In the Wake of the Crisis

In the Wake of the Crisis: Leading Economists Reassess Economic Policy

Olivier J. Blanchard
David Romer
A. Michael Spence
Joseph E. Stiglitz
Copyright Date: 2012
Published by: MIT Press
Pages: 256
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  • Book Info
    In the Wake of the Crisis
    Book Description:

    In 2011, the International Monetary Fund invited prominent economists and economic policy makers to consider the brave new world of the post-crisis global economy. The result is a book that captures the state of macroeconomic thinking at a transformational moment.The crisis and the weak recovery that has followed raise fundamental questions concerning macroeconomics and economic policy. For instance, to what extent are financial markets efficient and self-correcting? How crucial is low and stable inflation for growth and the real stability of the economy? How strong is the case for open capital markets? Too often, the standard models provided insufficient guidance on how to respond to the unprecedented situations created by the crisis. As a result, policy makers have been forced to improvise. What to do when interest rates reach the zero floor? How best to provide liquidity to segmented financial institutions and markets? How much to use fiscal policy starting from high levels of debt? These top economists discuss future directions for monetary policy, fiscal policy, financial regulation, capital account management, growth strategies, and the international monetary system, and the economic models that should underpin thinking about critical policy choices. Among the new realities they consider are the swing of the pendulum toward regulation; the need for new theoretical approaches, incorporating advances in agency theory, behavioral economics, and understanding of credit markets and finance based on theories of imperfect information; and the importance for macroeconomic policy to target not just inflation but also output and financial stability.

    eISBN: 978-0-262-30183-1
    Subjects: Economics

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-viii)
  3. Preface
    (pp. ix-x)
    Olivier Blanchard
  4. I Monetary Policy
    • Questions: How Should the Crisis Affect Our Views of Monetary Policy?
      (pp. 3-6)

      The years before the world economic crisis began in 2007 and 2008 saw the emergence of a consensus view of monetary policy. It went roughly like this:

      1. Flexible inflation targeting provides a sound framework for monetary policy.

      2. The supervisory and macroeconomic aspects of monetary policy can be largely separated.

      3. Departures of asset prices from fundamentals are hard to detect in real time, and the contractionary effects of sharp falls in asset prices can be greatly mitigated by monetary easing. As a result, asset prices should affect monetary policy only to the extent that they help predict goods price inflation and...

    • 1 Monetary Policy in the Wake of the Crisis
      (pp. 7-14)
      Olivier Blanchard

      Before the economic crisis began in 2008, mainstream economists and policymakers had converged on a beautiful construction for monetary policy. To caricature just a bit: we had convinced ourselves that there was one target, inflation, and one instrument, the policy rate. And that was basically enough to get things done.

      One lesson to be drawn from this crisis is that this construction was not right: beauty is not always synonymous with truth. There are many targets and many instruments. How the instruments are mapped onto the targets and how these instruments are best used are complicated problems, but we need...

    • 2 Conventional Wisdom Challenged? Monetary Policy after the Crisis
      (pp. 15-24)
      Guillermo Ortiz

      As Olivier Blanchard has pointed out, the global economic crisis of the early twenty-first century has challenged some aspects of the conventional wisdom regarding the conceptual framework and implementation of monetary policy. In my view, it has also reinforced the case for continuing the implementation of other aspects. Although the epicenter of the crisis was in the developed world, I believe that relevant lessons can be taken from previous emerging-market crises. In this chapter, I examine some of these lessons and discuss my own views.

      During the global economic crisis of 2008, emerging markets showed more resilience than advanced economies,...

    • 3 Lessons for Monetary Policy
      (pp. 25-30)
      Otmar Issing

      During my time at the European Central Bank, I had a number of stimulating discussions with Olivier Blanchard, and when we disagreed—which happened from time to time—I always thought twice before continuing with my dissenting view. But he has encouraged the contributors to this volume to come up with controversial statements about the global economic crisis that began in 2008, so I have done what I would have done anyway: I examine in this chapter what I see as a flawed postcrisis consensus.¹

      Consider a statement by Lars Svensson, who is one of the gurus of the concept...

