Blanchard on macroeconomic policy

There is an extensive interview with Olivier Blanchard on the IMF website, and a link to his recent paper on the future of macroeconomic policy making (co-authored with Giovanni Dell’Ariccia and Paolo Mairo), here. I can see this one ending up on lots of undergraduate reading lists.

Update: Krugman likes the paper, which makes sense. He alo cites a completely different argument in favour of moderate levels of inflation, which made quite a splash a few years ago: given that it is hard to cut nominal wages, inflation can be very useful in lowering real wages, when that is what is required.

Real wage reductions are required in Ireland, but nominal wage reductions remain elusive here, despite the spin. Can anyone doubt that Irish real wage adjustment would be easier if we could rely on higher inflation rates to do the bulk of the work?

14 replies on “Blanchard on macroeconomic policy”

Well there is plenty for undergraduates to find to debate in this paper, but I’m not sure policymakers would come out much the wiser after reading it.

We have grown to expect from the IMF research with good, sensible and practical advice for governments. This paper for me is light on useful analysis, and makes some broad brush but confused statements about history and policy making. Maybe that reflects the difficulty of such an enormous topic, or possibly it comes from several authors grappling with the issues in different ways.
What I particularly didn’t appreciate is that the more incendiary statements in the paper were leaked (to the WSJ in this case) before it appeared on the IMF website. That helped create a buzz around its publication. But it does not behove a serious research institution to continue playing this game.
In the section, “IMPLICATIONS FOR THE DESIGN OF POLICY”, the advice is seemingly orthodox at first…
“Stable inflation must remain one of the major goals of monetary policy. Fiscal sustainability is of the essence, not only for the long term, but also in affecting expectations in the short term.”
But not quite… the shock quotes picked up in the pre publication buzz and interviews are these ones…
“The crisis has shown that large shocks to the system can and do happen. … Maybe policymakers should therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks. To be concrete, are the net costs of inflation much higher at, say, 4% than at 2%, the current target range? Is it more difficult to anchor expectations at 4% than at 2%? At the same time, it is clear that achieving credible low inflation through central bank independence has been a historic accomplishment, especially in several emerging markets. Thus, answering these questions implies carefully revisiting the list of costs and possible benefits of inflation. “
“when the inflation rate becomes very low, policymakers should err on the side of a more lax monetary policy, so as to minimize the likelihood of deflation, even if this means incurring the risk of higher inflation in the event of an unexpectedly strong pickup in demand. This issue, which was on the mind of the Fed in the early 2000s, is one we must return to.”
So we need stable inflation… maybe “slightly” higher “stable” inflation, without upsetting anyone, but we don’t know, and we will return to it. there you have it. So the bark might be worse than its bite. There is no bite as the paper remains frustratingly vague all the way through.

The reason why we need higher inflation is because
“2% inflation seemed to provide a sufficient cushion to make the zero lower bound unimportant”, and that hasn’t been the case.
Effectively, if bond yields remain low, it is because of the fear that deflation still beckons over the coming years, especially if the bigger OECD governments get their public deficits down quickly enough.
The IMF also asks if we can go from a 2% inflation target to 4% and still keep credibility. The answer is a firm No. It’d be far more difficult to anchor expectations in such a shift, let the keep the ship on course at double the speed, once the adjustment to the new target is made.
There are a broader set of reasons why higher inflation could have been / could still be, useful
“Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions.”
A hint here of the nightmare of all bond investors Effectively governments could have skimped on their debt by inflating the economy. And could still do. But the paper goes no further than dropping a hint.
The paper makes the sweeping statement “It appears today that the world will likely avoid major deflation”. Well that depends on how policy shapes up. If there is a substantial cut in the budget deficits of major economies, there are fair odds still of deflation.
The paper makes a number of off the cuff, confusing and highly debatable remarks.
e.g. look at what it has to say about fiscal policy…by contrasting the following quotes
“in advanced economies, the priority was to stabilize and possibly decrease typically high debt levels”
“Some advanced economies that entered the crisis with high levels of debt and large unfunded liabilities have had limited ability to use fiscal policy.”
“policymakers had little choice but to rely on fiscal policy” “from its early stages, the recession was expected to be long lasting, so that it was clear that fiscal stimulus would have ample time to yield a beneficial impact”.
“Discretionary fiscal policy measures usually come too late to fight the downturn because it takes time to put in place tax cuts or new spending measures”.
“Those emerging market economies (some, for example, in Eastern Europe) that ran highly procyclical fiscal policies driven by consumption booms are now forced to cut spending and increase taxes despite unprecedented recessions.”
“we should revisit target debt to GDP ratios. Maybe we should aim for much lower ratios than before the crisis. This is a long way off”

These statements appear superficial, contradictory and each all too questionable to me. Ricardian equivalence is dismissed, with little acknowledgement of the long term costs of ever higher public debt.

