Paper Se ha descubierto la inflación “buena”: la teoría de la “deaudaflación”


- And the winner is… (once again, la banca: un monstruo grande, que pisa fuerte)



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- And the winner is… (once again, la banca: un monstruo grande, que pisa fuerte)

- El “retorno de la debtflation”, otro riesgo latente tras Grecia (Expansión - 11/2/10)

El compromiso de ayuda a Grecia no despeja, ni mucho menos, el panorama económico, ni el monetario. Las amenazas se suceden, y desde Morgan Stanley hacen hincapié en el “regreso de la debtflation”. Según sus analistas, los actuales niveles de deuda pública “requerirían” tasas de inflación de entre el 4 y el 6%. Además, temen que el BCE retrase la subida de tipos”… El “retorno de la debtflation”, otro riesgo latente tras Grecia (Expansión - 11/2/10)

El último análisis monetario global elaborado por Morgan Stanley incluye una seria advertencia, que llega además en pleno intento de remontada: “Dados los crecientes problemas fiscales en la mayoría de las economías más avanzadas, pensamos que los mercados infravaloran los riesgos inflacionistas”.

Para resaltar esta amenaza, la firma pone como ejemplo el hecho de que, de acuerdo con la serie histórica, “una (hipotética) estabilización a los actuales niveles de la ratio Deuda/PIB en Estados Unidos requeriría tasas anuales de inflación de entre del 4-6%”.

Los mercados, añaden, se desmarcan por completo de este escenario, y en la actualidad están anticipando unas tasas de inflación por debajo del 2,5%, de media, para los próximos 10 años. A modo de “respaldo” a sus alertas, recuerdan las propuestas de una “inflación controlada”. En este punto, añaden que el ex economista jefe del FMI Kenneth Rogoff ha sugerido a la Fed un objetivo de inflación de entre el 4 y el 6% para un periodo de tiempo limitado.

Los riesgos soberanos, tan presentes en los últimos tiempos en los mercados, en especial en Europa, pueden ser equivalentes a los “riesgos inflacionistas”, inciden desde Morgan Stanley. Europa está siendo uno de los mercados más damnificados por estos riesgos soberanos, y el rumbo de su política monetaria podría añadir un punto más de presión a la amenaza inflacionista.

Los analistas de la entidad estadounidense valoran “el riesgo” de un nuevo retraso en el inicio del ajuste al alza en los tipos de interés en la eurozona. Indican que las últimas referencias macro han reflejado un cierto freno en las señales de recuperación del crecimiento económico, y que este contexto, junto al tono utilizado tras la última reunión de tipos del BCE, podrían apuntar a una estabilidad en el precio oficial del dinero “incluso para el conjunto de este año”.

(Se puede solicitar a rlomoro2@yahoo.es el Informe original de Morgan Stanley)

El principal economista del Fondo Monetario Internacional, Olivier Blanchard, dijo que los directivos de los bancos centrales deberían considerar imponer tasas de inflación mayores a las que fijan hoy en día con el fin de aminorar las probabilidades de repetir una recesión severa como la actual”... El principal economista de FMI propone mayores techos inflacionarios para evitar una nueva crisis (The Wall Street Journal - 12/2/10)



Blanchard, macroeconomista con licencia del Instituto Tecnológico de Massachusetts, dice que la desaceleración económica global expuso una serie de fallas en política macroeconómica, particularmente una dependencia en las tasas de interés para gestionar las economías. Aunque Japón había experimentado un bajón de una década de duración, a pesar de una baja inflación, “la mayoría de las personas se convencieron de que los japoneses no sabían lo que estaban haciendo”, dijo Blanchard en una entrevista.

En un nuevo informe, escrito en colaboración con otros dos economistas del FMI, Giovanni Dell'Ariccia y Paolo Mauro, Blanchard señala que los encargados de la política económica necesitan considerar soluciones radicalmente diferentes para lidiar con las grandes crisis bancarias, las pandemias o los ataques terroristas. Específicamente, el documento del FMI sugiere apuntar hacia una inflación más alta en “épocas normales” para incrementar el campo de maniobra en el que la política monetaria se mueve para reaccionar a crisis de tal magnitud. Los bancos centrales deberían buscar una inflación del 4% en lugar del 2% que la mayoría trata de alcanzar actualmente, señala el documento.

A una tasa inflacionaria del 4%, dice Blanchard, las tasas de interés de corto plazo en las economías apacibles serían de alrededor del 6% o 7%, dándole a los bancos centrales mucho más maniobra para bajar las tasas antes de que éstas lleguen a casi cero, tras lo cual ya es prácticamente imposible reducir más las tasas a corto plazo.

“Ahora nos damos cuenta de que si hubiéramos tenido unos cuantos cientos de puntos base extra” -un punto base es la centésima parte de un punto porcentual- “como colchón, eso nos hubiera ayudado” a combatir la crisis actual, dice Blanchard. “Hubiera sido buenísimo empezar con una tasa nominal más alta. Y la única manera de llegar hasta ahí es con una inflación mayor”.

Durante décadas, el FMI ha presionado a los países a reducir sus niveles de inflación y considera como uno de sus mayores logros su éxito en convencer a los gobiernos de África, Latinoamérica y otros a abandonar la idea que pueden inflar su camino hacia la propiedad. Pero Blanchard dice que el FMI debería tomar la delantera en reconsiderar lo que sea necesario ahora que el mundo vive la peor recesión desde la Segunda Guerra Mundial.

Al recordar los errores incurridos y que condujeron a las altísimas tasas de inflación en los 70s y los 80s, es poco probable que la mayoría de los bancos centrales adopten rápidamente el consejo del FMI. Siguen convencidos de mantener baja la inflación, y el convencer a los mercados de que así lo harán es muy importante. John Taylor, un especialista en política monetaria de la Universidad de Stanford que trabajó en el departamento del Tesoro durante el gobierno de Bush, dice que la inflación podría ser difícil de contener si se aumenta la meta objetivo. “Si dices que será del 4%, ¿por qué no del 5% o del 6%?” dice Taylor. “Hay algo que la gente entiende por inflación cero”.

Blanchard argumenta que no hay mucha diferencia entre mantener la inflación en 2% o en 4%. Las categorías tributarias podrían ajustarse de modo que una mayor inflación, en sí misma, no implique que los contribuyentes paguen impuestos más altos. Los bonos ajustados a la inflación podrían proteger a los inversionistas. El documento del FMI señala la posibilidad de que la inflación podría aumentar si los gobiernos empiezan a ajustar los salarios automáticamente a la inflación, “pero sigue quedando la duda de si estos costos van a sobreponderar los beneficios potenciales” de evitar tasas de interés cero.

El nuevo documento, titulado “Rethinking Macroeconomic Policy”, (Repensando la política macroeconómica) también recomienda que los bancos centrales utilicen toda su artillería regulatoria para reventar burbujas de activos antes de que se vuelvan peligrosamente grandes. El depender exclusivamente en el aumento de las tasas de interés para lograrlo corre el riesgo de dañar la economía como un todo, algo que ha expresado con anterioridad el jefe de la Reserva Federal Ben Bernanke.

