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A paper, co-authored by the IMF’s chief economist, has admitted that orthodox macroeconomic policies may have exacerbated the recent financial crisis. Will the Fund now move away from its traditional insistence on low inflation at any social cost?

More Inflation May Be Better After All, Says IMF - Richard Adams, The Guardian

A Big Rethink at the IMF, with Subtitles for Non-Economists - Duncan Green, From Poverty to Power

When Facts Change, I Change My Mind. What Will You Do, IMF? - Eurodad

Link to IMF paper: Rethinking Macroeconomic Policy - Olivier J. Blanchard, Giovanni Dell'Ariccia and Paolo Mauro

19th February 2010

More Inflation May Be Better After All, Says IMF

12th February 2010 - Richard Adams, The Guardian

After years of lecturing governments on the need for low inflation and minimal intervention, the International Monetary Fund's top economist has admitted that orthodox policies were powerless to prevent the crisis that swept the global economy.

In a stunning turnaround, Olivier Blanchard, the IMF's chief economist, now suggests that higher inflation, help for the poor and greater government involvement might do a better job helping protect countries from financial turmoil.

The suggestions come in a paper published today, Rethinking Macroeconomic Policy [pdf], which is not a formal recommendation by the IMF. But its policy formulations will be greeted with indignation by those on the receiving end of the IMF's orthodox economic prescriptions, especially those whose alternatives were witheringly rejected but now find them being advanced by the fund's senior staff.

The new set of policies includes the need for active intervention to puncture dangerous asset bubbles, such as occurred in the housing market.

Blanchard and his co-authors Giovanni Dell'Ariccia and Paolo Mauro admit with chagrin that policymakers were too complacent in the years leading up to the financial disasters: "It surely puts into question the 'benign neglect' view that it is better to pick up the pieces after a bust than to try to prevent the buildup of sometimes difficult-to-detect bubbles," they write.

"As the crisis slowly recedes, it's time for a reassessment of what we know about how to conduct macroeconomic policy," they concede.

That reassement most controversially includes the possibility of raising the target for consumer price inflation to around 4%, rather than the 2% level that policymakers, including the European Central Bank, Bank of England and UK Treasury, have adopted.

By keeping inflation and interest rates low during good times, policymakers left themselves little room to loosen monetary policy in bad times. "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," argue the authors.

The paper also suggests that avoiding a reliance on monetary policy as the sole tool for economic management, and expansions of the use of regulation and taxation "need to be explored further".

While the paper is intended to start a debate on the best way to achieve stability and fend off shocks, its conclusions are also a blow to the monetarist orthodoxy that western democracies embraced from the late 1970s onwards, in the guise of Thatcherism in the UK and Reaganomics in the US, and then pressed upon developing countries.

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A Big Rethink at the IMF, with Subtitles for Non-Economists

19th February 2010 - Duncan Green, From Poverty to Power

The IMF is doing some very interesting (and praiseworthy) rethinking in response to the global crisis, if a new paper co-authored by its chief economist Olivier Blanchard is anything to go by. It’s written by and for economists, so it’s not exactly bedtime reading (unless you’re an insomniac), but here’s the highlights, and my attempts at translation.

Overview: ‘The great moderation lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy. The crisis clearly forces us to question that assessment.’

Translation: we thought we knew it all. We don’t. Back to the drawing board.

‘To caricature: we thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job. We thought of fiscal policy as playing a secondary role, with political constraints sharply limiting its de facto usefulness. And we thought of financial regulation as mostly outside the macroeconomic policy framework.’

Translation: We thought all you had to do was keep inflation down, and all you needed to do that was vary interest rates to control prices. Government finances were secondary, and anyway, we didn’t like pesky politicians interfering. We thought regulating financial institutions was irrelevant to overall stability. Whoops.

‘It is clear that the zero nominal interest rate bound has proven costly. 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.’

Translation: because we kept inflation rates so low, interest rates were also low, so when the crisis hit and we needed to boost the economy, we only had a bit of leeway to lower interest rates (you can’t take them below zero). Instead we had to spend shedloads of cash, and that has left us with a massive fiscal hangover.

