximizes pleasure (“utility”) given his or her income and who ensures that the firms that (s)he owns maximize profits. Maximization is crucial, as it allows the full weight of the associated mathematics to be used. The assumption of maximizing behavior plus a natural unit to account for such behavior (money and prices) has allowed economics to become the most developed of the social sciences. At its most basic level, economics involves the law of supply and demand. When a price rises, firms have an incentive to produce more while consumers will demand less. This is the basis for Adam Smith’s insight that the hidden hand of the market, in the form of price signals, produces a self-organizing and stable economic system.
Clearly, all sorts of imperfections that deviate from Adam Smith’s ideal can distort the economy. Firms can exploit their economic power to raise prices above the socially optimal, generating “excess” profits that harm individual consumers. More generally, laws and regulations can be used to favor some groups over others. Inventiveness can be harmed by the ability of others to copy an original idea (hence the existence of copyright laws), but the efficiency of the economy can also be harmed if firms are allowed to hold onto a copyright for too long and avoid legitimate competition that would lower prices. All of these issues have been extensively analyzed in microeconomics, which focuses on behavior in particular markets. When such analysis is elevated from specific markets to the behavior of the macroeconomy, the need to link many sectors together leads to simplification. In particular, it is generally assumed that all firms and households behave in the same way. Hence, while in reality firms find themselves in a myriad of situations, from highly competitive markets to monopolies, in macro-economic models it is generally assumed that all firms face the same level of competition. Similarly, households are assumed to work and spend in a highly stylized manner.
Even more importantly, macroeconomic models require assumptions about the future. To ensure that the resulting behavior is consistent with the underlying model, it is generally assumed that individuals and firms hold accurate views about its future path because they fully understand the workings of the economy and how central banks and other policymakers will react in any given set of circumstances. Such an approach, dubbed rational expectations, ensures that expectations about the future path of major macroeconomic variables such as prices, output, interest rates, budget deficits, and equity prices correspond to what the model says will occur (or, at least, what would occur if there were no further unexpected shocks). In this hyper-rational world people are assumed to fully understand the future.
The combination of microeconomic fundamentals and rational expectations is an impressive intellectual achievement that has generated powerful predictions about the macroeconomy. At the same time, such an approach finds it difficult to explain destabilizing behavior, including with respect to financial markets. Most prominently, theorists have found it essentially impossible to model “rational” financial bubbles. The basic issue is that far-sighted and well-informed investors will project the dynamics of the market and realize that the future path of assets prices is unstable and will at some point collapse. As a result, they will never start down the path towards a bubble as they understand that it is inherently unstable. This inability to model “rational” asset bubbles helped fuel the popularity of the efficient markets hypothesis—in which asset prices reflected the wisdom of crowds and were thus always accurate—that helped to lull policymakers into underestimating the risks emanating from growing financial imbalances in the United States and European economies.
More generally, the hyper-rational and far-seeing “homo economicus” has been elevated from a useful tool to something closer to a litmus test for economic modeling. Any macroeconomic analysis is seen as questionable unless the underlying behavior can be shown to derive from first principles. This approach has led to a focus on microeconomic incentives as a result of (say) lower marginal tax rates that largely ignores wider societal values such as inequality and economic fairness. It is the same desiccated approach that gave rise to the draconian English Poor Law of 1934.
While the experience of inflation in the 1970s underlines the importance of being careful about the use of ad hoc assumptions, the difficulty of theorists in producing a model of rational financial bubbles suggests that the pure theoretical approach also has its own limitations and should not be seen as an all-encompassing view of the world. In the end, economics is a practical science that should reflect underlying realities, akin to engineering or biology in which shortcuts are taken in order to explain real phenomena, rather than theoretical physics with its search for immutable principles. Indeed, even theoretical physics has accepted for around a century the existence of general relativity and quantum mechanics, two apparently incompatible approaches.