The paper claims that for economic policy “the focus was primarily on debt sustainability and on fiscal rules designed to achieve such sustainability”
Again a cloud cuckoo re interpretation of recent economic history.
The authors confuse talk with action e.g. “the focus in advanced economies was on prepositioning the fiscal accounts for the looming consequences of aging”
There was lots of talk about demographics, but hardly anything was done, and that is a contributory factor to today’s crises.
The paper derides the assumption that ” all interest rates and asset prices were linked through arbitrage.” and doesn’t seemingly like the Taylor Rule either, although the paper is strong on the need for policy makers to follow rules on the whole.
It suggests that economics was an art where “the details of financial intermediation are largely irrelevant”. A sweeping statement, and not quite true.

Of course it is easy to deride past policies. It is far harder to propose good alternatives.

The paper argues
“Little thought was given to using financial regulation as a macroeconomic policy tool”
The reason why is that it is difficult to conceptualise like monetary and fiscal policies, and still is.

The paper nevertheless proposes “macroprudential measures should be updated on a regular and predictable (or even semiautomatic) basis to maximize their effectiveness through a credible and understood policy stance.
Easy to propose. The devil is in the detail, and there is none in this paper.

The IMF is the agent of many western bankers. As the banking system is insolvent, the IMF is a spent force. The owners of the banks are withdrawing capital and dumping debt into so called sovereign borrowers. No glittering careers beckon after the IMF anymore. Too derided and well known…

They, the company etc await the bottom. They will ensure it comes sooner than later, so I side with them! But they underestimate the damage done. They may have miscalculated with China and India too. We shall see. Both those civilizations are far older than the west. India may have invented banking and China had it when Marco Polo introduced it to Venice(?).

So a spectacular failure is to be celebrated by a continuation of the juvenile assumptions underpinning the ‘Theory’!

Sunk Costs. You walk away from them! Lott like! But do Ye (of the economic faithful) have the testicles to do so? Theories that work in theory (that is; logical arguments) need to be replaced by Practical Processes that will work in practice. Not forgetting of course, our venial legislators who stare fixedly at the next date of the General Election!

Are Ye up to this intellectual challenge?

B Peter

You are right that inflation would help achieve real wage reductions when nominal wages are very resistant to reduction.

But we are enduring deflation and, more to the point, deflationary tendancies will persist as:

a. the ECB adopts an overly restrictive monetary policy; and
b. even a more rleaxed monetary policy appropriate for the Eurozone as a whole would be overly restrictive for Ireland as (i) our output gap is higher and (ii) our inflation is lower.

Time for regime change at the ECB?

@ Kevin O’Rourke

Why the focus on cutting real wages in Ireland?

Ireland has amongst the lowest real unit costs (wage share) in the Eurozone and relatively high nominal unit costs. The reason for this disparity our high price index.

The focus should not be on wages, but on cutting these other non-wage costs such as rents, electricity, professional fees and so on.

“Rethinking Macroeconomic Policy” is of course the name of the paper. And that is no small ambition. The authors “start by stating the obvious, namely, that the baby should not be thrown out with the bathwater. Most of the elements of the precrisis consensus, including the major conclusions from macroeconomic theory, still hold.” (Effectively, that would be my view too).
Hard then to create much of a revolution with these precepts, unless of course you selectively quote on one item – like Krugman does. That doesn’t advance us much in a debate (and no takers here it seems so far).

It would have been productive to have had a debate on this blog on fundamental issues such as “Rethinking Macroeconomic Policy”. Local political items like George Lee can get 235 comments (and counting), and speculative articles by journalists also attract good scores. Unfortunately they crowd out the more profound analytic issues like this. A pity.

Turning to more immediate challenges, Kevin, you have all the time been pushing for policies that encourage higher aggregate demand over the past year, namely driven by higher government spending. You are getting it…with double digit public deficits in the US and the UK, and deficits of 15%+ GNP in Ireland. And we have had a structural rise in OECD public deficits over the past 20 years.
However you still want us focus on three aspects in analysing how to exit the current round of crises.

1) “deficits will continue to rise if the real economy worsens”
Well no they won’t, because come hell or high water, there is going to have be quite a sharp turn around in the year or years to come.