‘The crisis has returned fiscal policy to center stage. It has also shown the importance of having “fiscal space”. The aggressive fiscal response has been warranted given the exceptional circumstances, but it has further exposed some drawbacks of discretionary fiscal policy for more “normal” fluctuations—in particular lags in formulating, enacting, and implementing appropriate fiscal measures (often due to an awkward political process).’

Translation: Fiscal policy really matters, and many governments have tried to spend their way out of recession, but getting spending plans through the legislature takes much longer than dropping interest rates, and gets bogged down in pork. In normal times, it’s better to have other options (like more leeway on interest rates).

‘Identifying the flaws of existing policy is (relatively) easy. Defining a new macroeconomic policy framework is much harder. The bad news is that the crisis has made clear that macroeconomic policy must have many targets; the good news is that it has also reminded us that we have in fact many instruments, from “exotic” monetary policy to fiscal instruments, to regulatory instruments. It will take some time, and substantial research, to decide which instruments to allocate to which targets, between monetary, fiscal, and financial policies.’

Translation: Damn, life is more complicated than we thought. Still, lots of work for us researchers….

‘The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers 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 percent than at 2 percent, the current target range? Answering these questions implies carefully revisiting the list of benefits and costs of inflation.’

Translation: We think we need to double inflation targets to give governments more room for manoeuvre on interest rates. But hold on a minute, we work for the IMF, so we’d better play safe and pretend we’re merely posing this as a question.

‘If one accepts the notion that, together, monetary policy and regulation provide a large set of cyclical tools, this raises the issue of how coordination is achieved between the monetary and the regulatory authorities, or whether the central bank should be in charge of both. The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators.’

Translation: The economy is just too important to be left to elected politicians. Why not put the Central Bank in charge of everything? 

This paper is mainly about policy in the rich countries, but if the change in tone ‘trickles down’ into the Fund’s work in poor countries, it should at least lead to a reduction in its traditional insistence on low inflation at any social cost. Encouraging signs? Further coverage in the FT and on the Vreelander blog.

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When Facts Change, I Change My Mind. What Will You Do, IMF?

18th February 2010 - Eurodad

In a paper published this week, “Rethinking Macroeconomic Policy”, the International Monetary Fund chief economist Olivier Blanchard recognises that the Fund was wrong in some of the macroeconomic policies advised in the last three decades. Stringent macroeconomic policies – such as very low inflation, neglecting the crucial role of fiscal policy, and financial sector deregulation – often attached as conditions to IMF loans for developing countries, are now listed among the old sins that made a bad crisis worse.

Such public recognition gives even more credit to academics and NGOs who said from an early stage that the IMF’s advice was hampering growth and poverty eradication in developing countries. However, this is just a first step in the right direction. The main challenge ahead for the IMF chief economist is to break the institution free from the straightjacket of their old policy framework, and acknowledge the need for a more nuanced approach to macroeconomic policy so that developing countries can implement alternative policies to ensure stability as much as equitable growth.

IMF’s Macroeconomic Policy Advice Was Wrong, Says Chief Economist

The IMF staff position note published this week is one of the most candid acknowledgements by the Fund in the last thirty years acknowledging that it is not infallible – and an implicit recognition that critics were not as misguided as they were portrayed to be a few years ago. Beginning with a shocking statement that critics have been longing to hear, “It was tempting for macroeconomists and policymakers alike to take much of the credit for the steady decrease in cyclical fluctuations from the early 1980s on and to conclude that we know how to conduct macroeconomic policy. We did not resist the temptation…we were wrong,” the paper is the Fund’s official recognition of the demise of the Washington Consensus.

More specifically, the paper recognises that the IMF’s approach to monetary policy was too narrowly focused on inflation and debt sustainability, and neglected the importance of fiscal policy and financial regulation. “We thought of monetary policy as having one target, inflation, and one instrument, the policy rate…thought of fiscal policy as playing a secondary role…and of financial regulation as mostly outside the macroeconomic policy framework,” they say. This means that the IMF turned a blind eye to problems which, in advanced economies, were seen as belonging to history, such as “the liquidity traps of the Great Depression”; they neglected fiscal policy as it was seen as “likely to be distorted by political constraints”; and they also dismissed the systemic importance of regulating the financial sector “given the enthusiasm for financial deregulation.” The paper also recognises that the global crisis brought to light fundamental flaws of this IMF approach, particularly as such limited policy tools proved to be insufficient for crisis response in advanced economies.