There is also a major issue as to whether a coherent view of the long-run path for the economy can be constructed. On a practical level, it assumes that individuals acting through the wisdom of crowds understand an awful lot about the economy. On a theoretical level, as discussed in an earlier chapter, the existence of “unknown unknowns” may make it impossible to calculate a well-defined future. In this case, ad hoc rules of thumb may be the best available option. The long-run may truly be a quantum process in which unexpected events cause shifts from one view of the world to another. Like physicists, economists may have to accept that that is an element of randomness at the core of the subject—that god does indeed play dice.
Another limitation with economic theory is that homo economicus, for all of his or her strengths, is not someone you would want as a neighbor. This is because (s)he is a loner who is completely self-focused. By contrast, one of the most striking features of real-life homo sapiens is that they are astonishingly social animals. Many of them live perfectly happily in big cities in which they interact regularly and closely with their own kind. They are extremely sensitive to each other’s moods and social cues. Subtle social interactions are also evident in mass gatherings. A concert or a football game is much more fun if you are part of a large audience who are also appreciating the spectacle. Maybe most relevant to financial bubbles, speeders on the highway embolden others to speed. Risky behavior encourages other risky behavior—a response that homo economicus would not recognize.
Along with social interactions comes a set of views about fairness that homo economicus would also find bemusing. People give up their seats on buses for the elderly and disabled, they give special consideration to those who are pregnant, and they accept that kids behave differently from adults. These are obvious adaptions to allow complex societies to function smoothly despite personal diversity. While such conventions are not always followed, they are surprisingly pervasive even in extreme situations. The survival rate of male first-class passengers on the Titanic, while much higher than their third-class fellow passengers because of better access to the deck, was surprisingly low as a result of the principle of women and children first. The importance of social norms and harmony can also help to explain some recent evidence suggesting that economic inequality lowers growth. Such a macroeconomic perspective is not linked to the types of incentives—marginal tax rates, generosity of unemployment benefits, and access to financial markets—that drive the homo economicus and hence the microeconomic theory embraced by modern macroeconomic models.
More generally, people naturally want to impress others, to be attractive to others, and to be seen as nice by others. Such drives create a huge range of assessments that are alien to homo economicus. The desire for social acceptance that makes people want to fit in with the views of others provides an obvious conduit through which views about the long-run can form. The innate desire not to be seen as disruptive discourages individuals from questioning the perceived wisdom of other investors, as underlined, for example, in the account of how a few outliers did resist such pressure in the book about the financial crisis, Michael Lewis’s The Big Short. More generally, Professor Robert Shiller of Yale, one of the few prominent economists who recognized that the US housing market was in a massive bubble before the crisis, has been one of several financial economists to suggest that financial market bubbles can be modeled as social waves in which ideas catch fire and become self-reinforcing before eventually deflating.7 Such social eruptions can be modeled using similar tools to those used to examine epidemics, involving the probability of passing on an infection from one person to the other and a rate at which people stop being infectious, which define the height and longevity of the craze. Examples of crazes include hit records, Rubik’s Cubes, and smart phone apps. This approach provides a way of thinking about asset price bubbles and the madness of crowds in a structured manner.
The increasing interest in behavioral economics provides another platform for considering how individuals deviate from pure rationality.8 Behavioral economics, which examines how individuals actually behave in various economic situations rather than how they are supposed to behave, provides many insights but remains a specialized field. It has had only a limited effect on economic theory, in part because it is often difficult to generalize the results. A similar comment can be made about game theory, used in economics to model how individuals interact. Important insights have been generated by game theory, the most striking of which is the “prisoners’ dilemma” in which two inmates who committed a crime are faced with the choice to confess or not confess. Unless they can communicate, each has an incentive to confess so as to minimize their sentence even though if they both deny the charge they will be set free. However, this is a simple and fairly stylized problem, and it rapidly becomes difficult to generalize how individuals will react in more complex situations.
