Remarks at the Ottawa Economics Association's Annual
by David A. Dodge
Tuesday, March 29, 2011
Over the last half century, economic policy making has always had to cope with economic situations that are somewhat messy and uncertain. This challenge has become more daunting over time as issues and shocks to address have proliferated along with the increasing integration and liberalization of the world economy. What I will try to do today is to sketch some of the manifestations of the increased integration of the world economy, identify the key issues and shocks that policy makers have to deal with at present, and outline what policies are underway and should be expected to bring "strong, sustained, balanced growth", to use the same words as the G-20 communiqués. All along I will try to indicate the interdependencies between problems and policies that make the present economic situation particularly complicated for economists and policy makers to deal with.
We are not presently going through the typical aftermath of a post-war business cycle downturn or even that of an oil supply shock. The situation is messier because many more issues have to be dealt with simultaneously and on a global basis. With the world economy now being highly integrated through trade and finance, individual countries, both advanced and emerging markets, are more sensitive than ever before to the shocks experienced, and policies pursued. It is in this setting that policy makers in advanced economies have to deal with:
- the unemployment legacy of a severe recession;
- the large structural fiscal deficits;
- the zero bound problem in monetary policy;
- the large global imbalances;
- an oil price shock of as yet uncertain magnitude;
- excessively levered banks and households;
- incomplete reform of financial sector regulation; and,
- the upcoming consequences of population aging.
The G20 communiqués provide a general blueprint for action, but many contentious issues remain and much of the will to pursue policy coordination that followed the Pittsburgh Summit has disappeared.
Relative to the past, some structural changes have occurred that complicate the process of adjustment and policy formulation, not to say coordination. Foremost is the unprecedented degree of world economic integration at present. This is manifest in the proliferation of global supply chains, the growth of offshoring, and most importantly, the elevation of the so-called emerging economies to the rank of major players on the world economic scene.
While international economic integration increased in the three or four decades following WW2, by-in-large the focus of national macro-economic policies was on the domestic economy – with a limited degree of policy cooperation among OECD countries from time to time. Of course, we in Canada had to always be cognizant of the spillover effects of U.S. policy on us, and all OECD countries had to deal with the effect of the oil supply shock of the early 1970s. But despite a few exchange rate "crises" which forced rapid and dramatic policy adjustments on individual OECD countries (eg. Britain), generally OECD countries set policy without regard to their impact on others. As the Americans said in the 1970s and 1980s: "the dollar is our currency and your problem".
But over the last two decades the world economic and financial system has become much more integrated. As Russia, China, India, the Asian Tigers and much of Latin America have joined the market system, policy spillovers have become much more pronounced. With the addition of important new players, policy cooperation and coordination – never easy before – has become more complex. But given the extent of global economic integration, such complex cooperation and coordination is more important for growth and stability than it has been.
At the same time as the world economy is more integrated, it faces heightened political uncertainty that also complicates policy making. Such heightened uncertainty relates not just to unrest in North Africa and the Middle-East, but also to the larger potential for conflicts over income inequality in advanced countries as incipient or impending fiscal consolidation is bound to constrain or roll back redistributive policies. Such conflicts could conceivably delay or dilute macroeconomic adjustment.
From a policy perspective it thus looks like the present decade will be qualitatively messier than in the past.
What is to be done, then?
Let me say right away that no matter how messy policy-making is due to global integration, deintegration is not the answer. Global market integration has lifted out of poverty hundreds of millions of people in what we used to call LDCs. It has boosted innovation and growth in OECD countries including Canada. And, with appropriate national fiscal, monetary, and financial policies will continue to do so. The messy part is determining what is appropriate in the context of an integrated world. I will start with fiscal issues.