(Se puede solicitar a rlomoro2@yahoo.es el Informe original del FMI)

- ... Y ahora la “deudaflación” (ABC - 21/2/10)

Los riesgos soberanos por los altos niveles de deuda adquiridos podrían traducirse a la larga en “riesgos inflacionistas”

(Por María Cuesta) Lectura recomendada



Entre el crecimiento desbocado de la deuda de las economías desarrolladas, los amagos de quiebra de Grecia y el pánico posterior al contagio de parte de la eurozona, una nueva amenaza comienza poco a poco a germinar: la “debtflation”. El término -que fusiona los conceptos de deuda e inflación (“debt” e “inflation” en inglés)- ha sido acuñado por el banco de inversión norteamericano Morgan Stanley y pretende reflejar lo que, según explica en su último análisis monetario global, será uno de los principales retos que la economía mundial deberá afrontar cuando comience despuntar la recuperación económica: el riesgo de impago de los Estados, tan presentes las últimas semanas en los mercados europeos, pueden llegar a traducirse en «riesgos inflacionistas».

Vieja receta

La advertencia de los economistas de Morgan Stanley -aunque puede sorprender a más de uno por la preocupación, aún latente, por el caso contrario, la deflación- recupera una vieja receta de la política monetaria para poder afrontar con una mayor ligereza los pagos de la deuda: provocar inflación. Cuánto más altos sean los precios, menor será el coste real de los préstamos. Para explicar su teoría, el banco de inversión estadounidense propone un ejercicio de memoria histórica.

Según explica en su informe Morgan Stanley, en el año 1946, la deuda pública de Estados Unidos representaba el 108,6% del Producto Interior Bruto (PIB). Sin embargo, el banco recuerda que 60 años después, en el año 2003, el endeudamiento público respecto al PIB era tan sólo del 36%. Es decir, que en dos generaciones, se había logrado reducir este desequilibrio económico en más de 70 puntos básicos.

Ahora bien, en ese mismo periodo, las cuentas públicas norteamericanas acumularon un déficit medio del 1,6% con respecto al Producto Interior Bruto. ¿Cómo pudo reducirse tanto la deuda cuando el presupuesto federal estaba en números rojos?, se pregunta la entidad norteamericana. La respuesta está en la inflación, que tuvo “un efecto considerable” en la erosión de la deuda, asegura Morgan Stanley.

Las advertencias de la entidad coinciden, precisamente, con las directrices marcadas por algunos economistas que miran a la inflación como vía para salir de la crisis económica. Unos de ellos es el economista jefe del Fondo Monetario Internacional, Olivier Blanchard. Hace unos días aseguraba en el informe “Repensando la política económica” -que firma junto a sus colegas del organismo Dell´Ariccia y Paolo Mauro-, que los bancos centrales deberían estudiar la posibilidad de establecer un objetivo de inflación más elevado del que existe actualmente -fijado en el entorno del 2%- para de esta forma facilitar los pagos de las deudas de los países, permitir que la política monetaria sea más eficaz y evitar consecuencias como las de la actual crisis económica.

Olivier Blanchard recuerda que los últimos años ha reinado la idea de que la inflación no sólo debe ser estable, sino también baja porque se creía que, “en un mundo de pequeños “shocks”, una inflación del 2% era un colchón suficiente”.

Sin embargo, continúa el economista, “cuando la crisis económica empezó en el año 2008 y la demanda se colapsó, muchos de los bancos centrales rápidamente redujeron su política de tipos interés a cerca de cero, y de haber podido, hubieran reducido la tasa todavía más”. “Como consecuencia”, asegura el Fondo Monetario, “ahora hay una mayor dependencia de la política fiscal y un mayor déficit público”.

“La bomba de la deuda”



Una tesis parecida esgrimieron a finales del año pasado economistas como Gregory Mankiw, asesor del ex presidente George Bush, Kenneth Rogoff, ex economista jefe del Fondo Monetario Internacional y Paul Krugman, Premio Nobel de Economía. En opinión de este economista, un control menos estricto de la inflación facilitaría a los consumidores y a los Gobiernos el cumplir con sus obligaciones. Además, explica que podría ayudar a la economía si anima a los estadounidenses a gastar ahora en lugar de hacerlo más adelante, cuando suban los precios.

Desapalancamiento



“Propongo una inflación del 6% durante al menos un par de años”, declaraba Rogoff, hoy profesor de Harvard, “pues mejoraría la bomba de la deuda y nos ayudaría en el proceso de desapalancamiento”. Mankiw tampoco lo duda: “Hay cosas peores que la inflación y Bernanke, actual presidente de la Reserva Federal estadounidense, es la persona perfecta para elevarla”. Y es que, recuerda, “Bernanke ha sido durante mucho tiempo un defensor de la inflación”.

También Paul Krugman reflexionaba sobre los precios en su blog: “¿Es la inflación la respuesta? Todo indica que sí”. pues el mayor riesgo a esquivar es caer en una espiral deflacionista como ocurrió en Japón, advierte el economista.

También riesgos

La estrategia, en cualquier caso, no es, sin embargo, ajena a los riesgos. Una perspectiva de altos precios sin un control podría pasar también factura a las economías, ya que podría ahuyentar a los inversores extranjeros y perjudicar también al dólar.

El principal reto estaría entonces en evitar que la inflación regresara a los niveles superiores al 10%, los que se registraron en los años setenta y necesitaron de una recesión económica y de casi una década para poder ser subsanados.

El presidente del Banco Central Europeo, Jean Claude Trichet, criticó abiertamente la petición del Fondo Monetario Internacional (FMI) de que los bancos centrales eleven sus objetivos de inflación”... Trichet arremete contra el FMI (Negocios.es - 4/3/10)

Mientras tanto, Trichet expresó su desconfianza respecto al papel que pudiera jugar la institución dirigida por Strauss-Kahn en la resolución de los problemas de Grecia.

En la tradicional rueda de prensa posterior a la reunión del Consejo de Gobierno del BCE, que mantuvo los tipos en el 1%, el máximo responsable de política monetaria de la eurozona consideró un “completo error” la sugerencia del economista jefe del FMI, Olivier Blanchard, quien el pasado 12 de febrero propuso a los bancos centrales elevar el objetivo de inflación más allá del 2% para contar con más margen de maniobra en futuras crisis.

“Tal sugerencia demuestra poca atención a los numerosos trabajos de investigación y análisis que defienden la idoneidad del objetivo del 2%”, dijo Trichet, quien advirtió de que una modificación de tales objetivos de inflación sería “contraproducente”, ya que enviaría a los mercados el mensaje de que “cualquier cambio es posible, lo que resulta extremadamente peligroso”.

Contra la subida de tipos



Asimismo, el banquero galo explicó que la ampliación del objetivo de inflación acarrearía una subida pronunciada de los tipos y conllevaría el pago de una prima extra. “Crear un “shock” inflacionario sería extremadamente peligroso”, aseveró.

