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Dangerous Thoughts about the Financial Crisis at the IMF

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On March 7-8, the International Monetary Fund organized a major conference on macroeconomics in the wake of the global financial crisis. IMF chief economist Olivier Blanchard led the proceedings. This event drew prominent speakers at a time when the fund is engaging in a reconsideration of macroeconomic policies. What struck me, however, was the contrast between what was said at the session, particularly Blanchard's summary, and how differently I see the new reality and what should be IMF aims.

A great new division has opened up between the Anglo-American macroeconomic mainstream and the rest of the world. As presented by Blanchard, “macroeconomics” focused on one target, inflation, and one instrument, interest rates. Now more targets and instruments are needed, the meeting was told. Well, did not most economists think so all along? Many economists have long argued for the need for nominal targets and anchors, notably limits to leverage, credit expansion, budget deficits, and public debt. Most of the world knew this and are now looking in amazement at the Anglo-American economists, who would be better served by a mea culpa than any claim that all we thought was wrong.

Former Mexican central bank governor Guillermo Ortiz pointed out that the crisis was the institutional failure of the Anglo-American system and that no emerging market suffered a crisis because of the global financial crisis, not least because they did not separate monetary policy from financial stabilization. It was no accident that emerging economies did not have toxic assets: They were not allowed to have them by the financial regulators. The same was true of Poland, the Czech Republic and Slovakia in Europe.

A major battle cry of the Blanchard camp, most clearly formulated by Dani Rodrik and David Romer, is that “this is a brave new world” and that rules must not be specified. Especially, they are attacking the old Washington consensus, seemingly not realizing that all the many emerging economics that maintained or drew closer to the Washington consensus did well. Instead, they advocate “pragmatism,” which is nothing but the absence of norms and theory. The essence of such normlessness is that central banks, governments and the IMF will be justified in doing whatever their bosses may desire. This is a truly dangerous idea that could cause more crises.

A strong countercurrent, both on the right and the left, argues on the contrary that it was the brave new world of irresponsible central banks and governments that failed in the last few years, and that we need to go back to firmer rules, such as the Washington consensus with its limited number of major ideas. Many European countries are now introducing fiscal discipline rules in laws and constitutions to avoid a repetition of the fiscal irresponsibility of recent years. The argument for or against rules seems to be replacing the old battle between right and left in fiscal and monetary policy.

Hopefully, most economists now agree that massive monetary activism of the large western central banks, led by US Federal Reserve, was the main cause of the global financial crisis, while the absence of fiscal discipline in the United States and much of old Europe have contributed to it. Naturally, these vast amounts of loose cash undermined regulation in many places, as always happens when too much money is sloshing around. At the IMF conference, however, the speakers were selected so that calls for even more discretionary fiscal policy dominated, mainly from Blanchard and David Romer.   

The crisis has shown that fiscal policy is key. The old idea has proven correct that governments should maintain budget surpluses in good times in order to have fiscal space to expand during crises. This is the policy prescription followed by many successful economies, from China to Sweden to Kazakhstan. Early and large fiscal adjustments, mainly through expenditure cuts, as shown by the economist Alberto Alesina, have proven most successful, but these insights were waved away at the IMF meeting.

Ortiz pointed out that all countries except for the United States and Japan have carried out fiscal consolidation. A natural conclusion would have been that Sweden's budget rule of a budget surplus of 2 percent of GDP over the business cycle would be preferable. Similarly, public debt must be kept lower than previously was perceived to be wise. Ireland's example shows that the Maastricht limit of a public debt of 60 percent of GDP is far too high in ordinary times, and that a level perhaps half as high would be preferable. Minimal public debt levels saved the Baltic countries. In these cases, stricter rules are needed, not their abandonment.

The discussion of financial regulation made a lot sense because it focused on monetary policy. Interestingly, Joseph Stiglitz joined Ottmar Issing in criticizing loose monetary policy, notably QE2, which they rightly accused of having destabilized the global economy. Stiglitz emphasized that it was movements of credit that had caused the crisis and called the risk of disorderly credit expansion and its unraveling the central failure of monetary policy. He complained about the lack of models for credit and criticized the working of the banking system in macroeconomics. Preoccupation with inflation, Stiglitz said, had led to neglect of the much more important goal of financial stability. QE1 had bailed out the banks in a massive, nontransparent redistribution of wealth in 2008-9, and QE2 has now destabilized global credit markets.

Princeton Professor Hyun Song Shin showed how loose monetary policy destabilized the global economy. He presented most interesting assessments of carry trade, noting that the net non-core dollar liabilities of 160 foreign banks in the United States currently amounts to $600 billion. This money is borrowed cheaply in the United States, because of the low interest rates, by Americans and foreigners who then use it to purchase more attractive assets abroad. Thus, this money is not invested int the US economy, though it depresses the dollar exchange rate.  Some would call this currency manipulation, though Shin did not. He called on central banks to lean against asset bubbles, changing the composition of capital flows rather than the total amount, by trying to reduce non-core liabilities through macroprudential regulation. A levy could be imposed on short foreign exchange bank liabilities, which bites hardest during the boom. Similarly, Adair Turner argued that the central problem is to regulate the supply of credit, because debt cycles are far more harmful than equity cycles.

One of Blanchard's strange conclusions was that the pendulum had swung from markets to the state. But the main problems are loose, discretionary monetary and fiscal policies, which are both state failures. The failure of regulation is a complex issue involving both state and market failure, reflected in a weak and captured state that regulates the details but not the principles. Ultimately, it is a matter of poor governance.

One of the oddest presentations was Paul Romer's. Effectively, he discussed Oliver Williamson's old theme of hierarchies versus markets, but he praised hierarchies, such as US Fed and the military, as enforcement systems and objected to legalistic processes with judicial oversight. This presentation dealt entirely with the United States, which is probably the only country to have such big problems with judicial oversight or parasitical trial lawyers. His answer was that we should rely more on executive action. Well, because of the US Constitution, the US has these very specific problems generating the most voluminous and therefore the worst laws in the world. Disturbingly, democracy and transparency did not enter his reasoning.

The big lesson from the political economy of the crisis is instead that people are prepared to accept large fiscal cuts, if they come early, are well explained, and are distributed in a socially just way, as the three Baltic countries have done especially well. But this was not discussed. Moreover, the Estonian and Latvian governments, as well as the Swedish government, have been reelected. Today, center-right governments rule no fewer than 23 of the 27 EU countries -- that is, more than ever. The voters want fast and credible solutions, not QE2, and they are voting for more market and less state.

Curiously, the role of the IMF and other international organizations in the crisis was hardly discussed. My view is that the IMF has acted well by moving even faster than usual, having programs focused on the essentials of the Washington consensus, and providing much larger financing than previously. Still, a useful discussion of swap lines took place, which should probably be further expanded in crisis but the pre-committed, as those who were left out suffered badly. The US Fed did well, offering large amounts early, while the European Central Bank did almost nothing.

My conclusion from this very interesting and stimulating conference is that the world has reason for worrying what kind of ideas the IMF will embrace. Another worry is how far the dominant thinking about macroeconomics is in the United States from both the rest of the world and common sense. These concerns raise a third worry about what the IMF may come up with in the future, having built up a huge money hoard without having any clear policy any longer.

Anders Åslund is a senior fellow of the Peterson Institute for International Economics and author of the book The Last Shall Be the First: The East European Financial Crisis.

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