Recognizing that homo economicus is only an approximation to the actual behavior of real-life homo sapiens does not imply rejecting the many insights that (s)he has generated. While people may on certain occasions deviate from self-centered maximization, it is clear that the pursuit of happiness is a pretty good description of most behavior. It is also clear that such models have provided extremely powerful insights into short-term activities in the real world, from explaining why asset prices are essentially unpredictable from day-to-day to the importance of maintaining a certain degree of policy predictability in maintaining macroeconomic stability. Rather, it implies accepting that there are more phenomena under heaven and earth than are dreamt of in homo economicus’ philosophy: that asset prices are not always fairly valued and that predictable policies can create incentives to take excessive risks.
Economists should be wary of deviating from maximizing theory, but open to doing so if there is strong evidence that such behavior occurs. This is surely true of asset price bubbles. Financial market trading involves outguessing other traders and hence the underlying strategies are in constant flux. This suggests that the smooth adjustment typical in macro-economic models should be combined with a more general approach that allows for fads and their collapse. While most fads are too localized to have macroeconomic consequences (think of the rise and fall in the popularity of the hula hoop, pet rocks, and cabbage patch dolls), financial market fads have the capability to create major disruptions. As the North Atlantic financial crisis amply demonstrates, unsustainable asset price bubbles fed by fads can create irrational rises and falls in asset prices that are extremely costly even if they are outside of the ken of homo economicus.
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Toward a More Encompassing View of Macroeconomics
If the lesson from the inflation of the 1970s was to be wary about assuming that governments are omnipotent, the North Atlantic crisis repeated this insight for the private sector. This lesson has been absorbed with regard to financial markets, which are now more closely regulated and where the need for government intervention in the form of macroprudential policies to limit systemic imbalances has been widely recognized. But a more wide-ranging reevaluation of macroeconomics is in order, embodying a more inclusive view of the role of fiscal, financial, and structural policies, of the advantages of policy cooperation, and of the manner in which macroeconomic behavior is approached.
The pre-crisis macroeconomic orthodoxy essentially saw macroeconomic policies as providing a platform for the private sector to thrive. An independent central bank guided by an inflation target was primarily responsible for keeping inflation low and unemployment on an even keel by varying financial conditions. Such policies would allow private individuals to plan ahead with relative certainty about the future path of prices, employment, and wages. In a similar manner, the focus of fiscal policy was on keeping taxes and spending within reasonable limits and the government deficit and debt low and sustainable. Regulators were tasked with maintaining financial stability of individual firms, while those in charge of structural policies ensured robust growth by improving private incentives.
Despite the widespread problems of low growth and disappointing inflation in the post-crisis period, this remains to a large extent the current paradigm. To be sure, financial stability has been given more prominence as a macroeconomic issue as opposed to a microeconomic one. In addition, calls are regularly made for greater fiscal stimulus and structural reforms to move growth out of the doldrums. In reality, however, central banks have continued to be the main instruments for reviving growth and inflation, fiscal policy has focused on long-term objectives such as lowering debt or cutting taxes, and many macroeconomists remain wary of major structural reforms because of their potentially adverse short-term impact on growth. One exception to this general rule is Japan, which has tried to integrate monetary, fiscal, and structural policies to overcome the long-term problem of deflation and disappointing growth. The wider approach to macroeconomic policies taken in Japan should be repeated elsewhere, particularly given that the problems of low growth and inflation currently besetting some regions such as the Euro area bear a striking similarity to the longer-term experience of Japan.
Along with this broader approach to macroeconomic challenges and policy cooperation, macroeconomic analysis should also become more integrated. In particular, it should be recognized that there are some economic phenomena that cannot be modeled using rational and forward-looking individuals. This is particularly true of financial markets, where in the presence of “unknown unknowns” asset prices may have more to do with the gut instincts and the inclination of homo sapiens to agree with each other than with precise calculations of the future. Such a perspective can help to explain the origins of asset price bubbles. In addition, innate beliefs in fairness may help explain other deviations from narrow self-interest, such as recent evidence that higher inequality may be detrimental to growth over and above the narrow incentives involved in microeconomic theory. This more fluid approach to economic analysis would allow macro-economics to come closer to the real world and make the economy more robust to shocks.