De este modo, el presidente del BCE respaldaba las críticas vertidas anteriormente por los consejeros Axel Weber y Lorenzo Bini Smaghi, quienes ya habían expresado su rotundo rechazo a la sugerencia del economista jefe del FMI, a la que tacharon de “jugar con fuego” o “un error diabólico”, respectivamente.

Crisis griega

Por otro lado, Trichet dejó notar su desconfianza respecto al papel que el FMI podría desempeñar en la crisis griega más allá de una mera colaboración técnica y declinó pronunciarse sobre la posibilidad de que el Gobierno heleno, que ayer se mostró dispuesto a escuchar las propuestas del Fondo, decidiera unilateralmente solicitar ayuda de la institución dirigida por Strauss-Kahn. “No confío en que resulte apropiado dar entrada al FMI como suministrador de ayuda (a Grecia) ya sea a través de acuerdos de “stand by” o cualquier otro tipo de ayudas de esa índole”, dijo el presidente del BCE, quien reiteró que las medidas de ajuste presentadas por Atenas en el día de ayer son “convincentes y sustanciales” y calificó como “absurda” la hipótesis de que Grecia abandone el euro.

Asimismo, el banquero galo rechazó comentar la posibilidad de cambiar la calidad de los activos aceptados como garantía en sus operaciones de financiación, que en el caso de Grecia dependen de que la agencia Moody's no recorte más la nota de su deuda.



M O R G A N S T A N L E Y R E S E A R C H

February 10, 2010

Global Economics

The Return of Debtflation?

Investment conclusion: For countries with their own currency, sovereign risk is equivalent to inflation risk.

We think inflation risks inherent in the current US fiscal position are substantially larger than priced by the market. We recommend investors buy inflation, rather than default, protection: TIPS, rather than CDS.

We calculate that for the US, stabilisation of public debt to GDP at current levels would require average inflation rates between 4-6% over the coming 10 years - even under much lower budget deficits than currently in place: We quantify the inflation risks inherent in the current level of public debt by looking at how the US economy escaped high debt after World War 2. Assuming debt will be dealt with in the same way now, we calculate the level of inflation required to keep debt in check for different levels of the budget deficit.

What’s new: We present an accounting framework that decomposes the evolution of public sector debt to GDP into inflation and real GDP growth effects (conditional on the budget deficit). Inflation was the largest factor behind the reduction of the US debt to GDP ratio following World War 2. Real GDP growth was the second-largest factor. The budget made a small contribution only through modest primary surpluses. Loose monetary policy -rather than tight fiscal policy- ensured debt sustainability.

The Return of Debtflation?

Summary and Conclusions

US public debt as a share of GDP is now higher than at any other time in history except after World War 2 (see Exhibit 1) –and rising: our US colleagues expect public debt to GDP to increase to 87% by 2020. How policymakers will deal with this fact will likely be one of the main drivers across markets going forward. So what are the implications of high public sector debt for fiscal sustainability and inflation? To answer this question, we look at how the US economy escaped high debt following World War 2. We then quantify the inflation risks inherent in today’s US fiscal position by asking what would happen if policymakers were to deal with the current debt overhang in the same way.

Stabilisation of public debt to GDP at current levels would require average inflation rates between 4-6% over the coming decade - even under much lower budget deficits than currently in place. On our numbers, even with budget deficits that are much lower than the current (and projected) levels, average inflation over the next ten years would have to be substantially above 2% to keep debt in check. Even a balanced budget would require 3% average inflation over the next decade. With an average deficit as low as 3% of GDP, debt stabilisation would require average inflation above 6%. Note that in the current fiscal year (FY) we expect a deficit of 9% of GDP, projected to decline to 5.2% of GDP by 2020. Suppose the government were to reduce the deficit to 5.2% from 2011 onwards - rather than by 2020. Stabilising the debt at current levels would then require an inflation rate of 9% on average over the next 10 years. What level of deficit would be consistent with achieving a 2% inflation target, on average, over the next 10 years? A 1% of GDP budget surplus.

It is clear that inflation risks of this magnitude are not in the price: currently, markets are anticipating inflation to be below 2.5% over the next 10 years, on average. (1) Should we be worried about ‘debtflation’ - the Fed engineering inflation to keep the debt in check? A forward-looking central bank may prefer to create a little controlled inflation now to the pressure of inflating a lot later on. And the idea of controlled inflation has influential advocates in policy circles. Former IMF Chief Economist Kenneth Rogoff has suggested the Fed announce a 4-6% inflation target for a limited period. Coincidence?

(1) On our numbers, an average inflation rate of 2.5% over the next 10 years would be consistent with debt stabilisation if the government runs a budget surplus of around 0.5% of GDP every year.

1. The Fiscal Consequences of the Crisis

The financial crisis and the Great Recession have increased US public indebtedness substantially. The debt to GDP ratio has shot up from 37% pre-crisis (fiscal year 2007) to around 60% in FY 2010, on our forecasts. With the exception of the World War 2 peak, this is higher than at any other time in the entire history of the US - including World War 1 or the Great Depression. From a fiscal perspective, it’s as if the economy has just gone through World War 3.

And it’s likely to get worse, implying fiscal and inflation risks. Our US colleagues expect public debt, as a share of GDP, to climb further to 87% by 2020. Given this trajectory, fiscal sustainability remains a concern with investors and the public. Further, given the historical link between high public debt and inflation both in the US and internationally, such a precarious fiscal position may also pose a danger for price stability.

Quantifying these inflation risks with the help of history - and a simple accounting framework. Yet how large, exactly, are the inflation risks inherent in the current US debt position?

Could inflation substitute for budgetary tightening in the pursuit of fiscal sustainability? Conversely, what is the size of the budget deficit or surplus consistent with low inflation? In short, what are the options policymakers have to keep debt in check?

To answer these questions, we look to history for guidance. We ask through what mechanisms -the budget balance, economic growth, or inflation- did the US economy escape the record World War 2 debt levels? In other words, what mix of fiscal and monetary policies ensured fiscal sustainability after World War 2? Assuming the same mix is applied to the current situation, we can then put a number on long-term inflation risks…

3. What If? Looking Ahead

Suppose policymakers deal with the debt now in the same way they did after WW2. Assuming the same relative roles for inflation and real economic growth as in the post-War period, how much inflation is needed, for a given budget deficit, to keep the debt ratio from increasing? Conversely, assuming a given inflation target -say 2%- what is the size of the budget deficit or surplus required to keep debt from increasing?

Our assumption for the policy objective is stabilising the debt ratio at our current estimate for FY 2010 -60% of GDP- rather than it increasing to 87% by 2020, our long-term projection. On the fiscal policy side, policymakers control the primary deficit -the deficit excluding interest payments on the debt- rather than the total deficit (at least in the long run). (4) Hence, the choice between inflation and the budget deficit is really a choice between inflation and the primary deficit, given the size of interest payments (as a share of GDP).

