An Important Starting Point—with One Gap

Guest post by David H. Romer,
University of California, Berkeley, and
co-host of the Conference on Macro and Growth Policies in the Wake of the Crisis

I had one major source of unhappiness with last week’s conference: the participants were largely silent about the dismal outlook in the advanced economies for the next several years. The current outlook for unemployment in the United States, Europe, and Japan is probably worse than it was in late 2008. Then, mainstream forecasts for 2009–2011 showed unemployment rising sharply—but generally to levels below what we are experiencing today—and then returning toward normal at a moderate pace. Today, not only is unemployment higher than most 2008 forecasts of its peak levels, but the expected pace of recovery is weaker.

Despite this deterioration, the dire sense of urgency in late 2008 has not increased. Indeed, it has largely disappeared. I find this complacency in the fact of vast, preventable suffering and waste hard to understand.

With the exception of that one critical omission, I was impressed by the discussion. One striking feature was the consensus that there is no consensus. That is, no one argued that there was widespread agreement about a simple set of rules for achieving macroeconomic stability, robust growth, and shared prosperity. Indeed, no one proposed such a set of rules. The crisis has, appropriately, made macroeconomists and policymakers humble about what we know. Although we must continue to give the best policy advice we can, this is also a time for intensive thought and research. I found the conference to be a valuable contribution to that process. And I thought that the fact that it was the IMF that organized the conference—and, especially, the wide range of perspectives of the people it invited to participate—reflects very well on the institution. It is a sign that the Fund understands that it does not have all the answers, and that it needs to look broadly in its efforts to rethink issues that were widely viewed as settled just a few years ago.

On some specific issues, there was, if not unanimity, considerable agreement:

  • Because of asymmetric information, agency problems, and behavioral forces, financial markets do not reliably produce efficient outcomes. Moreover, even well conceived and well implemented microeconomic regulation cannot ensure that financial market imperfections will not lead to adverse macroeconomic outcomes. Thus there is a need for “macro-prudential regulation”—that is, regulation and supervision that address financial risks to the macroeconomy.
  • The idea of “the” fiscal multiplier is not sensible. The impact of a change in fiscal policy is extremely dependent on whether monetary policy is able to respond, and on how it responds if it can. The impact also depends on the state of the economy, the health of the financial system, the time horizon of the change, its specific form, and more.
  • Capital controls should be part of the macroeconomic toolkit. Even speakers who were skeptical of capital controls thought there were circumstances under which they were a reasonable short-term expedient. And others felt they were a fully appropriate response to the prospect of large inflows of short-term capital that could lead to substantial overvaluation of the exchange rate.
  • The simple “one instrument/one target” view of monetary policy (where the instrument is a short-term interest rate and the target is inflation, or a weighted average of inflation and the output gap) is too simple. There are other instruments (exchange market intervention, capital controls, margin requirements, down payment requirements, capital requirements, and more), and other potential targets (notably the exchange rate and indicators of financial risks).
  • Having a domestic central bank—specifically, the U.S. Federal Reserve—be the main provider of emergency liquidity to central banks around the world, as occurred in 2008 through swap lines, does not seem optimal. Finding an arrangement where an international body plays that role would be desirable.

The discussion that was started at this conference needs to continue. We, the conference co-hosts, hope to hear your comments.

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Other conference-related blog posts by Olivier Blanchard:

9 Responses

  1. [...] Protocol for Climate Policy Josh Garret, CFTC Pushes for Position Limits David Romer on the IMF’s “New Economic Thinking” Paul Krugman, “The Nobodies of Macroeconomics” Jeffrey Rubin on Obama’s Trip to [...]

  2. @David H. Romer “Capital controls should be part of the macroeconomic toolkit”.

    Even when it was considered proof of primitivism in financial circles, I have spoken up for capital controls… on inflows… when:

    The size of the local market is like a bathtub lying on a beach next to the ocean… and the slightest wave… no tsunami needed, can cause a perfect storm in the bathtub.

    There is information asymmetry in the market and local capitals are being forced out of their own country because the foreign capital have less information about the risks or can afford to have a greater appetite for risk. We should not look at capital flows as one single flow, but divide it more in local capital flows and foreign capital flows to understand it.

  3. @David H. Romer “Even well conceived and well implemented microeconomic regulation cannot ensure that financial market imperfections will not lead to adverse macroeconomic outcomes.”

    Of course not, but that does not mean we should not avoid ill conceived and lousily implemented microeconomic regulations.

    A road can be extremely well constructed but lead from nowhere to nowhere. That is why it so extraordinary that we allow the global regulators in the Basel Committee to regulate our banks without defining a purpose for our banks.

    That said, since the Basel Committee proved that it was not even good at regulating basic road engineering, we now have a bad road coming from nowhere and leading to nowhere.

    The only risk the regulators considered in order to set the capital requirements for the banks in Basel II was the risk of default of their clients, mostly as this was perceived by the credit rating agencies. The higher the perceived risks, the higher were the capital requirements and vice versa.

    The above, though sounding logical to a layman, completely ignored that the market already arbitrages for the information provided by the credit rating agencies about the risk of default, by means of adjusting the risk-premiums it applies. And therefore, the unforeseen but should have been foreseen result of these capital requirements based on risk, was to dramatically increase the risk-adjusted return on bank capital when lending to anything officially perceived as “not-risky”, while making it, in relative terms, dramatically much less attractive to finance anything officially perceived as “risky” and which for the same adjusted risk premium required to hole much more bank capital.

    No wonder the banks stampeded into the triple-A rated waters where, since real triple-As are and will always be extremely scarce or non-existent, the market provided it with some Potemkin triple-A ratings.

    The only real Black Swan event that caused this crisis was that amazingly inept regulators got hold of the Basel Committee… and the most amazing thing is that they are still there!

  4. [...] dire sense of urgency in late 2008 has not increased. Indeed, it has largely disappeared. I find this complacency in the fact of vast, preventable suffering and waste hard to [...]

  5. [...] Via Paul Krugman, David Romer is not entirely happy with it: I had one major source of unhappiness with last week’s conference: the participants were largely silent about the dismal outlook in the advanced economies for the next several years. The current outlook for unemployment in the United States, Europe, and Japan is probably worse than it was in late 2008. Then, mainstream forecasts for 2009–2011 showed unemployment rising sharply—but generally to levels below what we are experiencing today—and then returning toward normal at a moderate pace. Today, not only is unemployment higher than most 2008 forecasts of its peak levels, but the expected pace of recovery is weaker. [...]

  6. [...] H. Romer, “An Important Starting Point—with One Gap“, iMFdirect, 16 March [...]

  7. [...] dire sense of urgency in late 2008 has not increased. Indeed, it has largely disappeared. I find this complacency in the fact of vast, preventable suffering and waste hard to [...]

  8. [...] JOLTS to Complacency Via Mark Thoma, David Romer has a complaint about the recent IMF conference on new thinking in macroeconomics: I had one major source of [...]

  9. [...] An Important Starting Point—with One Gap: I had one major source of unhappiness with last week’s conference: the participants were largely silent about the dismal outlook in the advanced economies for the next several years. The current outlook for unemployment in the United States, Europe, and Japan is probably worse than it was in late 2008. Then, mainstream forecasts for 2009–2011 showed unemployment rising sharply—but generally to levels below what we are experiencing today—and then returning toward normal at a moderate pace. Today, not only is unemployment higher than most 2008 forecasts of its peak levels, but the expected pace of recovery is weaker. [...]

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