Tag Archives: monetarism

The IMF’s Policy Shift

IMF Board

IMF Managing Board

Last Friday, the International Monetary Fund released a staff position note  (basically, a working paper) entitled “Rethinking Macroeconomic Policy.” The impetus for the paper, writing in a surprisingly clear and jargon-free tone, seemed clear enough. In the introduction, the authors argue that macroeconomists and policymakers had been lulled into a false sense of complacency about how to conduct macroeconomic policy. The onset of the global economic crisis—or perhaps more accurately, the inability of our macroeconomic policy toolkit to address the crisis—challenged that complacency, creating the need to rethink our policies.

But the surprising part doesn’t come from the paper’s assertion that we need to think about what our post-crisis macroeconomic policy might look like. Rather, the surprising part—and the part that has generated considerable discussion in the blogosphere—are the recommendations themselves. The report recommends that central banks and the International Monetary Fund make several key changes in their policy outlook:

  1. Increasing the inflation target from 2 to 4 percent.
  2. Automatic lump sum payments should be introduced for poorer families if unemployment crosses a pre-determined threshold.
  3. Exchange rate intervention should be permitted for developing countries heavily dependent on international trade.
  4. Central banks should be granted greater regulatory authority and capacity.

These proposals represent a dramatic departure from the Washington Consensus [glossary] that dominated international economic policy since the early 1980s. Indeed, the Financial Times noted that, “The suggestion that inflation targets should be raised to 4 per cent will cause many central bankers to choke on their breakfasts, since they have spent their whole careers gaining and preserving the creditability of keeping inflation at levels close to 2 percent.”

Needless to say, the proposal has sparked considerable coverage. While Ben Bernanke still seems to be committed to keeping inflation under the 2 per cent target, Paul Krugman and James Vreeland have both already chimed in the on discussion, offering some important contributions. (Krugman importantly notes that the current financial crisis facing Greece and the other PIIGS countries has its roots in this low-inflation policy). And Joseph Stiglitz has written several books critiquing the Consensus. But the new position note comes from within the IMF, suggesting a more dramatic policy shift may be on the horizon.

So why the move? The argument presented in the position note concludes that because the inflation targets were set so low, there was no room for central banks to maneuver once the global economic downturn hit. Central banks quickly lowered interest rates, attempting to stimulate the economy. But when this did not work, monetary policy provided few good options for addressing eh economic crisis.

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The Challenges of Monetary Union

Paul Krugman’s recent analysis of the “Spanish Tragedy” deserves more consideration than it’s received. Krugman’s argument is essentially that the current problems faced by several European Union members (chiefly the high rate of sovereign debt) are the result not of irresponsible governments spending recklessly. Rather, the fundamental problem is the European Monetary Union itself.

Monetary Unions are interesting things. When the Euro was established as the single currency for many European Union members, there were two schools of thought. The first (pro-integration) position was that it would lower transaction costs, increase efficiency, and make the European Union an important global player. The second (anti-integration) position argued that the single currency would be difficult to manage because of the competing impulses and demands of the individual member states. A single currency makes using monetary policy [glossary] to manage the economy across a large area increasingly difficult. Encouraging economic expansion in Spain, for example, by expanding the money supply could only work if the other monetary union members went along. If the European Central Bank is concerned about inflation in Germany and stagnation in Spain, what is it to do? The two problems require fundamentally different (indeed, opposite) policy approaches under monetarism. 

As Krugman summarizes the situation:

Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

The Spanish crisis, in other words, resulted from the monetary union. Can the monetary union now be its savior? Doubtful, but we’ll see.

The Return of Keynesianism, Redux

A couple of weeks ago, I wrote about the return of Keynesianism in the face of the exhaustion of monetarist policy options in the United States.  On Tuesday, the Financial Times carried a similar story.  In an editorial entitled “The Undeniable Shift to Keynes,” the FT argues that Keynes’s ideas are more relevant today than ever.  The story provides a great overview of the current policy options on the table in the United States, Germany, France, the United Kingdom and the European Union, nearly all of which have embraced Keynesian policy solutions to the economic crisis.  It’s well worth a read.

The Return of Keynesianism?

On Monday, the Federal Reserve’s Board of Governors took the dramatic move of lowering the federal funds rate—the interest rate the Fed charges banks on short term loans—by 50 basis points.  A half point cut would normally be noteworthy by itself.  But this cut was particularly newsworthy because it lowered the federal funds rate to 0.25 percent—one quarter of one percent—its lowest rate ever.

The Fed hopes that the move will provide the market a clear signal of the Fed’s willingness to take sweeping action to address the current financial crisis.  And indeed, U.S. markets briefly reacted positively to the announcement, with equities increasingly slightly before falling by day’s end.

However, the move also raises some concerns.  First, with the U.S. funds rate so much lower than the rate of other major central banks (especially in European Union), the move may put downward pressure on the dollar.  This could help the U.S.’s balance of trade, but it may also make investors more hesitant to hold dollar-denominated assets, particularly U.S. Treasury Bills, due to their historically low yields.  Some groups within the Chinese government, the single-largest holder of U.S. t-bills, have already raised such concerns and have been pushing the Chinese government to diversify its holdings.  Were this to happen, the U.S. government could find it increasingly difficult to finance its operations, not to mention its $10 trillion debt.

More generally, however, the current low federal funds rate raises some important questions regarding the relative influence of (Neo)Keynesian and Monetarist policy in the United States.  Since the early 1980s, monetarism has been the prime approach to managing the nation’s economy, and the most important tool in the monetarist policy kit is arguably the federal funds rate.  By increasing the rate, the Fed can slow down the economy and bring inflation under control.  Conversely, by lowering the rate, the Fed can inject liquidity into the system, stimulating the economy and encouraging expansion.  Until recently, this system worked relatively well, keeping recessions (such as the one that occurred in 1990-1991) relatively short and shallow.

But with the federal funds rate now near zero percent (and potentially negative in real terms), the most important tool in the monetarist economic policy kit is no longer available.  If this move does not work—and there is good reason to think that it may not—the Fed will be forced to come up with new ways to stimulate the economy.

The current situation may therefore call for a return to Keynesian policies of this post-Great Depression era.  By focusing on the maintenance and expansion of aggregate demand, Keynesian policies may provide an additional tool for the U.S. government to address the current crisis.  Although Keynesianism may have fallen out of favor in the 1980s, in truth Keynesian policies never fully disappeared from the scene.  Since the 1980s, the U.S. government has been much less willing to use Keynesian tools than it historically had been.  But now that monetarism’s most important tool has been exhausted, perhaps we are all, to paraphrase Richard Nixon, Keynesians again.

If you’re interested in learning more, Paul Krugman has written extensively on the topic.  There’s a great ongoing discussion of his book, Return of Depression Economics, at Taking Points Memo.  And Krugman’s blog always makes for an interesting read!