The Deficit-Inflation Frontier. Given the choice of (primary) deficit and the historical sizes of inflation and real GDP growth effects, we can calculate the inflation rate required to achieve the debt target: the Deficit-Inflation Frontier (DIF). On the horizontal axis we have the primary deficit, on the vertical axis the inflation rate. The DIF with the solid line assumes the long-term average (1946-2003) IE and RGE. The line above that assumes the 1946-1955 IE and RGE - it is above the long-term average DIF because in the first post-war decade the erosion of the debt was heavily skewed towards inflation. The least inflationary debt erosion took place in 1996-2003. Based on the IE and RGE of that period, we obtain the lower DIF.

Primary surpluses of at least 2.4% of GDP required to achieve a 2% inflation target. According to our numbers, with inflation at 2% on average, a primary surplus of 2.4% of GDP is required in the benchmark case of debt stabilisation at current levels.

Given 1.4% interest to GDP, this implies that a 1% budget surplus is required. After World War 2, primary surpluses of the required level have been achieved during one period only: 1996-2003.



A balanced primary budget would imply inflation of 4.7%. If government expenditure other than interest equals revenue, the primary balance would be zero. (The budget deficit would then be equal to interest expenditure.) In such a case, the inflation rate required to keep debt stable is 4.7%. What inflation rate would be consistent with the primary surpluses we have seen historically? The average primary surplus as a share of GDP over 1946-2003 was 0.3%. Stabilising the debt ratio at 60% with this primary surplus would require an inflation rate of 4.3% on average. A primary deficit of 1.2% - the 1915-2003 average- would imply an inflation rate of 6.1%.

Caveats. Our framework does not take into account the following factors: First, a given level of inflation may not have the same effect on the debt because the average maturity is shorter - though rising quickly towards, and above, the historical average on our forecasts. Second, by now almost half of federal outlays are de facto indexed to inflation. What does this mean for the inflation risks we outline?

Essentially, that possibly even more inflation is needed to erode a given level of debt - at least mechanically. And finally, we don’t take into account the potential effect of higher inflation on real GDP growth in the medium term - or of the potential repercussions of an inflation spiral. Nevertheless, these caveats do not substantially affect our main message. The level and trajectory of the debt imply tough choices between fiscal rectitude and price stability.

(4) This is because in any given period interest payments are a function of the stock of debt outstanding and the interest rate paid on that debt, which is determined by the market. Interest payments as a share of GDP are assumed fixed at the current level of 1.4% throughout.

4. Debtflation Nation?

This leaves one question open. Why would the Fed -in principle an independent institution- want to generate inflation? Independence means the Fed cannot be forced to inflate - at least not directly. Recent threats to its independence aside, for inflation to take hold it must be because the Fed allows it to happen. Surely, this is inconceivable?

Maybe not. Consider a Fed that faces the prospect of an 87% debt ratio in ten years’ time, with population ageing and all its negative budgetary consequences imminent. In that case, a rational central bank may prefer to create a little inflation now rather than having to create a lot of inflation later on. The forthcoming increase in the average debt maturity will help.

Last but by no means least, note that the range of inflation rates we have calculated here -around 5% for the case of a roughly zero primary balance- are already being debated in policy circles. Former IMF chief economist Kenneth Rogoff has advocated a 4-6% inflation target for the Fed, and ex Bank of England MPC member David Blanchflower has made similar proposals. And Professors Aizenman and Marion calculate -in a different framework- that a “moderate” inflation rate of 6% could reduce the debt/GDP ratio by 10 percentage points within four years.

We think investors should take note - and buy TIPS, rather than CDS, if they are worried about “default”: while hard default is inconceivable, soft default through inflation is a clear risk.



INTERNATIONAL MONETARY FUND

Research Department



Rethinking Macroeconomic Policy

Prepared by Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro

Authorized for Distribution by Olivier Blanchard

February 12, 2010

I. INTRODUCTION

It was tempting for macroeconomists and policymakers alike to take much of the credit for the steady decrease in cyclical fluctuations from the early 1980s on and to conclude that we knew how to conduct macroeconomic policy. We did not resist temptation. The crisis clearly forces us to question our earlier assessment.

This is what this paper tries to do. It proceeds in three steps. The first reviews what we thought we knew. The second identifies where we were wrong. The third, and the most tentative of the three, takes a first pass at the contours of a new macroeconomic policy framework.

A caveat before we start: the paper focuses on general principles. How to translate these principles into specific policy advice tailored to advanced economies, emerging market countries, and developing countries is left for later. The paper also mostly stays away from some of the larger issues raised by the crisis, from the organization of the international monetary system to the general structure of financial regulation and supervision, touching on those issues only to the extent that they relate directly to the issue at hand.

II. WHAT WE THOUGHT WE KNEW

To caricature (we shall give a more nuanced picture below): we thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job. We thought of fiscal policy as playing a secondary role, with political constraints sharply limiting its de facto usefulness. And we thought of financial regulation as mostly outside the macroeconomic policy framework.

Admittedly, these views were more closely held in academia: policymakers were often more pragmatic. Nevertheless, the prevailing consensus played an important role in shaping policies and the design of institutions. We amplify and modulate these points in turn.

A. One Target: Stable Inflation

Stable and low inflation was presented as the primary, if not exclusive, mandate of central banks. This was the result of a coincidence between the reputational need of central bankers to focus on inflation rather than activity (and their desire, at the start of the period, to decrease inflation from the high levels of the 1970s) and the intellectual support for inflation targeting provided by the New Keynesian model. In the benchmark version of that model, constant inflation is indeed the optimal policy, delivering a zero output gap (defined as the distance from the level of output that would prevail in the absence of nominal rigidities), which turns out to be the best possible outcome for activity given the imperfections present in the economy.

This divine coincidence (as it has been called) implied that, even if policymakers cared very much about activity, the best they could do was to maintain stable inflation. This applied whether the economy was affected by “animal spirits” or other shocks to consumer preferences, technology shocks, or even changes in the price of oil. The coincidence failed in the presence of further imperfections, further deviations from the benchmark, but the message remained: stable inflation is good in itself and good for economic activity.

In practice, the rhetoric exceeded the reality. Few central banks, if any, cared only about inflation. Most of them practiced “flexible inflation targeting,” the return of inflation to a stable target, not right away, but over some horizon. Most of them allowed for shifts in headline inflation, such as those caused by rising oil prices, provided inflation expectations remained well anchored. And many of them paid attention to asset prices (house prices, stock prices, exchange rates) beyond their effects on inflation and showed concern about external sustainability and the risks associated with balance sheet effects. But they did this with some unease, and often with strong public denial.

