The unexpected policy failures associated with the 2008 global financial crisis have provoked soul-searching among macro-economists. The leading lights among the profession were at the International Monetary Fund's Rethinking Macro Policy conference in April. Olivier Blanchard, the widely admired IMF Chief Economist, encapsulated the state of the debate in his Ten Takeaways: Progress or Confusion?
There is actually more agreement than might be implied by Blanchard's title – and more recognition of how far the conventional wisdom had to be changed to fit the evolving world.
Nowhere is this more evident than with international capital flows. Blanchard 'see(s) this as one area where the rethinking has been striking, compared to ten years ago'.
Indeed, ten years ago the Fund was urging countries to open up their capital accounts for foreign flows, unconstrained by any interference in the market. The promise was that the impact of volatile foreign flows would be ironed out with flexible exchange rates. The new consensus is that the effects of volatile capital flows are complex (impinging especially on the stability of the domestic financial sector) and can't be counter-balanced simply by exchange rate movements. In any case, exchange rates often overshoot, creating problems of their own.
So much for demolishing the old paradigm. Its policy implication was 'masterly inactivity' (leave it up to the market). Now the challenge is to formulate active policies which would address these newly perceived problems. There is less agreement here.
Some see the all-purpose answer in macro-prudential policies: adjusting the financial regulation parameters according to the state of the cycle, imposing lending limits and extra capital requirements during the upswing and easing them in the downswing. Some older hands among the central bankers remember that this is what used to be done before the financial deregulation revolution of the 1980s. But extra constraints on the regulated financial sector cause the action to shift to the less regulated shadow banking sector (this process used to be called 'disintermediation'), leaving the economy still vulnerable to surges and retreats of foreign capital flows.
While not a consensus, the majority opinion now accepts the need for foreign exchange intervention (a no-no in the old world) and restrictions to help manage capital flows, but without any firm belief that this is a complete answer to the challenge.
All this may get a field-test before long, when global financial markets, already twitchy about the impending shift of US monetary policy away from its stance of extreme ease, finally have to respond to the reality of tightening.
As Paul Krugman often reminds his readers, anyone who followed the 1997-98 Asian crisis would have recognised the inadequacy of the free-market view of capital flows. It was only when the problems directly impinged on the advanced economies that mainstream economists (and the Fund) saw the need for rethinking. This process has been assisted by mavericks within the IMF such as Jonathan Ostry, and more recently by the high-profile evangelising of Helene Rey.
This was just one of Blanchard's ten 'takeaways'. We'll return to the other important shifts in policy thinking at a later date.
Photo by Flickr user IMF.