An unprecedented coordinated relaxation of fiscal and monetary policies prevented a global depression and continues to underpin the present global economic recovery. The issue is when to exit the resulting abnormally lax policies and at what speed. For some European countries plagued by huge fiscal deficits in the wake of deep recession and banking sector rescue the market left no choice: they had to implement severe fiscal retrenchment last year and will continue tightening in 2011. In so doing they risk a protracted recession given that they cannot engineer a depreciation of their currency relative to their neighbours nor lower interest rates. For the advanced countries as a whole, and Canada in particular, a reduction of the cyclicallyadjusted general government balance as a share of potential GDP will start this year. In the U.S., it will start only next year. While this may be a sensible move for the U.S. to do in the short term given further weakness in housing prices and a stubbornly high unemployment rate, it makes its Toronto Declaration commitment to halve the deficit by 2013 harder to achieve. A more fundamental problem in the U.S. is a lack of support in the Congress for a comprehensive strategy of discretionary spending cuts and tax and entitlement reforms that is needed to restore sustainable fiscal health in the medium term. Such a strategy at the same time would support an increase in U.S. saving, thereby helping to reduce global imbalances. It might also leave more room to accommodate larger public spending on health care and pensions as a result of population aging. In fact, the problem of population aging in terms of cutting potential output growth and boosting public spending is expected to be more immediate and severe in Japan, Europe and even Canada.
The need for, and the efforts deployed toward, fiscal consolidation are not confined to advanced countries. While the debt problem of emerging economies is relatively benign, the wisdom of tightening fiscal policy early on is particularly great for many of them in view of their relatively high rate of capacity utilization, rising core inflation rates and for many, improved terms of trade. Fiscal retrenchment allows them to go easier on increases in policy interest rates, thereby providing less fuel for hot money inflows and currency appreciation than otherwise. The recent surge in world food and energy prices, however, may hamper consolidation as growth slows somewhat and subsidies to consumers and industries increase.
It is important to note that the synchronization of fiscal consolidation across advanced and emerging countries makes it more difficult for each one of them to rely on exports as offset to fiscal drag and may in fact intensify resistance to currency appreciation in order to maintain the competitiveness of exports.
Now a very few words on monetary policy.
Expectations regarding both the vigour of private domestic demand and exports over the short term as well as the effects of fiscal retrenchment (or lack thereof) are a key factor in monetary policy decisions in advanced economies, given the perceived current state of excess capacity and level of core inflation.
The main task of central banks is to preserve confidence in the future value of money. For countries experiencing domestic inflation pressures, tighter policy is warranted while for those with substantial excess capacity, accommodative policy continues to be warranted (although not necessarily the ultra low rates of 2008-2009). At a global level pursuit of this policy would encourage capital flows and exchange rate adjustments to re-balance global demand at a moderate level of global price inflation. The problem is, of course, that the implied exchange rate adjustments might be very large (as in Brazil for example) and domestic authorities would be under tremendous pressure to offset exchange rate appreciation:
- by leaning on the central bank to pursue inappropriately loose policy, (Argentina); and,
- by institutionalizing controls on capital inflows (Brazil) or prices of sensitive goods (India).
Policy indeed becomes very messy; cooperation and coordination are required and I will return to this in a moment.
But first permit me a very short sidebar on issues raised by the financial crisis for the conduct of monetary policy in view of the limitations and potential of policy interest rates. Besides the problem of the zero bound, and whether price level targeting might help deal with this, there remains the question of whether the policy rate should be adjusted to supplement the coordinated use of prudential tools when imbalances in a specific market can spill over to the entire economy. Boivin, Lane and Meh (2010) of the Bank of Canada reckon that this may be appropriate but that the resulting greater flexibility required in an inflation-targeting regime could be challenging in practice. Finally, the question of whether "old fashioned" control instruments (required reserves, exchange and credit controls) should be used to supplement policy rate movements is now being raised again. More work is probably needed to bring understanding of these issues to the level required to clarify the implications for the monetary policy framework. The end of monetary policy history has not yet arrived.
Now back to the issue of policy cooperation
Since their meeting in Pittsburgh, the G20 leaders have pledged to take action to rebalance growth within their economy and reduce global imbalances. Needless to say, much remains to be done in this area. Persistent, large current account imbalances are detrimental to global financial stability as they generate unsustainable paths for domestic demand, net debt and long-term real interest rates. Deficit countries accumulate unsustainable external debts which make them vulnerable to macroeconomic shocks and candidates for abrupt, costly adjustment at some point in the future. Persistent imbalances may have all sorts of other effects, including domestic resource misallocation, such as excess capacity and falling profit margins in the export firms of chronic surplus countries. Finally, they often become a source of political tensions and prompt strong political pressures for increased trade protectionism in deficit countries.