B. Low Inflation



There was an increasing consensus that inflation should not only be stable, but very low

(most central banks chose a target around 2 percent). This led to a discussion of the implications of low inflation for the probability of falling into a liquidity trap: corresponding to lower average inflation is a lower average nominal rate, and given the zero bound on the nominal rate, a smaller feasible decrease in the interest rate-thus less room for expansionary monetary policy in case of an adverse shock. The danger of a low inflation rate was thought, however, to be small. The formal argument was that, to the extent that central banks could commit to higher nominal money growth and thus higher inflation in the future, they could increase future inflation expectations and thus decrease future anticipated real rates and stimulate activity today. And, in a world of small shocks, 2 percent inflation seemed to provide a sufficient cushion to make the zero lower bound unimportant. Thus, the focus was on the importance of commitment and the ability of central banks to affect inflation expectations.

The liquidity traps of the Great Depression, combining significant deflation and low nominal rates, were seen as belonging to history, a reflection of policy errors that could now be avoided. The Japanese experience of the 1990s, with deflation, zero interest rates, and a continuing slump, stood more uneasily in the way. But it was largely dismissed as reflecting the inability or unwillingness of the Japanese central bank to commit to future money growth and to future inflation, coupled with slow progress on other fronts. (To be fair, the Japanese experience was not ignored by the Fed, which worried about deflation risks in the early 2000s.)

C. One Instrument: The Policy Rate

Monetary policy increasingly focused on the use of one instrument, the policy interest rate, that is, the short-term interest rate that the central bank can directly control through appropriate open-market operations. Behind this choice were two assumptions. The first was that the real effects of monetary policy took place through interest rates and asset prices, not through any direct effect of monetary aggregates (an exception to this rule was the stated “two-pillar” policy of the European Central Bank (ECB), which paid direct attention to the quantity of credit in the economy, but was often derided by observers as lacking a good theoretical foundation). The second assumption was that all interest rates and asset prices were linked through arbitrage. So that long rates were given by proper weighted averages of risk-adjusted future short rates, and asset prices by fundamentals, the risk-adjusted present discounted value of payments on the asset. Under these two assumptions, one needs only to affect current and future expected short rates: all other rates and prices follow. And one can do this by using, implicitly or explicitly, a transparent, predictable rule (thus the focus on transparency and predictability, a main theme of monetary policy in the past two decades), such as the Taylor rule, giving the policy rate as a function of the current economic environment. Intervening in more than one market, say in both the short-term and the long-term bond markets, is either redundant, or inconsistent.

Under these two assumptions also, the details of financial intermediation are largely irrelevant. An exception was made, however, for banks (more specifically, commercial banks), which were seen as special in two respects. First -and in the theoretical literature more than in the actual conduct of monetary policy- bank credit was seen as special, not easily substituted by other types of credit. This led to an emphasis on the “credit channel,” where monetary policy also affects the economy through the quantity of reserves and, in turn, bank credit. Second, the liquidity transformation involved in having demand deposits as liabilities and loans as assets, and the resulting possibility of runs, justified deposit insurance and the traditional role of central banks as lenders of last resort. The resulting distortions were the main justification for bank regulation and supervision. Little attention was paid, however, to the rest of the financial system from a macro standpoint.

D. A Limited Role for Fiscal Policy

In the aftermath of the Great Depression and following Keynes, fiscal policy had been seen as a -perhaps the- central macroeconomic policy tool. In the 1960s and 1970s, fiscal and monetary policy had roughly equal billing, often seen as two instruments to achieve two targets -internal and external balance, for example. In the past two decades, however, fiscal policy took a backseat to monetary policy. The reasons were many: first was wide skepticism about the effects of fiscal policy, itself largely based on Ricardian equivalence arguments.

Second, if monetary policy could maintain a stable output gap, there was little reason to use another instrument. In that context, the abandonment of fiscal policy as a cyclical tool may have been the result of financial market developments that increased the effectiveness of monetary policy. Third, in advanced economies, the priority was to stabilize and possibly decrease typically high debt levels; in emerging market countries, the lack of depth of the domestic bond market limited the scope for countercyclical policy anyway. Fourth, lags in the design and the implementation of fiscal policy, together with the short length of recessions, implied that fiscal measures were likely to come too late. Fifth, fiscal policy, much more than monetary policy, was likely to be distorted by political constraints.

The rejection of discretionary fiscal policy as a countercyclical tool was particularly strong in academia. In practice, as for monetary policy, the rhetoric was stronger than the reality. Discretionary fiscal stimulus measures were generally accepted in the face of severe shocks (such as, for example, during the Japanese crisis of the early 1990s). And policymakers would sometimes turn to discretionary fiscal stimulus even during “normal recessions.” A countercyclical fiscal stance was also seen as desirable in principle (though elusive in practice) for emerging markets with limited automatic stabilizers. This often took the form of louder calls for fiscal prudence during periods of rapid economic growth. And even for emerging markets, the consensus recipe for the medium term was to strengthen the stabilizers and move away from discretionary measures.

As a result, the focus was primarily on debt sustainability and on fiscal rules designed to achieve such sustainability. To the extent that policymakers took a long-term view, the focus in advanced economies was on prepositioning the fiscal accounts for the looming consequences of aging. In emerging market economies, the focus was on reducing the likelihood of default crises, but also on establishing institutional setups to constrain procyclical fiscal policies, so as to avoid boom-bust cycles. Automatic stabilizers could be left to play (at least in economies that did not face financing constraints), as they did not conflict with sustainability. Indeed, with the increase in the share of government in output as economies developed (Wagner’s law), automatic stabilizers played a greater role. Somewhat schizophrenically, however, while existing stabilizers were seen as acceptable, little thought was given to the design of potentially better ones.

E. Financial Regulation: Not a Macroeconomic Policy Tool

With the neglect of financial intermediation as a central macroeconomic feature, financial regulation and supervision focused on individual institutions and markets and largely ignored their macroeconomic implications. Financial regulation targeted the soundness of individual institutions and aimed at correcting market failures stemming from asymmetric information, limited liability, and other imperfections such as implicit or explicit government guarantees.

In advanced economies, its systemic and macroeconomic implications were largely ignored. This was less true in some emerging markets, where prudential rules such as limits on currency exposures (and sometimes an outright prohibition against lending to residents in foreign currency) were designed with macro stability in mind. Little thought was given to using regulatory ratios, such as capital ratios, or loan-to-value ratios, as cyclical policy tools (Spain and Colombia, which introduced rules that de facto link provisioning to credit growth, are notable exceptions). On the contrary, given the enthusiasm for financial deregulation, the use of prudential regulation for cyclical purposes was considered improper mingling with the functioning of credit markets (and often seen as politically motivated).

F. The Great Moderation

Increased confidence that a coherent macro framework had been achieved was surely reinforced by the “Great moderation,” the steady decline in the variability of output and of inflation over the period in most advanced economies. There is still some ambiguity as to whether this decline should be seen as having started much earlier, only to be interrupted for a decade or so in the 1970s, or as having started in earnest in the early 1980s, when monetary policy was changed. There is also some ambiguity as to how much of the decline should be seen as the result of luck, that is, smaller shocks, structural changes, or improved policy. Improvements in inventory management and good luck in the form of rapid productivity growth and the trade integration of China and India likely played some role. But the reaction of advanced economies to largely similar oil price increases in the 1970s and the 2000s supports the improved-policy view. Evidence suggests that more solid anchoring of inflation expectations, plausibly due to clearer signals and behavior by central banks, played an important role in reducing the effects of these shocks on the economy. In addition, the successful responses to the 1987 stock market crash, the Long-Term Capital Management (LTCM) collapse, and the bursting of the tech bubble reinforced the view that monetary policy was also well equipped to deal with the financial consequences of asset price busts.

