Growth policies and macroeconomic stability, OECD Economic Policy Paper, No. 8
How do growth-promoting policies affect macroeconomic stability?, OECD Economics Department Policy Notes, No. 22
Macroeconomic shocks as severe and protracted as those since 2007 warrant a reconsideration of the role growth-promoting policies play in shaping the vulnerability and resilience of an economy to macroeconomic shocks. Against this background, this paper looks at a vast array of policy recommendations by the OECD that promote long-term growth – contained in Going for Growth and the Economic Outlook –and attempts to establish whether they underpin macroeconomic stability or whether there is a trade-off.
Key policy messages
- OECD policy recommendations aimed at boosting long-run growth often have side effects –positive or negative – on an economy's vulnerability to shocks and their propagation. The Great Recession has prompted a review of such recommendations and the extent to which they involve trade-offs between long-run growth and stability and how such trade-offs can be mitigated.
Vulnerability to shocks
• The OECD Growth Study identified financial market deepening as supporting long-term growth, but the role of the financial sector as a source of instability was not considered. Robust micro and macroprudential regulation needs to be in place to reap the benefits of deep financial markets without increasing economic instability.
• Even with such regulation in place, policy may need to react to emerging threats from the financial sector and asset price bubbles.
- Pursuing price stability over a sufficiently long horizon will allow some leeway for monetary policy to contribute to financial stability. Nonetheless, interest rates are a blunt instrument with the costs felt widely across the economy.
- A regulatory framework that ensures a higher flexibility of housing supply ought in principle to be good for growth and may reduce the risk of house price bubbles, but at the price of greater volatility of building activity, leaving the overall effect on stability unclear.
- Both long-run growth and stability will be served by avoiding debt biases in the tax code – particularly for the housing market.
• Trade and financial openness support long-run growth but create vulnerabilities to external shocks. In addressing external imbalances and the risk of sudden stops of capital flows, fiscal policy may sometimes need to be tighter, impediments to direct and equity investment should be removed, and structural and financial policies more generally reformed to remove biases in capital flows contributing to financial account vulnerabilities.
• Monetary and budgetary policy settings aimed at low and stable inflation and sound public finances are conducive to long-term growth. Sometimes these policies will also help to contain shocks, but there can be trade-offs.
- Monetary policy that has ensured a firm anchoring of inflation expectations will allow a stronger response to shocks and helps guard against deflationary spirals in the wake of large negative shocks.
- Raising the inflation target could create additional room for monetary policy to react to a severe downturn, but the transition to a new target will involve costs and if the increase in inflation was substantial it would lead to efficiency losses.
- Low government debt levels and sustainable fiscal balances provide fiscal policy room to address large, adverse shocks and absorb liabilities held by other sectors.
- The strength of the automatic fiscal stabilisers depends on the size and progressivity of the tax system and the generosity of the unemployment insurance system. A generous unemployment insurance system and a large and progressive tax system stabilise the economy, but have detrimental growth effects. Making policies state contingent, for instance, by prolonging unemployment benefit payments temporarily during a downswing might ease the trade-off.
• Labour and product market policies can affect the size and persistence of a shock.
- Overly tight labour and product market regulations are generally bad for long-term growth. Such policy settings may damp the initial impact of a shock, but could raise its persistence. New findings concerning the recent crisis found no damping effects from such settings, but they still led to greater persistence.
- A number of labour market policies may harm long-term growth and prolong the duration of a shock. They include restrictive employment protection for regular workers, wider coverage of collective agreements and high replacement rates for unemployment benefits.
- Labour market policies that promote employment and growth, such as active labour market policies, are conducive to growth because they help contain the threat of hysteresis during a crisis and also lower shock persistence.
- Short-time working schemes helped cushion the impact of the recent crisis. However, if not well-designed, they may prevent or retard structural adjustment or augment wage pressures, implying a trade-off with long-term performance.
- Tight product market regulation undermines the capacity of an economy to reallocate resources in the face of a major supply-side shock. Light regulation promotes growth and reduces shock persistence.
• Financial sector policies can also influence how shocks are propagated.
- Regulation and supervision to ensure that banks are well capitalised and make sufficient provisions increases the robustness of the banking sector in the face of shocks.
- In the past, policy advice has not examined ways to deal with debt overhangs. Bankruptcy provisions and other institutions that facilitate debt restructuring may help limit the negative drag of deleveraging on consumption and investment. However, this could lead to lenders demanding higher risk premia with potential adverse consequences for growth.