What Have We Learned? What Have We Learned? Macroeconomic Policy after the Crisis edited by George Akerlof, Olivier Blanchard, David Romer, and Joseph Stiglitz The MIT Press Cambridge, Massachusetts London, England © 2014 International Monetary Fund and Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any elec- tronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. Nothing contained in this book should be reported as representing the views of the IMF, its Executive Board, member governments, or any other entity mentioned herein. The views expressed in this book belong solely to the authors. MIT Press books may be purchased at special quantity discounts for business or sales promotional use. For information, please email [email protected]. This book was set in Sabon by Toppan Best-set Premedia Limited, Hong Kong. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data What have we learned ? : macroeconomic policy after the crisis / edited by George Akerlof, Olivier Blanchard, David Romer, and Joseph Stiglitz. pages cm Includes bibliographical references and index. ISBN 978-0-262-02734-2 (hardcover : alk. paper) 1. Monetary policy. 2. Fiscal policy. 3. Financial crises — Government policy. 4. Economic policy. 5. Macroeconomics. I. Akerlof, George A., 1940 – HG230.3.W49 2014 339.5 — dc23 2013037345 10 9 8 7 6 5 4 3 2 1 Contents Introduction: Rethinking Macro Policy II — Getting Granular 1 Olivier Blanchard, Giovanni Dell ’ Ariccia, and Paolo Mauro Part I: Monetary Policy 1 Many Targets, Many Instruments: Where Do We Stand? 31 Janet L. Yellen 2 Monetary Policy, the Only Game in Town? 37 Lorenzo Bini Smaghi 3 Monetary Policy during the Crisis: From the Depths to the Heights 45 Mervyn A. King 4 Monetary Policy Targets after the Crisis 55 Michael Woodford Part II: Macroprudential Policy 5 Macroprudential Policy in Prospect 65 Andrew Haldane 6 Macroprudential Policy and the Financial Cycle: Some Stylized Facts and Policy Suggestions 71 Claudio Borio 7 Macroprudential Policy in Action: Israel 87 Stanley Fischer 8 Korea ’ s Experiences with Macroprudential Policy 99 Choongsoo Kim vi Contents Part III: Financial Regulation 9 Everything the IMF Wanted to Know about Financial Regulation and Wasn ’ t Afraid to Ask 129 Sheila Bair 10 Regulating Large Financial Institutions 135 Jeremy C. Stein 11 The Contours of Banking and the Future of Its Regulation 143 Jean Tirole 12 Banking Reform in Britain and Europe 155 John Vickers 13 Leverage, Financial Stability, and Deflation 165 Adair Turner Part IV: Fiscal Policy 14 Defining the Reemerging Role of Fiscal Policy 179 Janice Eberly 15 Fiscal Policy in the Shadow of Debt: Surplus Keynesianism Still Works 183 Anders Borg 16 Fiscal Policies in Recessions 193 Roberto Perotti 17 Fiscal Policy 209 Nouriel Roubini Part V: Exchange Rate Arrangements 18 How to Choose an Exchange Rate Arrangement 225 Agust í n Carstens 19 Rethinking Exchange Rate Regimes after the Crisis 229 Jay C. Shambaugh 20 Exchange Rate Arrangements: Spain and the United Kingdom 245 Martin Wolf 21 Exchange Rate Arrangements: The Flexible and Fixed Exchange Rate Debate Revisited 257 Gang Yi Contents vii Part VI: Capital Account Management 22 Capital Account Management: Toward a New Consensus? 265 Duvvuri Subbarao 23 Capital Flows and Capital Account Management 271 Jos é De Gregorio 24 Managing Capital Inflows in Brazil 289 M á rcio Holland 25 Capital Account Management 307 H é l è ne Rey Part VII: Conclusions 26 The Cat in the Tree and Further Observations: Rethinking Macroeconomic Policy II 317 George A. Akerlof 27 Rethinking Macroeconomic Policy 321 Olivier Blanchard 28 Preventing the Next Catastrophe: Where Do We Stand? 327 David Romer 29 The Lessons of the North Atlantic Crisis for Economic Theory and Policy 335 Joseph E. Stiglitz Contributors 349 Index 351 Introduction: Rethinking Macro Policy II— Getting Granular Olivier Blanchard, Giovanni Dell ’ Ariccia, and Paolo Mauro The 2008 – 2009 global economic and financial crisis and its aftermath keep forcing policymakers to rethink macroeconomic policy. First was the Lehman crisis, which showed how much policymakers had underes- timated the dangers posed by the financial system and demonstrated the limits of monetary policy. Then it was the euro area crisis, which forced them to rethink the workings of currency unions and fiscal policy. And throughout, they have had to improvise, from the use of unconventional monetary policies, to the provision of the initial fiscal stimulus, to the choice of the speed of fiscal consolidation, to the use of macroprudential instruments. We took a first look at the issues a few years ago, both in a paper ( Blanchard, Dell ’ Ariccia, and Mauro 2010 ) and at an IMF conference in 2011 ( Blanchard et al. 2012 ). There was a clear sense among both researchers and policymakers participating in the conference that we had entered a “ brave new world ” and that we had more questions than an- swers. Two years later, the contours