Thus, by the mid-2000s, it was indeed not unreasonable to think that better macroeconomic policy could deliver, and had indeed delivered, higher economic stability. Then the crisis came.

III. WHAT WE HAVE LEARNED FROM THE CRISIS

A. Stable Inflation May Be Necessary, but Is Not Sufficient

Core inflation was stable in most advanced economies until the crisis started. Some have argued in retrospect that core inflation was not the right measure of inflation, and that the increase in oil or housing prices should have been taken into account. This, however, goes against the conclusions from theoretical research (which suggests stabilization of an index corresponding to “sticky prices,” an index quite close to that used to measure core inflation) and is more a reflection of the hope that it may be sufficient to focus on and stabilize a single index, so long as it is the “right” one. This is unlikely to be true: no single index will do the trick.

Inflation, even core inflation, may be stable, and the output gap may nevertheless vary, leading to an obvious trade-off between the two. (This is hard to prove empirically, as the output gap is not directly observable. What is clear, however, is that the behavior of inflation is much more complex than is assumed in our simple models and that we understand the relationship between activity and inflation quite poorly, especially at low rates of inflation.) Or, as in the case of the precrisis 2000s, both inflation and the output gap may be stable, but the behavior of some asset prices and credit aggregates, or the composition of output, may be undesirable (for example, too high a level of housing investment, too high a level of consumption, or too large a current account deficit) and potentially trigger major macroeconomic adjustments later on.

B. Low Inflation Limits the Scope of Monetary Policy in Deflationary Recessions



When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further: estimates, based on a simple Taylor rule, suggest another 3 to 5 percent for the United States. But the zero nominal interest rate bound prevented them from doing so. One main implication was the need for more reliance on fiscal policy and for larger deficits than would have been the case absent the binding zero interest rate constraint.

It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap. But it is clear that the zero nominal interest rate bound has proven costly. Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions.

C. Financial Intermediation Matters

Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks.

When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy. Interventions, either through the acceptance of assets as collateral, or through their straight purchase by the central bank, can affect the rates on different classes of assets, for a given policy rate. This is indeed what, under the heading of credit easing, the central banks have done in this crisis.

Another old issue the crisis has brought back to the fore is that of bubbles and fads, leading assets to deviate from fundamentals, not for liquidity but for speculative reasons. At the least, the evidence from the crisis strengthens the case for the existence of and the dangers associated with such bubbles, in this case in the housing market. And it surely puts into question the “benign neglect” view that it is better to pick up the pieces after a bust than to try to prevent the buildup of sometimes difficult-to-detect bubbles.

D. Countercyclical Fiscal Policy Is an Important Tool



The crisis has returned fiscal policy to center stage as a macroeconomic tool for two main reasons: first, to the extent that monetary policy, including credit and quantitative easing, had largely reached its limits, policymakers had little choice but to rely on fiscal policy. Second, from its early stages, the recession was expected to be long lasting, so that it was clear that fiscal stimulus would have ample time to yield a beneficial impact despite implementation lags.

It has also shown the importance of having “fiscal space” (and here there is a parallel with the earlier discussion about inflation and room to decrease nominal interest rates). Some advanced economies that entered the crisis with high levels of debt and large unfunded liabilities have had limited ability to use fiscal policy. Similarly, those emerging market economies (e.g., some in eastern Europe) that ran highly procyclical fiscal policies driven by consumption booms are now forced to cut spending and increase taxes despite unprecedented recessions. By contrast, many other emerging markets entered the crisis with lower levels of debt. This allowed them to use fiscal policy more aggressively without fiscal sustainability being called into question or ensuing sudden stops.

The aggressive fiscal response has been warranted given the exceptional circumstances, but it has further exposed some drawbacks of discretionary fiscal policy for more “normal” fluctuations -in particular lags in formulating, enacting, and implementing appropriate fiscal measures (often due to an awkward political process). The U.S. fiscal stimulus bill was enacted in February 2009, more than a year after the start of the recession, and only half of the authorized spending is projected to have been spent by the end of 2009 (see www.recovery.gov).

Furthermore, the wide variety of approaches in terms of the measures undertaken has made it clear that there is a lot we do not know about the effects of fiscal policy, about the optimal composition of fiscal packages, about the use of spending increases versus tax decreases, and the factors that underlie the sustainability of public debts, topics that had been less active areas of research before the crisis.

E. Regulation Is Not Macroeconomically Neutral

Just like financial intermediation itself, financial regulation has played a central role in the crisis. It contributed to the amplification effects that transformed the decrease in U.S. housing prices into a major world economic crisis. The limited perimeter of regulation gave incentives for banks to create off-balance-sheet entities to avoid some prudential rules and increase leverage. Regulatory arbitrage allowed financial institutions such as AIG to play by different rules from other financial intermediaries. Once the crisis started, rules aimed at guaranteeing the soundness of individual institutions worked against the stability of the system. Mark-to-market rules, when coupled with constant regulatory capital ratios, forced financial institutions to take dramatic measures to reduce their balance sheets, exacerbating fire sales and deleveraging.

F. Reinterpreting the Great Moderation

If the conceptual framework behind macroeconomic policy was so flawed, why did things look so good for so long? One reason is that, during the past two decades, policymakers had to deal with shocks they understood rather well and for which policy was indeed well adapted. For example, the lesson that, with respect to supply shocks, anchoring of expectations was of the essence, was well understood when the price of oil increased again in the 2000s. But, even though they were better prepared to deal with some shocks, they were just not prepared for others. (This is despite the fact that they had, in effect, a number of warnings, from the LTCM crisis to the sudden stops of capital in the Asian crisis. But LTCM was dealt with successfully and was seen as a one-off event, not a potential rehearsal of the same problem on a larger, macro, scale. And the difficulties faced by the financial systems of Asian countries were not thought to be relevant to advanced economies.) The poor performance of Japan in dealing with the bursting of the 1980s real estate bubble can be read in this light: the Japanese economy was exposed to a shock whose implications were not understood at the time.

It may even be that success in responding to standard demand and supply shocks, and in moderating fluctuations, was in part responsible for the larger effects of the financial shocks in this crisis. The Great Moderation led too many (including policymakers and regulators) to understate macroeconomic risk, ignore, in particular, tail risks, and take positions (and relax rules) -from leverage to foreign currency exposure, which turned out to be much riskier after the fact.