    • 4 Macroeconomics, Monetary Policy, and the Crisis
      (pp. 31-42)
      Joseph Stiglitz

      I begin with a simple observation: the current global economic crisis was man-made. This was the consensus of both the U.S. Financial Crisis Inquiry Commission in its 2011 report,¹ as well as a broad range of economists. The economic crisis that began in 2008 in the United States was not inevitable. The implication is that policies, particularly the policies of the U.S. monetary and regulatory authorities, led to the crisis. (In many countries, central banks have responsibilities as regulatory authorities and, I think, should have such obligations.)

      Sins of both commission and omission—most notably, excessive deregulation, a failure to...

  5. II Fiscal Policy
    • Questions: How Should the Crisis Affect Our Views of Fiscal Policy?
      (pp. 45-48)

      The issues involving fiscal policy that are raised by the global economic crisis fall largely into two categories. One set of issues concerns the use of fiscal policy for short-run stabilization, and the other involves the long run. Of course, many issues involve interactions between short-run and long-run considerations.

      Before the crisis, there was broad consensus that monetary policy should be the primary tool of stabilization policy and that fiscal policy should play little role beyond allowing automatic stabilizers to operate. But almost all major countries used discretionary fiscal policy during the crisis. This raises a host of issues:

      1. Was...

    • 5 Fiscal Stimuli and Consolidation
      (pp. 49-56)
      Parthasarathi Shome

      Developed and emerging countries alike introduced fiscal stimuli in response to the global financial crisis of 2008. Affected countries experienced severe economic contraction—reduction in or negative growth in gross domestic product. This was generally accompanied by a decline in revenue per GDP and a rise in expenditures per GDP. The revival of economic activity anchored on quantitative easing did not materialize because the injected money,M, did not move to improvem, the collapsed money multipliers. The focus turned to fiscal stimuli through tax reductions and mainly current expenditure enhancements. But the size of the fiscal multiplier was not...

    • 6 What Have We Learned about Fiscal Policy from the Crisis?
      (pp. 57-66)
      David Romer

      The financial and macroeconomic crisis that began in 2008 has shattered some of the core beliefs of macroeconomists and macroeconomic policymakers:

      We thought we had macroeconomic fluctuations well under control, but they are back with a vengeance.

      We thought that the zero lower bound on nominal interest rates was a minor issue, but it has proved central to the behavior of the macroeconomy.

      We had not paid much attention to issues of financial regulation and financial disruptions, but they too have turned out to be critical to macroeconomic performance.

      The idea that policymakers would tolerate years of exceptionally high unemployment...

    • 7 Fiscal Policy Responses to Economic Crisis: Perspectives from an Emerging Market
      (pp. 67-72)
      Sri Mulyani Indrawati

      This chapter focuses on fiscal policy responses to the global economic crisis of 2008 from the perspective of an emerging-market country, drawing on my experience as minister of finance of Indonesia at that time.

      For emerging economies, the 2008 global economic crisis was markedly different from previous crises of the 1980s and 1990s. Most of those economic crises were the result of policy or institutional problems in the emerging-market countries themselves. These problems included bad macroeconomic policy, bad governance, or weak institutions that led to instability, low growth, high inflation, credit collapse, and balance-of-payments problems.

      The first decade of the...

    • 8 Fiscal Policy
      (pp. 73-76)
      Robert Solow

      One important lesson that I hope we have learned from the global economic crisis that began in 2008 and the deep recession that has followed is that economies like that of the United States can experience uncomfortably long intervals of general excess supply or excess demand. Economists and interested civilians used to know this. But it was largely forgotten during the great moderation during the two decades leading up to the crisis and the accompanying optimism among economists and civilians about smoothly self-correcting markets.

      The general belief then was that monetary policy was an adequate tool for taking care of...

