Monetary Policy Will Never Be The Same [Wonkish]

I would strongly recommend this article to all fellow Economics students.

A fantastic summary by Olivier Blanchard on the kind of change the financial crisis has brought about in policy debates and the way in which we understand monetary policy [and by extension, fiscal policy]. While I am sceptical and critical about the methodologies employed in economic theory and the denial of any ideological tilt in its analyses, I find it hard to accept statements (made fairly often) such as “The crisis is proof that Economics has failed”. I definitely cannot be classified as a ‘mainstream’ believer; in fact I often have blogged about the various criticisms I have of modern [“Neoclassical”] Economics. From a philosophical point of view, modern Economics is fraught in controversy. But the point is, macroeconomic theory, as taught in textbooks, has done pretty well during and after the crisis. And has proved to be incredibly enlightening. Simon Wren-Lewis and Paul Krugman have written about this. While I am definitely less optimistic than them, I think there’s definitely an element of truth there. So, in that vein, I shall end with this fabulous summary on policy-making after the crisis:

Two weeks ago, the IMF organized a major research conference, in honour of Stanley Fischer, on lessons from the crisis. Here is my take. I shall focus on what I see as the lessons for monetary policy, but before I do this, let me mention two other important conclusions.

One, having your macro house in order pays off when there is an (external) crisis. In contrast to previous episodes, wise fiscal policy before this crisis gave emerging market countries the room to pursue countercyclical fiscal policies during the crisis, and this made a substantial difference.

Second, after a financial crisis, it is essential to rapidly clean up and recapitalize the banks. This did not happen in Japan in the 1990s, and was costly. But it did happen in the US in this crisis, and it helped the recovery.

Now let me now turn to monetary policy, and touch on three issues: the implications of the liquidity trap, the provision of liquidity, and the management of capital flows.

On the liquidity trap: we have discovered, unfortunately at great cost, that the zero lower bound can indeed be binding, and be binding for a long time—five years at this point. We have also discovered that, even then, there is still some room for monetary policy. The bulk of the evidence is that unconventional policy can systematically affect the term premia, and thus bend the yield curve through portfolio effects. But it remains a fact that compared to conventional policy, the effects of unconventional monetary policy are very limited and uncertain.

There is therefore much to be said for avoiding the trap in the first place in the future, and this raises again the question of the inflation rate. There is wide agreement that in most advanced countries, it would be good if inflation was higher today. Presumably, if it had been higher pre-crisis, it would be higher today. To be more concrete, if inflation had been 2 percentage points higher before the crisis, the best guess is that it would be 2 percentage points higher today, the real rate would be 2 percentage points lower, and we would probably be close in the US to an exit from zero nominal rates today.

We should not dismiss the possibility, raised by Larry Summers that we may need negative real rates for a long time. Countries could in principle achieve negative real rates through low nominal rates and moderate inflation. Instead, we are still facing today the danger of an adverse feedback loop, in which depressed demand leads to lower inflation, lower inflation leads to higher real rates, and higher real rates lead in turn to even more depressed demand.

Turning to liquidity provision: in advanced countries (but, again, the lesson is more general), we have learned that runs are relevant not only for banks, but also for other financial institutions, and for governments. In an environment of high public debt, rollover risks cannot be excluded. An implication, and one of the themes emphasized by Paul Krugman, is that it is essential to have a lender of last resort, ready to lend not only to financial institutions but also to governments. The evidence on periphery sovereign bonds in the euro area, pre and post the European Central Bank’s announcement of outright monetary transactions, is quite convincing on this point.

Finally, turning to capital flows. In emerging markets (and, more generally, in small advanced economies, although these were not explicitly covered at the conference), the evidence suggests the best way to deal with volatile capital flows is by letting the exchange rate absorb most—but not necessarily all—of the adjustment.

The standard argument in favour of letting the exchange rate adjust was stated by Paul Krugman at the conference. If investors want to take their funds out, let them: the exchange rate will depreciate, and this will lead, if anything, to an increase in exports and an increase in output.

The Lessons of the North Atlantic Crisis for Economic Theory and Policy (Wonkish)

An interesting, but long, piece on the lessons from the crisis by Joe Stiglitz:

In analysing the most recent financial crisis, we can benefit somewhat from the misfortune of recent decades. The approximately 100 crises that have occurred during the last thirty years –as liberalisation policies became dominant – have given us a wealth of experience and mountains of data. If we look over a 150-year period, we have an even richer data set.

With a century and half of clear, detailed information on crisis after crisis, the burning question is not ‘How did this happen?’ but ‘How did we ignore that long history, and think that we had solved the problems with the business cycle’? Believing that we had made big economic fluctuations a thing of the past took a remarkable amount of hubris.

Markets are not stable, efficient, or self-correcting

The big lesson that this crisis forcibly brought home – one we should have long known – is that economies are not necessarily efficient, stable or self-correcting.

There are two parts to this belated revelation:

One is that standard models had focused on exogenous shocks, and yet it’s very clear that a very large fraction of the perturbations to our economy are endogenous.

There are not only short run endogenous shocks; there are long run structural transformations and persistent shocks. The models that focussed on exogenous shocks simply misled us – the majority of the really big shocks come from within the economy.

Secondly, economies are not self-correcting.

It’s clear that we have yet to fully take on aboard this crucial lesson that we should have learned from this crisis: even in its aftermath, the tepid attempts to fix the economies of the United States and Europe have been a failure. They certainly have not gone far enough. The result is that we continue to face significant risks of another crisis in the future.

So too, the responses to the crisis have not brought our economies anywhere near back to full employment. The loss in GDP between our potential and our actual output is in the trillions of dollars.

Of course, some will say that it could have been done worse, and that’s true. Considering that the people in charge of fixing the crisis included some of the same ones who created it in the first place, it is perhaps remarkable it hasn’t been a bigger catastrophe.
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This is more than just a balance sheet crisis. There is a deeper cause: The United States and Europe are going through a structural transformation. There is a structural transformation associated with the move from manufacturing to a service sector economy. Additionally, changing comparative advantages requires massive adjustments in the structure of the North Atlantic countries.

More here: The lessons of the North Atlantic crisis for economic theory and policy | vox.

Conflicting Theories About How to Fix the Economy

Ok, this post is more for my own archives than for general reading. Some hard-core economics on the policy options available for the US government (Complete with colourful charts and the like):

A Visual Guide to the Conflicting Theories About How to Fix the Economy.

End This Depression Now!

Paul Krugman on his new book. Short, 20-minute talk and then Q&A:

The Rescue Plan (h/t Pranav Nagendran)

Pranav pointed me to this morbidly amusing little cartoon. It pretty much sums up the American situation right now I think. The once beleaguered banks are now well along the road to profitability. Yet, political focus remains on keeping the bankers safe and fighting the non-existent threat of inflation and bond vigilantes. All this while metaphorically, the rest of America still “burns”.

Chairman Bernanke Should Listen to Professor Bernanke

Krugman’s article on the American Economic situation. Good if you want a plain-language introduction to what’s happening, and what needs to be done:

Chairman Bernanke Should Listen to Professor Bernanke – NYTimes.com.