However, the paper fails to recognise that the neglect of tools in monetary policy other than inflation, and the oversight of the key role of fiscal policy and financial regulation have seriously hampered developing countries’ efforts to raise and retain much needed resources for development. This has for the last three decades had deadly effects on the poorest countries of the world.

The World’s Poor Paying the Price for the IMF’s Temptations

Not only was the IMF’s macroeconomic policy advice often wrong, as has now been acknowledged, but most importantly for developing countries, the fund did not take into account that the conduct of these policies needs to be tailored to developing country circumstances. Also, monetary or fiscal policies are not neutral – as the IMF tended to assume – in fact they have a tremendous impact on equity and development.

NGOs and academic research repeatedly warned throughout the decade that stringent monetary and fiscal policy (such as 2% inflation targets, caps on the wage bills, and stringent targets for governments’ borrowing) were threatening the scaling up of aid and achieving the Millennium Development Goals.

ActionAid’s report “Contradicting Commitments” showed that the IMF’s stringent monetary policies present serious challenges for the ability of countries’ to generate more revenues, and correspondingly increase spending on health and education. A Ministry of Education official from Sierra Leone quoted in the report explained that “IMF policies create and sustain poverty. IMF/World Bank policies are diametrically opposed as the former stymied the realisation of the latter.”

Research by UNDP’s International Poverty Center, “Pro-Growth Alternatives for Monetary and Financial Sector Policies in Sub-Saharan Africa”, shows that “setting the inflation threshold at five per cent creates by itself a slow-growth bias since the primary methods recommended for dampening inflationary pressures are to raise nominal interest rates and cut government spending.” Yet, IMF advice has focused on keeping very low levels of inflation, bypassing distributional implications.

Even in the context of the current financial and economic crisis, Eurodad research “Bail out or blow out? IMF policy advice and conditions for low-income countries at a time of crisis” found that the majority of IMF programmes still advise countries to keep inflation below 5% and prioritise rebuilding of reserve positions, rather than spending. While it is important that countries count on a reasonable level of reserves to weather external shocks, joint Eurodad, Solidar and Global Network research “Doing a decent job?” also points out that “the burden of exchange-rate management and making the necessary adjustments was expected to fall entirely on these deficit countries individually, while ignoring the continuing problem of global imbalances. Exchange rate fluctuations and volatility is simply accepted as a given, and countries are expected to take steps to adjust to the market’s vicissitudes. No steps are being taken to address structural imbalances in the global economy through establishing mechanisms for multilateral exchange rate coordination, leaving a gaping hole in the current global financial architecture.”

When the Facts Change, I Change My Mind. What Will You Do, IMF?

As Keynes famously said, he would change his mind when the facts changed. It still remains to be seen whether the IMF can live up to such Keynesian standards. The spirit of the paper and its promises for further reform at the Fund are most welcome. However, it is unfortunate that despite criticism by NGOs and heterodox macroeconomists the Fund had to wait until the debacle of the current global crisis to understand that a complex set of objectives ranging from macroeconomic stability, growth, employment, and adequate provision of credit – among others – require a complex mix of policy tools which cannot end in the overly simplistic inflation targeting that dominated past policy advice. Most importantly, the Fund must understand that developing countries should be allowed to implement macroeconomic policies that are tailored to their needs for equitable growth and poverty eradication.

The Fund’s call for a more flexible monetary policy- flexibilising inflation just from 2% to 4%, and emphasising that price stability remains the main focus of monetary policy-  falls short of any decisive departure from the old orthodoxy. As with the Fund’s half-hearted support for fiscal stimulus during 2009 (only for few a countries, and only for a very short period), the newly published paper still fails to acknowledge the need to allow developing countries to consider alternative policy frameworks which also take into account considerations such as equitable growth or employment creation – beyond the considerations for macroeconomic stability.

However, even if there remains a lot to be desired, such changes open up policy space for developing countries to choose among a broader set of policies- going beyond what used to be the IMF’s iron laws on monetary and fiscal policies.  What Ilene Grabel has called IMF’s “productive incoherence in an uncertain world” could lay the ground for the final demise of the Washington Consensus.

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