  6. III Financial Intermediation and Regulation
    • Questions: How Should the Crisis Affect Our Views about Financial Intermediation and Regulation?
      (pp. 79-82)

      The financial sector, which until 2008 had been hailed as a hub of innovation and a driver of growth, led to a crisis that brought the world economy to the brink of collapse and caused unemployment for millions. As a result, there is broad agreement on the need for reform that minimizes the chances of future catastrophes while maintaining as much as possible of the social benefits of the financial sector. Unfortunately, there is little agreement beyond that. The range of issues concerning financial intermediation that policymakers must consider is exceptionally wide.

      One set of issues concerns the role of...

    • 9 Financial Crisis and Financial Intermediation: Asking Different Questions
      (pp. 83-90)
      Y. V. Reddy

      The financial sector, which once was hailed as the driver of growth, brought about a global crisis in finance and the real economy in 2008. Reforms are needed in the financial sector and also in the ways that we think about the financial sector in the context of the ultimate objectives of economic and social well-being.

      Rather than asking the same questions that were asked before the crisis and getting the same answers, we need to ask a different set of questions or put the same questions differently. This chapter examines India’s experience with regulation of the financial sector.


    • 10 Global Liquidity
      (pp. 91-100)
      Hyun Song Shin

      Low interest rates maintained by advanced-economy central banks in the aftermath of the global financial crisis that began in 2007 have ignited a lively debate about capital flows to emerging economies. The argument is that such capital flows are driven by carry trades that seek to exploit the interest-rate differences between advanced and emerging economies and that such flows result in overheating and excessively permissive financial conditions in the recipient country, posing challenges for policymakers.

      The U.S. dollar has special significance in this debate. As well as being the world’s most important reserve currency and an invoicing currency for international...

    • 11 Optimal Financial Intermediation: Why More Isn’t Always Better
      (pp. 101-110)
      Adair Turner

      How should the global economic crisis that began in 2008 affect our views about financial intermediation? This is a fundamental issue. We need to ask questions about the value of financial intermediation, about optimal levels of financial intermediation, and about reliance on free-market forces to select the optimal level and precise mix of financial intermediation.¹

      Over the last thirty years, financial intensity has grown remarkably, with increases in real-sector leverage but even more dramatic increases in financial-sector balance sheets as a percentage of gross domestic product, increases in trading volumes as a percentage of GDP, and the financial innovations of...

    • 12 Process, Responsibility, and Myron’s Law
      (pp. 111-124)
      Paul Romer

      In the wake of the financial crisis, any rethinking of macroeconomics has to include an examination of the rules that govern the financial system. This examination needs to take a broad view that considers the ongoing dynamics of those rules. It will not be enough to come up with a new set of specific rules that seem to work for the moment. We need a system in which the specific rules in force at any point in time evolve to keep up with a rapidly changing world.

      A diverse set of examples suggests that there are workable alternatives to the...

  7. IV Capital-Account Management
    • Questions: How Should the Crisis Affect Our Views of Capital-Account Management?
      (pp. 127-128)

      The economic crisis that began in 2008 revealed the tight links that financial globalization has created across countries. Large capital outflows at the height of the crisis created serious funding problems. Balance-sheet effects, affecting either ultimate borrowers or financial intermediaries, often led to perverse effects of depreciation.

      The environment since the peak of the crisis shows the tensions coming instead from large capital inflows. Many emerging-market countries are considering—and some are implementing—capital controls. They often blame policies in advanced countries, from low interest rates to quantitative easing, for generating excessive and volatile capital flows.

      How should countries deal...

    • 13 Notes on Capital-Account Management
      (pp. 129-132)
      Ricardo Caballero

      In this chapter, I look at two sets of capital-account issues—country-specific dilemmas in dealing with large capital inflows and global equilibrium issues.

      What are the conditions under which a real appreciation caused by large inflows is a problem? There are many specific channels through which a problem can arise, but the generic concern is that somehow the medium- and long-run health of the economy will be compromised by a sustained appreciation. To justify policy intervention, these concerns must be about externalities, either pecuniary or technological. I focus on the former.