The problem with implementing national policies that would lead to reduced imbalances is twofold. First, there are the asymmetric pressures on, and responsibilities of, deficit and surplus countries to adjust their spending patterns. Ever since Bretton Woods, the pressure for adjustment has been on the deficit countries since they depend on foreign creditors to buy their increased debt. The burden of unilateral adjustments in terms of reduced output and employment may be excessive for deficit countries and impart a deflationary bias to the global economy. Second, there are structural impediments to adjustment by the largest deficit and surplus countries. Because of its "exorbitant privilege", the United States has as yet felt no compulsion to set policies other than for its own internal balance. China and many other emerging economies have up to now been willing to finance the U.S. deficit because they have needed rapid export growth to provide adequate levels of employment to their populations. A managed exchange rate and capital controls were vital tools for remaining ultra-competitive in world markets. Imbalances, temporarily reduced during the recession are growing again. And they cannot grow forever without another global financial crisis.
To make progress on reducing imbalances, deficit and surplus countries must agree on a path for reducing or increasing net exports relative to domestic demand, on allowing real exchange rates to support this path, and on implementing structural policies, including fiscal measures, to raise national savings in deficit countries and to reduce savings in surplus countries. This is the "grand bargain", to use Mervyn King's words, that the G20 must achieve. But achievement of such a "grand bargain" is messy in the extreme.
Let me now say just a few words on financial stability.
Like price stability, financial stability is a fundamental policy goal for advanced and emerging economies, but one whose profile has taken an entirely new dimension with the financial crisis. For advanced economies, whose financial systems revealed deep flaws, the reform of the financial sector has become a priority. For emerging economies, faced with destabilizing capital inflows, recourse to capital controls has intensified. The need to achieve greater financial stability has necessitated more effective regulation, tighter supervision and greater capital controls. For the moment stability has trumped efficiency; regulation and control have trumped innovation and liberalization. Clearly some re-regulation was needed in light of the huge costs of the financial meltdown.
But, the new banking rules will impose transitory costs over the medium term. The OECD has recently estimated that the higher capital requirements of Basel III effective as of 2019 would increase bank lending spreads by about 50 basis points over about five years, thereby cutting GDP growth in the United States, Europe and Japan by an average 0.15 percentage points per annum over this period. Over and above the warranted costs of higher capital requirements, the precise and detailed rules proposed will add to operational and compliance costs for banks and financial intermediaries. But the long run stability benefits flowing from greater capital and liquidity requirements should outweigh transition costs provided the new principles are adopted globally and applied in a way to minimize the dead weight loss of operational inefficiency. Here again international cooperation and coordination will be required.
Let me conclude.
Global economic integration has brought and will continue to bring real economic benefits to advanced and emerging economies alike. But one of the implications of global integration is that economic policy making has become more difficult and complex – more messy. And, if we are to continue to garner the benefits of global integration, we may have to rethink somewhat the policy paradigms which we have developed over many years and the instruments which we use.
We may have to set fiscal policy not just from the standpoint of domestic output stabilization, but also from the standpoint of global economic and financial stability. Our integration into the global economy may well constrain our fiscal options.
- We may have to think beyond domestic price stability, both in setting the policy interest rate and in determining the monetary policy instruments we use.
- We may have to regulate financial markets and institutions within a global context even if this might not be seen as totally appropriate for our domestic needs.
- We may have to accept some degree of control over international capital flows.
- We may have to live in a world of partially controlled exchange rate adjustment mechanisms.
- We may well require interventionist structural adjustment programs at national and sub-national levels.
- And we will probably have to think harder and more radically about domestic social and income distribution policies.
- But what we certainly will have to do is to strengthen the international governance of our global economic and financial system. Without a permanent enhancement of our international institutions, the spirit of cooperation that was evident at the London & Pittsburg G-20 meetings will wither and die.
Reform of the IMF and other institutions is a frustrating business. But we must get on with it. We need tables around which systemically important global players gather, discuss and in the end agree to cooperate. We need a reformed IMF first to establish a consensus about the principles of appropriate international economic market behavior and then to "call out" those whose behavior is detrimental to global growth and stability.
Yes, reform of the international institutions is a messy business, just as domestic policy making is a messy business in the context of a globally integrated economy. But if we are to continue to reap the benefits of global integration, then we need to get on with it.
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