Exploring Economic Policy Frontiers After the Crisis: 2010 IMF Research Conference

By Olivier Blanchard

The crisis has forced economists and policymakers to go back to their drawing boards. Where did they go wrong, and what implications does the crisis have for both macroeconomic theory and macroeconomic policy making?

This was the topic of this year’s IMF Jacques Polak Research Conference. The conference was the first since the passing of Jacques Polak, after whom the conference has been named, and to which he came every year until last year. Present at the Fund’s creation and a long time Fund economist, Jacques had been described by the Managing Director as “a leader of critical thought during the post-war evolution of the global economy.” As such, this conference, and its focus on the post-crisis evolution of the global economy, was fitting a fitting tribute to Jacques. We shall miss him.

Post-crisis policymaking

The twelve papers presented at the conference provided rich fodder for discussion. For two days, researchers and policymakers explored the contours of policy making in the post-crisis world. I want to share with you some of the major themes:

1.  The crisis has forced us to pay much more attention to fiscal policy. The rising public debt in advanced economies poses questions on the appropriate scope and timing of fiscal action, be it further stimulus or consolidation. One paper presented a framework for assessing the scope for fiscal maneuver (fiscal space), by comparing current debt levels with what might be the sustainable level of debt based on each country’s track record with fiscal adjustment. Another paper investigated the optimal timing of fiscal consolidation when monetary policy is constrained by the zero lower bound. A commitment to future consolidation can generate an immediate stimulus by lowering the long-run risk premium. The difficulty, as policy makers understand well, is obviously how to make such commitments about the future credible today.

2.  Monetary policy can lessen the adverse effects of financial disruptions on the real economy. One paper showed, using a quantitative macroeconomic model, how the negative feedback between the financial sector and real economy resulted in such a deep economic contraction with the 2007-09 crisis. Policy simulations using the model show the macroeconomic benefit of a monetary policy rule that allows the policy rate to respond to changes in financial conditions. Another paper gave evidence that lax monetary policy leads to a decline in risk aversion in financial markets. If present, this effect should be taken into account in designing monetary policy. Whether this should be done through adjustments of the policy rate, or through macro prudential measures, is clearly a central issue of monetary policy today.

3.  International capital flows can weaken financial stability. One paper modeled so called “hot money episodes.” When one country experiences a crisis, global investors need to find other destinations for their investments, leading to inflows of hot money into other countries. While the next destination can benefit for some time, all too often these capital inflows are followed by another crisis. Another paper showed that international financial integration—when not accompanied by fiscal integration among countries—can result in an undersupply of safe assets (high-grade sovereign bonds) and spread the financial fragility. The relevance of these papers to capital flows, either to safe havens or to emerging market countries, that we are observing today is an obvious one.

4.  Given the critical role of the financial sector in the crisis, regulatory issues and the interplay with the real economy took center stage.

  • One theoretical paper examined how the behavior of firms can be less efficient because government bailouts are highly likely in a deep crisis. Regulatory design should take this into account, thereby reducing the distortions due to expected bailouts and facilitating better outcomes. Another paper emphasized the need to strike the right balance between too lax or restrictive regulation. Very light-handed regulation, together with expectations of bailouts, can lead to very risky behaviors and an excessive expansion of the financial sector, while an ‘overregulating’ to prevent crises will stifle economic growth. The link to the problems faced by a number of advanced countries today is, again, an obvious one.
  • Macro prudential regulation was also the theme of two major sessions of the conference. For the keynote address of the conference—the Mundell-Fleming lecture—Anil Kashyap (University of Chicago) focused on fire sales—asset sales at an excessive discount—as a source of financial and economic instability, drawing some implications for the design of macro prudential regulation. The same theme was debated among four expert panelists who joined the Economic Forum, the concluding session of the conference.

The conference was an important opportunity to contribute to the post-crisis policy debate. But, it also made clear how much we still have to learn, from the interaction between monetary policy and financial markets, to the meaning of fiscal sustainability, and to the design of macro prudential regulation, to name just a few.

4 Responses

  1. The second paper refers to “the need to strike the right balance between too lax or restrictive regulation. Very light-handed regulation, together with expectations of bailouts, can lead to very risky behaviors and an excessive expansion of the financial sector, while an ‘overregulating’ to prevent crises will stifle economic growth”

    But besides differentiating between lax or restrictive regulation… for instance 4 percent or 12 percent basic capital requirement, what we need is to focus much more on understanding the differences between intrusive or non-intrusive regulations.

