I am travelling to the US and UK to discuss my ideas on monetary policy with some of the best economic minds in the world, including former World Bank chief economist Joseph Stiglitz, Harvard academic Jeffrey Frankel and IMF chief economist Olivier Blanchard.
Olivier Blanchard says:
- Overvaluation of exchange rates “can be very damaging and we can need interventions to deal with such outcomes”
- We “need a twist to monetary policy”
- Friction in the wheels of capital flows make exchange rate interventions work better
Our third to last meeting was with Olivier Blanchard, Chief Economist at the IMF.
If any further evidence is needed of how far the world has moved on as a consequence of the limitations and side effects of inflation targeting exposed by the GFC, then writing out of the IMF since should suffice.
The most senior of economists in powerful positions write and talk in accessible language. They don’t use jargon as a barrier to discussions and are genuinely interested in our experiences, as well as interested in offering their own views.
Olivier Blanchard is one such man. He is both erudite and engaged. He was taking notes, as we were.
In advance of the meeting I had read the book “In the Wake of the Crisis – Leading Economists Reassess Economic Policy” edited by Olivier Blanchard, David Romer, Michael Spence, and Joseph Stiglitz. I recommend the book. Those like Steven Joyce who superficially defend the status quo – and accuse me and others who have challenged it as voodoo economists – could benefit from reading it.
The preface, first chapter and concluding remarks are by Olivier. Read as a whole, there can in my view be no doubt that inflation targeting has been exposed as seriously deficient.
Page one of the preface asks: Is inflation targeting the right way to conduct policy, or should the monetary authority watch a larger set of targets?… Should there be limits on current account imbalances? …..Should countries use capital controls? …. Should there be better mechanisms to deliver global liquidity?…
The book addresses these issues by presenting contributions from 23 leading economists, all of whom present their critiques in less than 10 pages.
A number refer to how developing countries and increasing numbers of developed countries are intervening to influence their currencies. The old view that you lose control of inflation if you address currency is debunked by a number of the contributors from both developing and developed countries. See for example the chapters by Guillermo Ortiz (Mexico) and Rakesh Mohan (Yale, and former deputy governor of the Reserve bank of India).
Mohan says sound economic management requires a combination of sound macroeconomic policies (both fiscal and monetary), plus exchange rate flexibility with some degree of management, and a relatively open capital account, but some degree of management and control is needed. This balanced approach is referred to with approval by Olivier in his concluding chapter.
The enormous blind spot in central bank policy around the world – which largely ignored asset price bubbles – receives repeated criticism. Some, like Stiglitz, think central banks were, and are, largely populated by, and captured by, the interests of bankers. Labour’s policy of broadening the membership of the Board of the Reserve Bank to include the interests of exporters and labour will help remedy this, as will the broadening of objectives. (Given the Stiglitz view that the consequences of monetary policy are disproportionately visited upon the vulnerable, maybe we should add representation of women, who so often bear the consequences of adversity-facing families).
Otmar Issing (Goethe University, Frankfurt) points out that it cannot be right that central banks intervene asymmetrically to deal with asset prices, ie only when they go down.
“All concepts of inflation targeting are based on inflation forecasts in which money and credit do not play an active role. They are a passive part of the forecast but are irrelevant once it comes to monetary policy decisions. …[Central banks had the view that they] should not target asset prices, should not prick a bubble, and should follow a mop-up strategy after a bubble has burst. ….. If asset prices collapse after a bubble bursts, then the central bank come to the rescue…”
Olivier agreed the one-way interventions by central banks have distorted asset prices (which is not to say that he opposes current central bank interventions to support economies).
Stiglitz noted monetary policy has protected bond and asset values for a subset of the population, while inflation targeting has visited the costs of readjustments caused by higher interest rates in other parts of the cycle upon the unemployed, the under employed and wage workers.
The themes of credit expansion and asset bubbles was emphasised by Olivier Blanchard when we met. Reserve banks post the GFC are starting to use prudential tools not just to protect the financial sector from collapse, but also to influence economic outcomes. He thought the separation of interest rate decisions from so-called prudential measures “is arbitrary”. I agree – which is one of the reasons we in the Labour party support the decisions on both prudential rules and interest rates being integrated and being for the board, not the GBvernor.
As Issing said in his chapter, price stability and financial stability must not be seen as a trade-off. Stiglitz puts it slightly differently, he says that the huge societal consequences of financial imbalances/collapses ought never be subjugated to a narrow focus on inflation.
