In recent years, research at the International Monetary Fund (IMF) had waded into previously sacrosanct areas such as income inequality, labour share of income, labour unions, and free flow of capital across borders. In all these cases, the official view was that economic growth was the best medicine for inequality and that efficiency gains would filter down to labour on their own, and that free capital flows was the next best thing to mother’s milk, etc. In recent years, economists at the Fund have written papers challenging these views. They have written that addressing inequality matters for sustaining economic growth. They hold that declining unionization might have contributed to the declining labour share of income, and that capital controls might actually be desirable. It is a different issue that some of these research conclusions have not yet become part of the policy prescriptions that the Fund makes to member countries.

To this genre belongs the working paper, published in November 2017, titled Booms, Crises And Recoveries: A New Paradigm Of The Business Cycle And Its Policy Implications. The authors—Valerie Cerra and Sweta C. Saxena—raise expectations bravely with their title, and, to their credit, they deliver. Every one of the recommendations arising out of their study goes against the conventional wisdom that is still in vogue in the policy prescriptions of the Fund and mainstream economists in the US.

Their simple thesis is that crises alone do not lead to permanent output loss. Even garden-variety recessions have that effect. And it is not because economic growth was unsustainably high before crises. They find that more often than not, signs of financial excess do not show up in economic growth. Second, contrary to what many think, they find that post-crisis growth always tends to belie the optimism of a swift reversal to trend. It’s not because crises result in sudden stops in technological progress or productivity improvements, for it is hard to explain why financial crises should result in such an abrupt reversal in technology and productivity-related developments. But they find that the rise in unemployment and fall in prices, after a crisis or recession, eventually leads to a cumulative shortfall in economic output that never catches up with the pre-crisis trend. In short, and in economics jargon, “demand shocks" eventually morph into “supply shocks" that permanently lower the trend rate of growth.

At this stage, the authors could be mistaken for economists who simply prescribe a more aggressive economic stimulus, post-crisis, in order to prevent such a permanent loss in output. They don’t. In fact, they suggest that fiscal dynamics, post-crisis, should take into account the fact that output would never return to the pre-crisis trend, and, hence, accept that pre-crisis trends in tax revenue would be unlikely to be met. Further, they do not advocate that policymakers avoid recessions at all costs because output loss, post-recessions and crises, is permanent.

That is the attitude that mainstream academics and central bankers have adopted. They think that they can avoid a recession altogether if they keep interest rates reasonably low and monetary policy sufficiently accommodative. It reflects a hubris that they can influence and control economic growth, recessions, and recoveries. In reality, by giving rise to the confidence and hope that central bankers can avoid a recession, they encourage excessive risk-taking that eventually produces a recession, or, worse, an economic crisis. It is gratifying to note that the authors have courageously challenged this prevailing orthodoxy in articulating prescriptions for economic policy, arising out of their work.

In particular, they are in favour of “more financial regulation, financial stability to be included as a consideration for monetary policy, building a larger war chest of foreign reserves, and maintaining a conservative fiscal stance during booms". In calling for greater financial regulation, and for financial stability considerations to be included in the monetary policy framework, the authors go against the prevailing institutional view of their employer. In a box-item in the “Selected Issues" report on China issued in August 2017, the Fund stated clearly that it did not favour financial stability as an aim of monetary policy. It favoured macroprudential measures—i.e., regulatory actions such as modifications to risk weights for loans to certain sectors, mandating lower loan-to-value ratios for real estate, raising stamp duties, etc.—to achieve financial stability.

Despite this official view, the authors bravely assert that monetary policy actions might be needed to supplement regulation and supervision. Prudential regulations may not be effective as, in practice, they can be sidestepped by misclassifying loans, for example. Further, in a world of international capital flows and shadow banking, there are questions over the full effectiveness of prudential regulations in isolation. For example, asset management companies and hedge funds provide credit through specially structured products that circumvent banking regulations.

In all, it is refreshing thinking from economists working for the establishment. It will be interesting to see if that box-item on the Fund’s official view on monetary policy changes this year. If it does, it may well signal the beginning of the end of the capture of monetary policy by financial markets.

V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns at www.livemint.com/baretalk

Comments are welcome at baretalk@livemint.com

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