With some of the best economists in the world, the IMF has held its second conference on the ‘Rethinking of Macropolicy’. Addressing the issues that I touched upon last week (see here ), this is a very valuable exercise for the economics profession. The crisis of 2007/2008 was missed by the majority of economists, mainly due to flawed and incomplete models, but the challenge now is ensure that it is does not happen again.
The recently held conference had many great speakers, including Janet Yellen and Joe Stiglitz, but I have chosen three contributions to the conference that I have found especially interesting. It will be a long time before we have a consensus on incorporating the financial sector into economic models and policymaking, but these contributions have given us a great platform to work from.
Borio and the BIS
As highlighted a couple of times on this blog (see here and here), Claudio Borio of the Bank for International Settlements is doing intriguing work on what he calls the ‘Financial Cycle’ (FC). To Borio, the FC should be at the centre of our economic thinking, as it has ramifications for both macroprudential policy and monetary policy. The FC is shown to be procyclical, which makes sense when considered alongside Minsky’s investment theory (see here) and Bernanke’s financial accelerator. One of the key properties of the FC is that it is more of a medium term phenomenon, lasting 16-20 years, making it longer than the usual business cycle. Importantly, using real estate prices and credit as proxies for financial imbalances, the risks of the FC can be identified in real time. Moreover, the busts of the FC are associated with balance sheet recessions, which ties in nicely with the notion of ‘financial recessions’ discussed here.
In terms of policy and the FC, Borio states that macroprudential policy has to have a systemic element and build up buffers during a boom. But, crucially, macroprudential policy faces many challenges. Firstly, its effectiveness varies across tools and secondly, it has a political economy element, as it will always be difficult to take away the punchbowl when the party has already started.
This all sounds reasonable, but I’m less clear than Borio on his call for monetary support of macroprudential policies. He warns of overburdening these polices and says that monetary policy, in terms of the interest rate, should be used to lean against financial imbalances, even if near term inflation is under control. This gets to the crux of the matter for the interplay of macroprudential and monetary policy.
Mervy King and the additional trade-off
When I was taught macro-economics, the trade-off facing monetary policymakers was that between output variation and inflation variation. The challenge of monetary policy was to find the best point on the trade-off curve. What the crisis has taught King, however, was that there is an additional trade-off to consider – that of financial vulnerabilities over the medium term. As we saw, periods of calm from a traditional macro standpoint can also be periods where financial risks are rising. King also cites Minsky’s key point, that stability encourages exuberance in credit markets that eventually leads to instability.
Diagrammatically, King highlights this point with the chart below. The dotted line shows the ‘Taylor’ frontier without consideration of financial imbalances. King suggests that the blue line may be the true trade-off, as consideration of the FC moves the curve away from the origin making the trade-off less favourable. For King, this denotes the ‘Taylor-Minksy’ frontier of the new macroeconomic environment.
In terms of what this means for policy, King makes three important points:
- Although they should be realistic about what can be achieved, it is right that elected politicians and parliaments decide on the objectives of policy.
- As we learned in the 1970s, if the central bank is to achieve price stability – its fundamental role – it must be sufficiently independent.
- In order to protect that independence, its limits should be very clearly circumscribed, and we should be exceptionally careful with decisions that put public funds at risk.
In his briefing document for the IMF conference, Olivier Blanchard touched on many important issues. One particularly relevant section was on the types of macroprudential policy tools and their effectiveness. For Blanchard, these tools can fall into three categories:
- Tools that seek to influence lenders behaviour
These tools include such policies as cyclical capital requirements, leverage ratios and dynamic provisioning. Cyclical capital requirements require banks to hold more capital in good times, thus building up buffers to draw upon when needed. The idea is that this would smooth credit growth and reduce the negative effects of a bust. The implementation of these policies can be difficult, however. One issue refers to what ‘cycle’ they should be based upon: GDP growth, credit growth or asset price movements? Blanchard notes that the evidence on these measures has been mixed, but there is some evidence that they curb the growth of some loans.
2. Tools that focus on borrowers behaviour
These polices include measures such as loan-to-value and debt-to-income policies, aimed at reducing the vulnerabilities on the borrower side. Again, however, they can be difficult to implement, as they may not apply beyond the household sector and people may try to circumvent them. In practice, there is some evidence that they can be effective. Blanchard cites academic work where the use of these measures during periods of quickly rising real estate prices reduced the incidence of credit booms and decreased the probability of financial distress.
3. Capital flow management tools
Also known simply as capital controls, these measures are aimed at reducing the risk from volatile capital flows. These measures are particularly controversial, but the IMF has said that under some circumstances, they can be justified on economic management grounds. While evidence of their effectiveness is inconclusive, Brazil has provided some recent evidence during this crisis. Brazil has used taxes on capital flows, varying both the rate and that to which they are applied, which seems to have slowed down portfolio flows and reduce exchange rate appreciation.
Despite the fact that it will take a long time for consensus to emerge on these issues, the IMF conference served a great purpose by bringing together those at the forefront of rethinking macroeconomic policy.