IV. IMPLICATIONS FOR THE DESIGN OF POLICY

Identifying the flaws of existing policy is (relatively) easy. Defining a new macroeconomic policy framework is much harder. The bad news is that the crisis has made clear that macroeconomic policy must have many targets; the good news is that it has also reminded us that we have in fact many instruments, from “exotic” monetary policy to fiscal instruments, to regulatory instruments. It will take some time, and substantial research, to decide which instruments to allocate to which targets, between monetary, fiscal, and financial policies. What follows are explorations.

It is important to start by stating the obvious, namely, that the baby should not be thrown out with the bathwater. Most of the elements of the precrisis consensus, including the major conclusions from macroeconomic theory, still hold. Among them, the ultimate targets remain output and inflation stability. The natural rate hypothesis holds, at least to a good enough approximation, and policymakers should not assume that there is a long-term trade-off between inflation and unemployment. Stable inflation must remain one of the major goals of monetary policy. Fiscal sustainability is of the essence, not only for the long term, but also in affecting expectations in the short term.

A. Should the Inflation Target Be Raised?



The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future -the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?

Achieving low inflation through central bank independence has been a historic accomplishment, especially in several emerging markets. Thus, answering these questions implies carefully revisiting the list of benefits and costs of inflation. The inflation tax is clearly distortionary, but so are the other, alternative, taxes. Many of the distortions from inflation come from a tax system that is not inflation neutral, for example, from nominal tax brackets or from the deductibility of nominal interest payments. These could be corrected, allowing for a higher optimal inflation rate. If higher inflation is associated with higher inflation volatility, indexed bonds can protect investors from inflation risk. Other distortions, such as the lower holdings of real money balances and a greater dispersion of relative prices, are more difficult to correct (the empirical evidence is, however, that their effects on output are difficult to discern, so long as inflation remains in the single digits). Perhaps more important is the risk that higher inflation rates may induce changes in the structure of the economy (such as the widespread use of wage indexation) that magnify inflation shocks and reduce the effectiveness of policy action. But the question remains whether these costs are outweighed by the potential benefits in terms of avoiding the zero interest rate bound.

A related question is whether, when the inflation rate becomes very low, policymakers should err on the side of a more lax monetary policy, so as to minimize the likelihood of deflation, even if this means incurring the risk of higher inflation in the event of an unexpectedly strong pickup in demand. This issue, which was on the mind of the Fed in the early 2000s, is one we must return to.

B. Combining Monetary and Regulatory Policy

Part of the debate about monetary policy, even before the crisis, was whether the interest rate rule, implicit or explicit, should be extended to deal with asset prices. The crisis has added a number of candidates to the list, from leverage to current account positions to measures of systemic risk.

This seems like the wrong way of approaching the problem. The policy rate is a poor tool to deal with excess leverage, excessive risk taking, or apparent deviations of asset prices from fundamentals. Even if a higher policy rate reduces some excessively high asset price, it is likely to do so at the cost of a larger output gap. Were there no other instrument, the central bank would indeed face a difficult task, and this has led a number of researchers to argue against reacting to perceived asset bubbles and other variables. But there are other instruments at the policymaker’s disposal -call them cyclical regulatory tools. If leverage appears excessive, regulatory capital ratios can be increased; if liquidity appears too low, regulatory liquidity ratios can be introduced and, if needed, increased; to dampen housing prices, loan-to-value ratios can be decreased; to limit stock price increases, margin requirements can be increased. True, none of these is a magic bullet and all can be, to some extent, circumvented. Nevertheless, they are likely to have a more targeted impact than the policy rate on the variables they are trying to affect. In this light, it seems better to use the policy rate primarily in response to aggregate activity and inflation and to use these specific instruments to deal with specific output composition, financing, or asset price issues.

A related issue is the potential conundrum created by the effect of low interest rates on risk taking. If it is indeed the case that low interest rates lead to excessive leverage or to excessive risk taking, should the central bank, as some have suggested, keep the policy rate higher than is implied by a standard interest rule? Again, absent other instruments, the central bank would face a difficult choice, having to accept a positive output gap in exchange for lower risk taking. If, however, we take into account the presence of the other instruments, which can directly affect leverage or risk taking, then the problem can be better handled through the use of those instruments, rather than through modification of the policy rule.

If monetary and regulatory tools are to be combined in this way, it follows that the traditional regulatory and prudential frameworks need to acquire a macroeconomic dimension. Measures reflecting systemwide cyclical conditions will have to complement the traditional institution-level rules and supervision. As for monetary policy decisions, these macroprudential measures should be updated on a regular and predictable (or even semiautomatic) basis to maximize their effectiveness through a credible and understood policy stance. The main challenge, here, is to find the right trade-off between a sophisticated system, fine-tuned to each marginal change in systemic risk, and an approach based on simple-to-communicate triggers and easy-to-implement rules.

If one accepts the notion that, together, monetary policy and regulation provide a large set of cyclical tools, this raises the issue of how coordination is achieved between the monetary and the regulatory authorities, or whether the central bank should be in charge of both.

The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators. They are ideally positioned to monitor macroeconomic developments, and in several countries they already regulate the banks. “Communication” debacles during the crisis (for example on the occasion of the bailout of Northern Rock) point to the problems involved in coordinating the actions of two separate agencies. And the potential implications of monetary policy decisions for leverage and risk taking also favor the centralization of macroprudential responsibilities within the central bank. Against this solution, two arguments were given in the past against giving such power to the central bank. The first was that the central bank would take a “softer” stance against inflation, since interest rate hikes may have a detrimental effect on bank balance sheets. The second was that the central bank would have a more complex mandate, and thus be less easily accountable. Both arguments have merit and, at a minimum, imply a need for further transparency if the central bank is given responsibility for regulation. The alternative, that is, separate monetary and regulatory authorities, seems worse.

C. Inflation Targeting and Foreign Exchange Intervention

The central banks that adopted inflation targeting typically argued that they cared about the exchange rate only to the extent that it had an impact on their primary objective, inflation. This was certainly the case in large advanced economies. For smaller countries, however, the evidence suggests that, in fact, many of them paid close attention to the exchange rate and also intervened on foreign exchange markets to smooth volatility and, often, even to influence the level of the exchange rate.

Their actions were more sensible than their rhetoric. Large fluctuations in exchange rates, due to sharp shifts in capital flows (as we saw during this crisis) or other factors, can create large disruptions in activity. A large appreciation may squeeze the tradable sector and make it difficult for it to grow back if and when the exchange rate decreases. Also, when a significant portion of domestic contracts is denominated in foreign currency (or is somehow linked to its movements), sharp fluctuations in the exchange rate (especially depreciations) can cause severe balance sheet effects with negative consequences for financial stability, and thus, output.

In that context, the discrepancy between rhetoric and practice is confusing and undermines the transparency and credibility of the monetary policy action. Central banks in small open economies should openly recognize that exchange rate stability is part of their objective function. This does not imply that inflation targeting should be abandoned. Indeed, at least in the short term, imperfect capital mobility endows central banks with a second instrument in the form of reserve accumulation and sterilized intervention. This tool can help control the external target while domestic objectives are left to the policy rate.