      A pecuniary externality can arise when there is limited...

    • 14 Remarks on Capital-Account Management and Other Macropolicy Topics
      (pp. 133-136)
      Arminio Fraga

      The efficacy of capital controls is usually overestimated by governments and underestimated by market participants. Market players ignore the fact that governments may go way beyond optimal levels of taxes and controls, often because governments tend to ignore long-term costs and side effects. But if participants underestimate what governments may do, that is their problem. It does not matter.

      More serious is what happens on the policy side. Policymakers see too little room for arbitrage, and therefore tend to ignore the loss of efficacy over time of most such policies. They also ignore or underestimate the side effects of controls....

    • 15 Capital-Account Management: Key Issues
      (pp. 137-144)
      Rakesh Mohan

      The basic assumption in a lot of discussions about the capital account is that, in principle, the flow of capital across borders brings benefits to both capital importers and capital exporters. But historical evidence, reinforced by the current North Atlantic (not global) financial crisis that began in 2008, shows that it can create new exposures and bring new risks. In many emerging-market economies, financial or monetary stability has been compromised by the failure to understand and analyze such risks and by the excessive haste that many countries showed over time in liberalizing capital accounts. Such liberalization has usually been done...

    • 16 The Case for Regulating Cross-Border Capital Flows
      (pp. 145-150)
      José Antonio Ocampo

      Let me start this chapter with two remarks. The first one is that cross-border capital flows are one of the expressions of finance. It is thus peculiar that the Group of Twenty excluded this topic in its discussions about reregulating finance, as if cross-border finance were not finance. In fact, when we talk about regulating domestic finance, we always use the wordregulation, but when we talk about cross-border finance, we use the wordcontrols. I prefer and have long used the concept of capital-account regulations because they are regulations. Some are quantitative, such as the prohibitions on certain activities...

  8. V Growth Strategies
    • Questions: How Should the Crisis Affect Our Views of Growth and Growth Strategies?
      (pp. 153-156)

      The economic crisis that began in 2008 was preceded by a long period of high growth and rising income inequality. This was true in both advanced countries and emerging-market countries. The distribution of wages widened. The share of profits increased. The share of income going to the top 1 percent increased even more.

      These patterns raise important and well-understood issues of equity. They also potentially raise issues of efficiency. Some argue that the increase in income inequality was at the source of the large decrease in household saving in the United States as people tried to maintain consumption growth by...

    • 17 Do We Need to Rethink Growth Policies?
      (pp. 157-168)
      Dani Rodrik

      The current economic crisis has taught us new things, but it does not require a complete rethinking of what we know about growth. The main new thing is that the context in which we are going to think about growth policies might be different. The context arises partly from the difficulties that the advanced countries are going to be facing with the debt overhang and possibly lower growth. What does that do to the growth prospects of the developing countries?

      As we go forward, there are doubts about the system for cross-border financial flows, and there is a systemic worry...

    • 18 Is the Chinese Growth Model Replicable?
      (pp. 169-174)
      Andrew Sheng

      Although I refer to the Chinese growth model in this chapter, I am really talking about the Asian growth model more generally. The real issue is that the global financial crisis that began in 2008 has challenged our thinking about growth, equity distribution, industrial policy, and the role of the markets. Going forward, we are facing both a financial crisis and a global climate-change crisis. One is immediate, the other one is longer term, but both have the same origin—excess consumption financed by excess leverage.

      Crises seem to occur every ten years. Twenty years ago, it was the failure...

    • 19 Growth in the Postcrisis World
      (pp. 175-184)
      Michael Spence

      Before the crisis of 2008, macroeconomic stability was correctly perceived as a necessary but not sufficient condition for sustained growth. There were muted business cycles, shocks, and asset bubbles in the advanced economies but not really bouts of instability that threatened the balance of these economies. Macroeconomic instability was viewed mainly as a challenge in developing economies. The crisis turned this thinking on its head.

