Olivier Blanchard - Progress and Confusion: The State of Macroeconomic Policy

Progress and Confusion

The State of Macroeconomic Policy

edited by Olivier Blanchard, Raghuram Rajan, Kenneth Rogoff, and Lawrence H. Summers

The MIT Press

Cambridge, Massachusetts

London, England

2016 International Monetary Fund and Massachusetts Institute of Technology

All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher.

Nothing contained in this book should be reported as representing the views of the IMF, its Executive Board, member governments, or any other entity mentioned herein. The views expressed in this book belong solely to the authors.

This book was set in Sabon by Toppan Best-set Premedia Limited. Printed and bound in the United States of America.

Library of Congress Cataloging-in-Publication Data

Names: Blanchard, Olivier (Olivier J.) editor.

Title: Progress and confusion : the state of macroeconomic policy / Blanchard, Olivier, Raghuram Rajan, Kenneth Rogoff, and Lawrence H. Summers, eds.

Description: Cambridge, MA : The MIT Press, 2016. | Includes bibliographical references and index.

Identifiers: LCCN 2015039939 | ISBN 9780262034623 (hardcover : alk. paper)

eISBN 9780262333436

Subjects: LCSH: Monetary policy. | Fiscal policy. | Economic policy. | Macroeconomics.

Classification: LCC HG230.3 .P76 2016 | DDC 339.5dc23 LC record available at http://lccn.loc.gov/2015039939

10987654321

Table of Contents

List of Tables

List of Illustrations

1A Road Map to Progress and Confusion

On April 1516, 2015, the IMF organized the third Rethinking Macro Policy conference. Held every two years since 2011, these conferences have brought together academics and policymakers to assess how the global financial crisis and its aftermath should change our views of macroeconomic policy. This time around, the focus was on the contours of policy in the future, once the global financial crisis is finally over. Will the macro framework look like the precrisis consensus, or will it be different? Have we made progress on this question, or does confusion remain?

The twenty-seven chapters in this book reflect the discussions that took place at the conference, covering many dimensions of macro policy. The chapters are organized into seven topics: the new normal, financial regulation, macroprudential policies, monetary policy, fiscal policy, capital flows and exchange rate management, and the international monetary system. Given the breadth of issues, we thought we needed to provide a road map to guide the reader. For each topic we present a list of questions, then provide a summary of each chapter and where it fits within the broader policy debate. Not all of the questions are addressed in this volume, though some of them are discussed in the two previous conference volumes.

The New Normal

At the core of the conference is the question of the new normal. Will the macro landscape of the future be similar to the precrisis landscape, one of decent growth and normal interest rates? Or are we in for a prolonged period of stagnation, negative real rates, and deflationary pressures, similar to the experience of the last few years?

Two of the books editors provide opposing views on this issue. On the one hand, Kenneth Rogoff argues that we are in the adjustment phase of a debt supercycle. Following the excessive expansion in credit that led to the global financial crisis, subsequent deleveraging has been a persistent drag on growth. This is typical of a financial crisis. But, he argues, these are not secular trends: as these headwinds subside, we should expect higher growth rates. The United States and the UK have already reached the end of the deleveraging cycle, while the euro zone is in the thick of it and China is starting to face challenges from the debt buildup of recent years. As for real interest rates, Rogoff makes the case that low safe rates mask much tighter financial conditions for many households and firms. As deleveraging comes to an end and financial conditions soften, safe real rates should again increase.

On the other hand, Lawrence H. Summers elaborates on his secular stagnation hypothesis, which he first put forward at an IMF conference in 2013.

The two views have very different policy implications. For example, the secular stagnation view calls for boosting investmentincluding investment in public infrastructureto raise aggregate demand and equilibrium real interest rates. Rogoffs view, on the other hand, that low safe rates mask tight financial conditions, suggests that greater public borrowing may end up crowding out the private sector even further.

What to make of these competing arguments? Much of it hinges on how to interpret movements in interest rates. Recent IMF work provides a somewhat nuanced view.

Systemic Risk and Financial Regulation

The global financial crisis resulted from the interaction of excessive leverage in the financial system and the related interconnectedness and complexity of the balance sheets of banks and nonbanks. In other words, the crisis revealed the existence of large and previously undetected systemic risk. Since then, there have been efforts to better understand and measure the many dimensions of systemic risk. But where do we stand on these? Are some aspects easier to measure than others, such as leverage in the financial system versus risks from shadow banking, or solvency risks versus liquidity risks?

In addition, regulatory reforms have been pervasive, as the Dodd-Frank Act, the UK Vickers Commission, the work of the Financial Stability Board, and similar efforts attest. Are reforms succeeding in reducing systemic risk? Do they have unintended effects? More generally, do the ever-changing financial landscape and the incentives for the system to remain excessively leveraged imply regulatory reform is hopeless?

In his introduction to this part of the volume, Paul A. Volcker summarizes its two main themes: the importance of avoiding excessive leverage in the financial system, and the need to expand the regulatory framework beyond banks.

Viral V. Acharya s chapter shows there has been progress in measuring systemic risk, at least in banking. He presents a measure developed at NYUs Volatility Institute, called SRISK, and uses it to assess progress with regulatory reform. This measure provides a market-based estimate of banks capital shortfalls during episodes of aggregate stress. By comparing a firms leftover equity in the event of a hypothetical market collapse with the level implied by a capital ratio considered prudent, and aggregating across all listed financial firms, SRISK provides a quantitative, time-varying indicator of financial fragility.

With the help of such a measure, Acharya paints a mixed picture of regulatory reform across the world. He sees considerable improvements in US banks since the crisis, thanks to capital injections and measures put in place following passage of the Dodd-Frank Act, including stress testing of systemically important financial institutions. But systemic risk in Europe remains more than twice as large as it was before the crisis, which Acharya argues is the result of insufficient recapitalization and ineffective stress tests (with an excessive focus on risk-weighted capital ratios instead of direct leverage). He also detects a large increase in systemic risk in Asia, especially China, following the massive increase in debt and leverage of recent years.

Anat R. Admati is pessimistic. She argues that the failure of financial regulation made evident during the global financial crisis has not been addressed. Conflicts of interest between creditors and shareholders can lead to excessive leverage, what Admati calls the leverage ratchet effect. This effect is particularly acute in banking because of the implicit guarantees regarding debt and the expectation of support from central banks and governments, which weakens creditor discipline. Capital regulations should correct these distortions. But they still allow extremely high levels of indebtedness, in part because of the complex system of risk weighting, which distorts investment decisions and increases systemic risk.