Mike Callaghan is Director of the Lowy Institute's G20 Studies Centre.
The world is going through a macroeconomic policy experiment, with many countries having very high levels of public debt, short-term interest rates close to zero, and central banks with balance sheets bloated with public debt and other assets as a result of aggressive quantitative easing. How will the experiment end?
We hope we are heading in the right direction, but the emphasis is on hope. The use of such descriptive words as 'unorthodox' and 'extraordinary action' by central banks aptly signals that we are in an unusual policy space. History is not a good guide for forecasting outcomes.
Long-standing market relationships have broken down as a result of this policy experiment. Stock prices in Europe used to be inversely related to unemployment levels. But since 2011, both stock prices and the unemployment rate have been rising.
We may not know how the experiment ends, but one thing that should be clear is that close international cooperation is required, particularly when it comes to exiting from these policies, a point emphasised by Erik Opper (How to Make a Graceful Exit: The Potential Perils of Ending Extraordinary Central Bank Policies). This should be seared into the minds of G20 finance ministers and central bank governors.
In February 2010, Olivier Blanchard, the IMF's Economic Counsellor, released Rethinking Macroeconomic Policy. In this paper he observed how the crisis had exposed flaws in the pre-crisis policy framework (such as monetary policy having one target, inflation, and one instrument, the policy rate), forced policy makers to explore new policy tools, and forced a rethink of the architecture of macroeconomic policy.
Blanchard released an update in April 2013 called Rethinking Macro Policy II: Getting Granular, and this was the topic of a seminar at the recent IMF meetings in Washington. In the latest paper, IMF staff note that while it is five years since the crisis, the contours of a new macroeconomic policy consensus remain vague. The relative roles of monetary, fiscal, and macro prudential policy remain unclear. Blanchard concludes: 'where we end up is likely to be the result of experimentation, with learning pains but with the expectation of more successful outcomes'.
The period of policy experimentation has been described as 'navigating by sight'. We may have a general sense of where we want to go, but there is no agreement on the right policy tools to get there, let alone the exact final destination. What this means is that in these uncertain times, policy makers have to be alert to developments and flexible enough to adjust policy as required.
This is also the case for international efforts to strengthen financial regulation. Notwithstanding new capital and liquidity standards with Basel 3, there is no agreed vision of what the future structure of the financial system should look like, and as a consequence, no agreement as to what the appropriate regulation should be. Blanchard notes that there is uncertainty and disagreement about the effects of the agreed measures to strengthen financial systems through higher capital ratios on funding costs and lending.
Some feel the new regulations do not go far enough, David Romer from the University of California believes that the changes to date are helpful but unlikely to be enough to prevent future financial shocks from inflicting large economic costs. Again, policymakers have to be alert and prepared to respond. And given the extra-territorial implications of many of the measures, close international cooperation is required.
The main risk when central banks eventually exit from unconventional monetary policies is a more-rapid-than-expected rise in interest rates. Central banks will start to increase rates and they may begin selling some of their bond holdings. Bond prices will fall. If markets respond by seeking to get out of bonds, prices will fall further and interest rates will spike. Central banks and financial institutions with large bond holdings will incur large capital losses. Higher interest rates may make it harder for customers to repay loans and may bring into question the sustainability of governments with large public debt levels. They may also lead to potentially large and disruptive capital flows and exchange rate movements.
Exit policies will need to be well planned and well communicated. As the premier forum for international economic cooperation, the need for close cooperation during this period of policy experimentation should be front and centre at the meetings of G20 finance ministers and central bank governors.
Photo by Flickr user practicalowl.