There has been a quiet revolution underway in economics in the wake of the global financial crisis. The “Washington Consensus” is no longer a consensus. The “Great Moderation” has become a Memphis meltdown.
As in most revolutions, pressure begins gradually. Someone then states what is already obvious to all: the “Emperor has no clothes”. Suddenly, orthodoxy crumbles. As shown by the recent Toronto G20 summit, in 2010 orthodox economics stands suddenly naked.
The foundations have been shaking for a while. Assumptions of “rationality” have taken a hit from “behavioural economics”. Stock markets over-react due to fear and greed. Trickle down trickles up. Asset bubbles inflate then burst, as in 2008.
For me the “no clothes” moment for macroeconomics happened in February this year. The Chief Economist of the International Monetary Fund (IMF), Olivier Blanchard, released a ‘position note’ entitled “Rethinking Macroeconomic Policy”.
Early local media pickup focused on monetary policy, noting Labour’s recently announced withdrawal from the previous monetary consensus. This has been comprehensively confirmed in two speeches last week by Phil Goff and David Parker.
Blanchard’s critique of “What We Thought We Knew” is, however, much broader than earlier local reaction:
- Monetary policy had one target, inflation, and one tool, the policy rate (our ‘official cash rate’ (OCR)). With low, stable inflation the ‘output gap’ (unemployment) would be small and monetary policy would always do its job: spot the Tui billboard moment.
- Fiscal policy (government spending and taxing) was secondary at best: hopelessly slow, un-necessary if monetary policy was sound, and subject to nefarious political influence.
- Some financial regulation was ok but financial intermediation (leverage, derivatives and stuff) didn’t matter much in terms of managing the broader economy.
Welcome to the Washington Consensus: “By the mid-2000s, it was not unreasonable to think that better macroeconomic policy could deliver, and indeed had delivered, higher economic stability. Then the crisis came”.
Recounting “what we have learned”, Blanchard nails with laser-like clarity six home truths for our uncertain new world.
- Stable inflation may be necessary but is not sufficient. Housing bubbles, current account deficits and consumptions binges are serious problems.
- Low inflation limits the scope of monetary policy in a severe recession. There may not be room to cut policy interest rates far enough to avoid deflation.
- Financial intermediation matters. When financial markets are segmented and arbitrage (interest rate pass-through) breaks down, the OCR no longer works as a policy tool. Our 2009 Parliamentary Banking Inquiry found just that.
- Counter-cyclical fiscal policy is an important tool. Take a bow Michael Cullen, who cut Crown debt by saving surpluses then timed perfectly the recession-fighting 2008 Budget. That gave NZ a buffer to limit the 2008-09 slump.
- Regulation is not macro-economically neutral. Weaknesses in US financial regulation amplified a local property crash into a global crisis. More generally, deregulation is no cure-all (not welcome news in the current Beehive).
- The “Great Moderation” looked good for so long because it coped with small imbalances and had not faced the full consequences of understated systemic risk, especially around financial leverage and exchange rate exposure.
So what does this all mean for the next generation of policy makers? The next era should retain the best of the previous consensus, while creatively addressing the challenges that previously lay outside it.
Part 2 of this post will follow shortly. Comment is welcome on Blanchard’s critique.