Photo: Reuters
Photo: Reuters

The blunting of macroeconomic policy tools

Globalizing forces, in particular rising cross-border trade and capital flows, have weakened tested policy methods

Ever since the Great Depression and the Keynesian Revolution economists have assumed that macroeconomic policies are instrumental in stabilizing business cycles. “We are all Keynesians now," the legendary Milton Friedman famously remarked even as he dethroned fiscal policy and put monetary policy in the pole position in the conduct of stabilization policies. Fiscal policy was deemed too destabilizing and political to be nimble, especially in the exit phase. Discretionary policies fell out of fashion. Fiscal policy was mostly limited to automatic stabilizers with seamless and automatic entry and exit.

Over time monetary policy became rule-bound, exemplified by the Taylor Rule. This told central bankers what the policy rate should be, using the deviation between actual and potential growth, and between actual and targeted core consumer price inflation. The equation had a constant of 2%, for reasons not entirely clear, other than historical. This meant that if growth was at full potential, and inflation on target, the predicted policy rate, based on successful interventions by the US Federal Reserve in the past, should be current inflation plus the constant.

Fiscal multipliers were found to be variable, ranging from negative to positive values. It was nevertheless assumed that macroeconomic policies were effective tools for stabilizing business cycles. This was especially so after Paul Volcker’s dogged and aggressive use of monetary policy to slay stagflation.

Economists and policymakers are no longer so sanguine in the wake of the global financial crisis. Aggressive fiscal and monetary policies have been unable to lift growth back to pre-crisis levels. Indeed, the protracted use of what were designed to be short-term policy tools is generating fresh sources of instability in the form of unsustainable public debt and new asset bubbles.

Part of the problem lies in measuring growth potential. The global economy grew at an average of 5% between 2003 and 2007. But it grew at only 3.5% in the preceding 10-year period, and at 3-3.5% since the height of the crisis. If 5% was above trend, why was consumer price inflation within the central bankers’ comfort zone? If 5% was indeed the growth potential, why have aggressive, including unconventional, macroeconomic policies, been unable to lift growth to this level?

The convenient answer to the conundrum is that potential growth has declined since the crisis. Why then is International Monetary Fund (IMF) advising policymakers to persist with highly stimulative monetary policy?

To resolve the conundrum, we need to turn to another part of the problem. This is the blunting of extant macroeconomic tools, both fiscal and monetary, by globalizing forces, in particular by rising cross-border trade and capital flows. This blunting was evident prior to the global financial crisis, undermining the Taylor Rule, but went largely unnoticed. It may have also deluded central bankers into overestimating potential growth. They kept policy rates so low that they contributed to inflating the underlying asset bubble.

Core consumer price inflation is no longer simply domestically driven. Rapid productivity shifts, especially following the entry into the global market of large developing countries such as China, for goods, and India, for services, has kept core consumer price inflation in check. Excessive liquidity is diverted instead to asset markets that are less tradable across borders. But asset price inflation is not an input into the Taylor equation.

Sharp increases in two-way cross-border capital flows prevent central bank interventions at the short end of the yield curve from being transmitted to long-term interest rates. It is the latter that matters for savings and investment, and therefore for economic growth. Former chairman of the US Federal Reserve Alan Greenspan famously observed that the Fed was losing control of long-term interest rates because of large and volatile capital flows.

Developing countries, such as India, too adopted variants of the Taylor Rule. Their problems were even more acute, as their transmission channels were already blunt on account of relatively illiquid bond markets and administered interest rates. They therefore continued to use control of monetary aggregates alongside short-term interest rates as policy tools. The control of inflation in such economies is arguably more attributable to the impact of international trade than to monetary policy. Inflationary pressures in their economies stem from the non-core side, namely commodities such as oil and food where various trade barriers still exist in international agreements. In India this is reflected in the periodic sharp divergence between wholesale and consumer price inflation. These supply side constraints do not respond easily to monetary policy.

Large capital flows also distracted central bankers in developing countries from a single-minded focus on the domestic business cycle. At any one point in time monetary policy is usually a trade-off between higher growth and lower inflation. But they often found themselves trapped by the impossible trinity, constrained to use monetary policy to counter the destabilizing impact of volatile capital flows. The relevance of the 2% constant in developing countries was also arguable, as they needed to incentivize higher savings rate as well as to channel them from unproductive non-financial channels, such as gold, to financial channels such as bank deposits.

The bottom line is that the forces of globalization have broken or at least blunted tried and trusted macroeconomic policy tools. We still don’t quite know how to put Humpty Dumpty back on the wall. Macroeconomics awaits its 21st century Keynes, or maybe even Adam Smith, for a comprehensive reshuffle.

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Alok Sheel is a civil servant. These are his personal views.

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