2) “the more the ECB does to loosen monetary policy, the less is the burden which fiscal policy has to shoulder”.
Cloud cuckoo land again. Monetary conditions can barely become easier. They can become a lot tougher. And it makes eminent sense for the ECB to threaten tough love… and even to carry it out. Especially if collective mindsets like yours are driving fiscal policy !

3) “if we experience another year like 2008-2009 any time soon, the probability of a wave of defaults will rise sharply”.
At last, something we can agree on! And worth preparing for. Governments and central banks – at least the better ones – are or will be preparing contingency plans.

Part of the role of the economics profession is to dispel the myth that there are free lunches, while supporting good cuisine, and especially good value cuisine. The public and their governments collectively seem to think that they just need to stoke the appetite, rather than putting the bloated consumer on a diet. Wrong.

Okay, here goes.

Monetary policy should sit in a band. Interest rates should be goldilocked to deal with internal issues, not external ones. The band for the eurozone should be between, say, 3% and 7%, that is, money shouldn’t be cheaper than this or more expensive than that. The point being that money should be neither free nor prohibitively expensive. If either of those scenarios occur, bad things start to happen.

Bad things at the higher bound – all sorts of stuff starts to go bust.

Bad things at the lower bound – all sorts of things become desperate to make a return that they need so they won’t go bust in the future – insurance companies, banks, pensioners, &c. I suspect the results of low interest rates are not just chasing higher yielding structured assets, but actively betting against other assets – the rise in sovereign yields is a result of the necessity in having higher sovereign yields…

So what should happen then for currency or liquidity?

The ECB has already shown that it can manage liquidity through repo, varying haircut by quality and finessing the haircuts as required. Exceptional measures should be available as standard with greater emphasis on ratings (i.e. on their accuracy). Ratings need to be future proofed (easier said than done, I guess). Duration and haircut could then be flexible measures – when the ECB sees no stress, it can make duration short and haircut high. In times of stress, duration can be lengthened and haircut lowered. In effect, the ECB acts in an anti-cyclical manner to preserve money cost stability.

As for currency (and indeed for liquidity), QE and QT (Quantative Tightening) can be used, that is the ECB buys or sells in the market (creates or locks up liquidity). If they do this is foreign currencies, they can effectively manage the level of the currency. This is, after all, what the Chinese Central Bank do with their treasury purchases. No?

PS I also think we need a different framework for measurement within a currency area and indeed within the global economy.

Inflation, whether HICP or CPI is largely meaningless. It counts and omits too much to reflect increases in costs that might drive prices or wages. GDP is a busted flush. It too does not reflect what needs to be known. What we need is something that will measure whether ‘wages’ or wage-like equivalents (such as tax breaks, pensions, future ‘promises’, interest on debt, rent) are exceeding ‘growth’ (as in the productive output of the economy to satisfy those wages).

“The IMF also asks if we can go from a 2% inflation target to 4% and still keep credibility. The answer is a firm No. It’d be far more difficult to anchor expectations in such a shift, let the keep the ship on course at double the speed, once the adjustment to the new target is made.”

Why so? What’s so special about 2%?

@James Conran

There is absolutely nothing ‘special’ about the “2%” – it merely reflects the imposition of the institutional power of key actors on a complex reality and live-as-lived under the delusion that human reality can be made to fit abstract mathematical equations ………. it is in part based on objective reality, but is incapable of incorporating either social or subjective realities – yet it impacts on both of the latter. In other words, neo-classical economics, notwithstanding its usefullness, has its limits. The trouble begins when these limits are not recognised or when ideological delusions – such as self-correcting totally free markets – are taken to be ‘facts’ or projected as the equivalent of ‘fundamentalist religious dogmas’ ……


I just read page 15. It suggests that making ‘taxes more progressive or to make social insurance programs more generous’ might actually be positive (though there are qualifications).

Sounds more like the International Metalworkers Federation than International Monetary Fund.

@Rory O’Farrell

Live a year in Scandinavia …. preferabley with a bit of Scandinavian company …. experience the quality of life ……. pack a few wooly jumpers, a good leather jacket, and an open mind (-; Enjoy!

@Ciaran O Hagaan

“It would have been productive to have had a debate on this blog on fundamental issues such as “Rethinking Macroeconomic Policy”. Local political items like George Lee can get 235 comments (and counting), and speculative articles by journalists also attract good scores. Unfortunately they crowd out the more profound analytic issues like this. A pity.”

Hear hear

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