    The current Basel regulations, by using risk-weights, are highly intrusive regulations, inasmuch the regulators quite arbitrarily discriminate the capital requirements based on the perceived risk of defaults, resulting in that low risk borrowers who are already benefited from being perceived as low risk are further benefitted from having to provide the banks with a return on less capital, while those perceived as having a higher risk of default and who are already because of that forced to pay higher risk premiums must additionally provide the banks with a return on more capital.

    When I read the second paper segmenting the economy in “three production technologies: a safe one, a risky one and an inferior technology. The first two have positive net present value (NPV), while the third technology has negative NPV. …With the objective to characterize conditions under which there is trade-off between regulatory restrictiveness and efficiency, and conditions under which this trade-off breaks down” — I feel we remain in the intrusive mode, where our ex-ante perceptions are supposed to match ex-post realities… What if the world’s only chance to solve an emergency lies in taking exorbitant risks?

    Perhaps the emerging countries need to remind some submerging countries about risk-taking being an absolute necessity in order to move forward.

    • “The Basel regulations, by using risk-weights, are highly intrusive regulations, inasmuch as the regulators quite arbitrarily discriminate the capital requirements based on the perceived risk of defaults, resulting in that low risk borrowers who are already benefited from being perceived as low risk are further benefitted from having to provide the banks with a return on less capital, while those perceived as having a higher risk of default and who are already because of that forced to pay higher risk premiums must additionally provide the banks with a return on more capital.”

      Per Kurowski’s observation above, one made in different words many times on iMFDirect blogs, is warning everyone that the obviously logical thing for bank regulators to do, which is require risk-weighted reserve capital factors, and which the Basel framework does, has very pernicious effects. Specifically, the Basel framework skews bankers’ attention toward investing in sovereign debts whose risk assessment has been desktop-easy but which can, and clearly has, led to catastrophic system shocks seemingly only avertable by complex inter-bank derivatives or taxpayer bailouts; and diverts their attention energies away from considering/refining investment in just those smaller, more clearly risky sustainability ventures that do not entrain systemic shocks but which are hopeful if not always immediately practically obvious routes to social and environmental sustainability (per Jared Diamond).

      Unfortunately this insight is not yet, apparently, clear to the Basel Committee on Banking Supervision. Perhaps someone reading this blog would bring it to the attention of Mr. Lipsky or Mr. Strauss-Kahn for it needs to be heard in Basel.

      Nonetheless, it is a rational conclusion that the BCBS and we ignore at, arguably if we notice the mounting evidence, civilization’s peril.

      Could it be that the BCBS, like most of us, is
      conflating the meanings of the words “logical”, which is old world and dying, and “rational”, which is new world and realistically vitalizing?

      The chart following is how I alert my clients to become aware of the crucially important distinction between the logical and the rational:

      (Use your page “zoom” to improve its legibility!).

      • Yesterday, at IMF, I heard some new-old discussions about the Debt Sustainability Framework.

        Besides once again finding it to be somewhat like a torturer trying to establish the limit where the tortured might faint, as well as having excruciatingly little about the fact that any debt taken on for a wrong purpose or for a badly executed project is per-se unsustainable, the thought of who are we to decide where the border of sustainability lies came to my mind.

        What if the only entrance door to true sustainability lies way beyond avoiding what we believe might be unsustainable debt levels? In other words, where would the world be without crazy unsustainable risk-taking and resulting bank crisis? Is it not time to stop focusing on the bust and start focusing on getting the most out of the whole boom-bust cycle?

  2. Last friday 2010-11-21, the European Association of European Public Banks (EAPB) convened its second Chief Economist Meeting in Brussels, Belgium.

    Chief economists and experts of EAPB Member Banks and partners from 14 European countries took part in the meeting and gave their opinion on the current economic situation. Further contributions by delegates of the European Central Bank, KfW, Caisse des Depots et Consignations and the Romanian Banking institute were scheduled.

    Two main blocks were tackled. On the one hand the macroeconomic outlook for Europe with a still vulnerable but progressing recovery, a flat employment, exit strategies and imbalances of public deficits. On the other hand a special emphasis was laid, amongst others, on the implication and effects of the new waves of regulation, Basel III and G-20 discussions, in the financial sector after the crisis.

    With regard to the latter it was mentioned that Basel III is expected to effect the real economy by, amongst others, creating higher rates for loans and by reducing the Gross Domestic Product by approximately 0.2% to 0.8% in the EU area. The assessment is that the regulations increase importance of public funding as a financial resource.

    After the financial crisis there is a broader economic recovery taking place at different speeds in the world. It is Asia which is the locomotive of the recovery. Growth remains sluggish in many of the old industrial countries.

    Lena Bäcker
    Chief Economist Kommuninvest in Sweden, Initiator of the EAPB Chief Economist Network
    and moderator at the meeting.

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