Of course, there are limits to sterilized intervention, and these can be easily reached if capital account pressures are large and prolonged. These limits will be specific to each country and will depend on countries’ openness and financial integration. When these limits are reached and the burden falls solely on the policy rate, strict inflation targeting is not optimal, and the consequences of adverse exchange rate movements have to be taken into account. Note that this discussion provides yet another example of the important interrelationship between policies and regulation discussed in the previous subsection. For instance, to the extent that prudential rules can prevent or contain the degree of contract dollarization in the economy, they will allow for greater policy freedom with respect to exchange rate movements. In turn, the perception of an “excessively stable” exchange rate can lead to greater incentives for contract dollarization.

D. Providing Liquidity More Broadly

The crisis has forced central banks to extend the scope and scale of their traditional role as lenders of last resort. They extended their liquidity support to non-deposit-taking institutions and intervened directly (with purchases) or indirectly (through acceptance of the assets as collateral) in a broad range of asset markets. The question is whether these policies should be kept in tranquil times.

The argument for extending liquidity provision, even in normal times, seems compelling. If liquidity problems come from the disappearance of deep-pocket private investors from specific markets, or from the coordination problems of small investors as in the traditional case of bank runs, the government is in a unique position to intervene. Given its nature and its ability to use taxation, it has both a long horizon and very deep pockets. Thus, it can, and indeed should, step in and be ready to replace private investors, if need be.

Two arguments have traditionally been made against such public liquidity provision. The first is that the departure of private investors may reflect, at least in part, solvency concerns. Thus, the provision of liquidity carries risk for the government balance sheet and creates the probability of bailout with obvious consequences for risk taking. The second is that such liquidity provision will induce more maturity transformation and less-liquid portfolios. While this outcome is sometimes referred to as moral hazard, it is not by itself a bad one: to the extent that public liquidity provision can be provided at no cost, it is indeed optimal to have the private sector do this maturity transformation. The cost may, however, be positive, reflecting the need for higher taxation or foreign borrowing.

Both problems can be partly addressed through the use of insurance fees and haircuts (the first argument suggests, however, relying, in normal times, on indirect support and appropriate haircuts to reduce credit risk, rather than on direct purchases). The problems can also be addressed through regulation, by both drawing up a list of assets eligible as collateral (in this respect, the ECB was ahead of the Fed in having a longer list of eligible collateral) and, for financial institutions, by linking access to liquidity to coming under the regulatory and supervision umbrella.

E. Creating More Fiscal Space in Good Times

A key lesson from the crisis is the desirability of fiscal space to run larger fiscal deficits when needed. There is an analogy here between the need for more fiscal space and the need for more nominal interest rate room, argued earlier. Had governments had more room to cut interest rates and to adopt a more expansionary fiscal stance, they would have been better able to fight the crisis. Going forward, the required degree of fiscal adjustment (after the recovery is securely under way) will be formidable, in light of the need to reduce debt against the background of aging-related challenges in pensions and health care. Still, the lesson from the crisis is clearly that target debt levels should be lower than those observed before the crisis. The policy implications for the next decade or two are that, when cyclical conditions permit, major fiscal adjustment is necessary and, should economic growth recover rapidly, it should be used to reduce debt-to-GDP ratios substantially, rather than to finance expenditure increases or tax cuts.

The recipe to create additional fiscal space in the years ahead and to ensure that economic booms translate into improved fiscal positions rather than procyclical fiscal stimulus is not new, but it acquires greater relevance as a result of the crisis. Medium-term fiscal frameworks, credible commitments to reducing debt-to-GDP ratios, and fiscal rules (with escape clauses for recessions) can all help in this regard. Similarly, expenditure frameworks based on long-term revenue assessments help limit spending increases during booms. And eliminating explicit revenue earmarking for prespecified budget purposes would avoid automatic expenditure cuts when revenues fall. A further challenge, as governments come under greater pressure to display improved deficit and debt data and are tempted to provide support to ailing sectors through guarantees or off-budget operations, is to ensure that all public sector operations are transparently reflected in fiscal data and that well-designed budget processes reduce policymakers’ incentives to postpone needed adjustment.

F. Designing Better Automatic Fiscal Stabilizers

As discussed above, the exception of this crisis confirms the problems with discretionary fiscal measures: they come too late to fight a standard recession. There is, thus, a strong case for improving automatic stabilizers. One must distinguish here between truly automatic stabilizers -that is, those that by their very nature imply a procyclical decrease in transfers or increase in tax revenues- and rules that allow some transfers or taxes to vary based on prespecified triggers tied to the state of the economic cycle (see Baunsgaard and Symansky, 2009).

The first type of automatic stabilizer comes from the combination of rigid government expenditures with an elasticity of revenues with respect to output of approximately one, from the existence of social insurance programs (defined-benefit pension and unemployment benefit systems fall into this category), and from the progressive nature of income taxes. The main ways to increase their macroeconomic effect would be to increase the size of government or (to a lesser extent) to make taxes more progressive or to make social insurance programs more generous. However, reforms along these lines would be warranted only if they were based on a broader set of equity and efficiency objectives, rather than motivated simply by the desire to stabilize the economy.

The second type of automatic stabilizer appears more promising. This type does not carry the costs mentioned above and can be applied to tax or expenditure items with large multipliers. On the tax side, one can think of temporary tax policies targeted at low-income households, such as a flat, refundable tax rebate, a percentage reduction in a taxpayer’s liability, or tax policies affecting firms, such as cyclical investment tax credits. On the expenditure side, one can think of temporary transfers targeted at low-income or liquidity-constrained households. These taxes or transfers would be triggered by the crossing of a threshold by a macro variable. The most natural variable, GDP, is available only with a delay. This points to labor market variables, such as employment or unemployment. How to define the relevant threshold, and which taxes or transfers to make contingent, are issues we must work on.

V. CONCLUSIONS



The crisis was not triggered primarily by macroeconomic policy. But it has exposed flaws in the precrisis policy framework, forced policymakers to explore new policies during the crisis, and forces us to think about the architecture of postcrisis macroeconomic policy.

In many ways, the general policy framework should remain the same. The ultimate goals should be to achieve a stable output gap and stable inflation. But the crisis has made clear that policymakers have to watch many targets, including the composition of output, the behavior of asset prices, and the leverage of different agents. It has also made clear 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 regulation tools, and the design of better automatic stabilizers for fiscal policy, are two promising routes. These need to be explored further.

Finally, the crisis has also reinforced lessons that we were always aware of, but with greater experience now internalize more strongly. Low public debt in good times creates room to act forcefully when needed. Good plumbing, in terms of prudential regulation, and transparent data in the monetary, financial, and fiscal areas are critical to our economic system functioning well. Capitalizing on the experience of the crisis, our job will be not only to come up with creative policy innovations, but also to help make the case with the public at large for the difficult but necessary adjustment and reforms that stem from those lessons.

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