Macro-economic policies in the post-crisis economy

As the crisis has continued for the last three years, longer than most economists predicted, it increasingly raises self-doubt among economists and invites a rethinking of macro-economics and the way macro-economic policies are conducted. In March last year, the chief economist and director of the Research Department of the International Monetary Fund (IMF), Olivier Blanchard, hosted a two-day conference on “Macro and Growth Policies in the Wake of the Crisis” which included prominent economists and policymakers looking at macro-economic thinking – or rethinking. The conference focused on six areas: monetary policy, fiscal policy, financial regulation, management of capital accounts, growth strategies and the international monetary system, particularly with respect to the rules of the game and global liquidity provision.

Before the crisis there was a convergence in the thinking of mainstream economists, central bankers and policy-makers toward a rule-based monetary policy framework, emphasising one monetary policy goal – stable inflation, an inflation target consistent with a stable output gap – and one policy instrument. The instrument is the policy (interest) rate, more precisely the policy-rate rule. And that was basically it. Sometimes additional consideration is given to what is known as the “Taylor rule”, which relates the nominal interest rate to the choice of a target nominal interest rate, target inflation and target employment rate, with appropriate weights placed on inflation and unemployment by policy-makers.

The use of this rule, even implicitly, lends credibility to central banks. This together with the fact that monetary policy has the advantage of bypassing legislative processes and shortens the lag in policy response makes it a preferred policy. In spite of this, as Blanchard observed, “this construction was not right: beauty is not always synonymous with truth”.

Two lessons emerged. First, the link between inflation stability and the output gap turns out to be more tenuous than originally thought. Second, even if stable inflation and the output gap are closely linked, there might be problems in the financial sector leading to financial instability, which eventually affects economic activity and output adversely. Practitioners such as central bankers and policy-makers, more so than academics, believe that we need to think about monetary policy as having many targets – inflation, output gap and financial stability or risks – and many instruments, including macro-prudential tools. The latter might include capital controls and other regulations that require changing the rules of the international monetary systems. The IMF is receptive to exploring a new framework.

Let’s turn to discretionary fiscal policy. A key lesson from this crisis is that monetary policy may reach its limits without generating adequate aggregate demand to close the output gap during long and deep recessions. Governments turned to discretionary fiscal policy which can be politically more contentious and controversial. In the US, contentions frequently arise between ideological and pragmatic division. Ideologues hold that what is right ipso facto must work; pragmatists believe that what works is right. Robert Solow, a Nobel laureate in economics and a participant in this conference, observed that the legislative process in the US context had led to “partisan stupidities inside and outside Congress that drive serious students up the wall”.

The appropriate approach to assess the efficacy of fiscal policy is through the use of estimated multipliers – measuring the change in output in response to changes in particular government expenditures or taxes. Unfortunately, these estimates tend to vary widely from negative to slightly positive to greater than one. They are often sensitive to other factors, such as the state of the economy, the character of other economic policies, as well as a good track record of sound public finances, and low public debt.

Thailand is vulnerable to the uncertain global economic outlook because it is heavily export and capital flow dependent. Additionally, it also faces the challenge of accelerating recovery from last year’s floods. As the above suggests, there are many policy instruments that can be coordinated to serve multiple policy goals. According to the IMF Regional Economic Outlook for Asia and the Pacific, Thailand, despite some rising debt ratio in recent years, still has the fiscal space (with debt to GDP ratio estimated at about 60 percent) for an expansionary fiscal policy to support economic recovery. Thailand is largely on track in managing changes in inflation expectations, and in inflation target tracking.

 

Kiertisak Toh is a member of the economics faculty at Radford University, Virginia and a senior fellow at the Centre for International Development, Sanford School of Public Policy, Duke University, North Carolina.