of monetary, fiscal, and macropru- dential policies remain unclear. But policies have been tried and progress has been made, both theoretical and empirical. This introduction updates the status of the debate. It was prepared for a second conference that was hosted by the IMF on the same topic in spring 2013 and as a springboard for further discussion. A few observations on the scope of the analysis: our comments focus on the design of macroeconomic policy after the global economy emerges from the crisis rather than on current policy choices, such as the design of exit policies from quantitative easing or the pros and cons of money-financed fiscal stimulus. The two sets of issues are obviously 2 Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro related, but our objective is to analyze some general principles that could be used to guide macroeconomic policy in the future rather than to sug- gest specific measures to be taken today. We also take a relatively narrow view of macroeconomic policy, leaving out any discussion of structural reforms and financial regulation. Although the border between finan- cial regulation and macroprudential policies is fuzzy, we concentrate on the cyclical component of financial regulation rather than on the overall design of the financial architecture. This introduction is organized in three main sections: monetary policy, fiscal policy, and — what may be emerging as the third leg of macroeco- nomic policy — macroprudential policies. I. Monetary Policy The monetary policy theme that emerged from the first conference on rethinking macro policy, held in March 2011, was that central banks had to move from an approach based largely on one target and one instrument (the inflation rate and the policy rate, respectively) to an approach with more targets and more instruments. Two years later the choice of both the set of targets and the set of instruments remains controversial. A. Should Central Banks Explicitly Target Activity? Although the focus of monetary policy discussions has been, rightly, on the role of the financial system and its implications for policy, macroeco- nomic developments during the crisis and after have led to new questions about an old issue, the relation between inflation and output, with direct implications for monetary policy. One of the arguments for the focus on inflation by central banks was the “ divine coincidence ” aphorism: the notion that, by keeping inflation stable, monetary policy would keep economic activity as close as possible (given frictions in the economy) to its potential. So, the argument went, even if policymakers cared about keeping output at potential, they could best achieve this by focusing on inflation and keeping it stable. Although no central bank believed that divine coincidence held exactly, it looked like a sufficiently good approximation to justify a primary focus on infla- tion and to pursue inflation targeting. Introduction 3 Since the crisis began, however, the relation between inflation and out- put in advanced economies has been substantially different from what was observed before the crisis. With the large cumulative decline in output relative to trend and the sharp increase in unemployment, most economists would have expected a fall in inflation, perhaps even the appearance of deflation. Yet in most advanced economies (including some experiencing severe contractions in activity), inflation has remained close to the range observed before the crisis. As a matter of logic, there are two interpretations of what is happen- ing. Either potential output has declined nearly as much as actual out- put, so that the output gap (the difference between potential and actual output) is in fact small, thus putting little pressure on inflation, or the output gap is still substantial but the relation between inflation and the output gap has changed in important ways. With regard to the first interpretation, it is possible that the crisis itself led potential output to fall, or that output before the crisis was higher than potential output — for instance, if it was supported by unsustainable sectoral (housing) bubbles — so that the actual output gap is small. This could explain why inflation has remained stable. Empirically, however, it has been difficult to explain why the natural rate of unemployment should be much higher than before the crisis, or why the crisis should have led to a large decline in underlying productivity. And although there is a fair amount of uncertainty around potential output measures (especially in the wake of large shocks such as financial crises), by nearly all estimates, most advanced economies still suffer from a substantial output gap. This leads to the second interpretation. Indeed, convincing evidence suggests that the relation between the output gap and inflation has changed. Recent work (e.g., the IMF’ s 2013 World Economic Outlook report) attributes the change to the following two factors.