I would add that even short of financial instability, a setting which sees little problem in the country’s balance sheet getting worse and worse through prolonged current account deficits (funded by asset sales to foreigners and increased overseas debt) must be wrong.
At our meeting Olivier was interested in New Zealand’s experience where interest rate differentials drove liquidity into New Zealand via the banking channel, which was borrowed and consumed, and further drove up our exchange rate to the detriment of all exporters.
I have been banging on about this for many years, and think it is now abundantly clear that in New Zealand, and overseas, central banks – who had the independent power and responsibility to curb this – failed. It is time that they – and not politicians – get some stick about this. It was an abysmal failure and has left New Zealand with high debt. Yes, governments of Labour and National could have helped by introducing a CGT, but that does not absolve our Reserve Bank from responsibility. They should have acted. They say they now can without any change in the law, so why didn’t they?
Olivier, and the commentators in the book, point out that the countries worst affected by the GFC in general had not run fiscal surpluses in the good times. Michael Cullen and Helen Clark – take a bow. Those surpluses and the strong government balance sheet which resulted have shielded New Zealand from the fate suffered by many other western countries.
On the subject of Dutch disease, we explained how the effects of a high and volatile currency are concentrated for the non-dominant export sector. He of course understood this, but was interested in our views about how this makes it hard to broaden our export base. He was interested in Selwyn Pellet’s hydraulics analogy. The greater the dominance of an export sector, the greater the hedge received by that sector, and the more concentrated the negative effect for the non-dominant sector. A small hedge spread across a wide base translates to a much larger negative effect concentrated upon the minority.
Olivier commented that it is not the short term volatility that is the greatest problem – short term volatility can be hedged via financial instruments.
Olivier said the overvaluation of exchange rates “can be very damaging and we can need interventions to deal with such outcomes”
He agreed countries need to attend to the competitiveness of their exchange rates. He referred us to a recent IMF staff discussion paper: “Two target, Two Instruments”, which again is worth reading.
He said the effects of a high exchange rate relative to fundamentals means that we “need a twist to monetary policy” as well. To make interventions for the benefit of exchange rates work it may be wise “to introduce friction in the wheels of capital flows, which make exchange rate interventions work better”. “Untrammelled flows of capital are bad”. Brazil, Switzerland, Turkey and Chile all provide examples of different responses (so of course does China, but in a much more controlled way).
I raised with Olivier the statements recently made by our outgoing Reserve Bank Governor that the focus on and remedies being used in the likes of Europe are distorting settings to the detriment of other countries. I said I shared that view. He noted this, and I suspect will look up Alan Bollard’s comments.
So, in terms of inflation targeting and leaving exchange rates alone, the IMF has moved on – probably more than the prevailing (not unanimous) views at the OECD.
It has become clearer and clearer to me as this trip has proceeded that the primacy of inflation targeting as we have known it really is dying and should be called dead, as Ambrose Evans Pritchard said to me in my first meeting this trip.
As was mentioned by more than one of the contributors to the IMF book, proponents of inflation targeting like Lars Svenson (the man chosen to critique and approve NZs approach some years back) seem to justify any change needed as being consistent with the original idea. Annual inflation targets morphed into ranges, the period from a year and a half, then to two, and now to six or seven years. To the devotees, “if flexible inflation targeting has not worked as expected, either it was not applied properly or some information was missing. But the strategy was fine. In this way, you can continue with such concepts indefinitely, making mistake after mistake.”
We finished up with a discussion about the effects of income and asset inequality. He noted that while we are seeing income inequality between countries decrease, we are seeing income and asset (ie wealth) inequality rising within countries. On that count we know from our own statistics that New Zealand is performing badly.
These discussions do lead to value judgments about the political economy, and it was evident the head economist at the IMF was reluctant to become too involved in these. At one level I can see why this might be delicate territory for the head economist at the IMF. However, the reality is that economic settings and international rules around banking, trade and investment do have societal effects including to wealth distribution. I find the reluctance of the economists from advisory bodies like the IMF to express opinions about these outcomes political in its own right, given that for many years they have promoted ideologies as well as policies which most definitely have these effects.
Anyway, the limited consideration of these effects (as opposed to discussions about economic efficiency) at the IMF and OECD is one of the reasons I am looking forward to my meeting with Joseph Stiglitz, because he faces no such constraint.
I was impressed with Olivier. He has self-confidence but was ready to listen. He has led the IMF forward. He is cautious, but encourages wide ranging debate. Through incremental change he has moved things on substantially.