      Postcrisis, we no longer take macroeconomic stability for granted and must rethink the proposition that emerging economies are inherently more prone to instability than the advanced ones. But the necessary condition remains true, and the...

  9. VI The International Monetary System
    • Questions: How Should the Crisis Affect Our Views of the International Monetary System?
      (pp. 187-190)

      The early phase of the global economic crisis that began in 2008 was dominated by large capital outflows, induced foreign-liquidity shortages, and, in some cases, large induced changes in exchange rates. The current phase is characterized by large capital inflows, strong appreciation pressure on many currencies, concern about currency manipulation, and talk of currency wars. So it is not surprising that the French have put reform of the international monetary system at the top of their agenda for the Group of Twenty presidency.

      Reform of the international monetary system means many things to many people, from increases in allocations of...

    • 20 The Implications of Cross-Border Banking and Foreign-Currency Swap Lines for the International Monetary System
      (pp. 191-198)
      Már Guðmundsson

      The financial crisis in Iceland that struck with full force in 2008 throws light on one of the more important fault lines at the intersection between the international monetary system and the international financial system.¹ This fault line was the operation of cross-border banks with large foreign-currency balance sheets featuring significant maturity mismatches but without an effective lender of last resort (LOLR) in terms of foreign currency.²

      In this chapter, I concentrate mostly on this fault line, its implications for the international monetary system, and potential remedies, leaving aside many other important issues regarding the international monetary system.³ This topic...

    • 21 The International Monetary System
      (pp. 199-208)
      Olivier Jeanne

      This chapter about the international monetary system is structured around two themes—global financial imbalances and global financial safety nets.

      Many economists think that improving global financial safety nets will help address the problem of global imbalances. The idea is that global imbalances come in part from the accumulation of reserves by emerging-market countries trying to self-insure against volatile capital flows. Thus, better safety nets, in addition to their intrinsic merits, will reduce the need for self-insurance through precautionary savings and will mitigate the global savings glut.

      How important for global imbalances is the precautionary accumulation of reserves? One answer...

    • 22 International Monetary System Reform: A Practical Agenda
      (pp. 209-214)
      Charles Collyns

      Reform of the international monetary system is always an intellectually stimulating topic, but sometimes it gets lost in abstruse debates that lead nowhere. The turbulent economic developments of the past several years underline that now is a moment when our collective attention needs to focus on a pragmatic policy agenda with real practical consequences.

      In this chapter, I address three immediately relevant issues: first, ensuring effective international economic cooperation to achieve a sustained, well-balanced global recovery; second, moving to more consistently flexible exchange-rate management across all the major economies to support rebalancing and reduce the long-prevailing asymmetric bias in the...

    • 23 Liquidity and the International Monetary System
      (pp. 215-224)
      Maurice Obstfeld

      In this chapter, I touch on points that are inspired by the crisis of 2008 to 2009, which displayed a number of stresses in the international system. Not surprisingly, these stresses are related to the problems that motivated the founding of the International Monetary Fund nearly seven decades ago.

      Global liquidity needs, exchange rates, and external imbalances were fundamental problems in the interwar period and before, and the original design of the IMF devised ways to address these coordination problems within a framework that was appropriate to the economic and financial conditions of the time. But conditions have changed dramatically...

  10. Concluding Remarks
    (pp. 225-228)
    Olivier Blanchard

    I took a lot of notes during the conference at which all these papers were presented and discussed. I organized my thoughts around the following nine points:

    1. We have entered a brave new world. The economic crisis has put into question many of our beliefs. We have to accept the intellectual challenge.

    2. In the age-old discussion of the relative roles of markets and of the state, the pendulum has swung, at least a bit, toward the state. We probably have revised our views on the need for regulation and on the limits of regulation. Both are stronger than we thought...

  11. List of Contributors
    (pp. 229-232)
  12. Index
    (pp. 233-240)