Pier Carlo Padoan, Chief Economist and Deputy Secretary-General of the OECD
31/01/2012 - A prominent paradigm shift took place in the early 1990s, when structural policy issues progressively gained prominence while macroeconomic policies became more rules-based. The “Great Moderation” of stable growth and prices since the mid 1990s was seen as evidence of the paradigm’s success.
However, favourable headline statistics masked growing underlying imbalances and, when these erupted with the financial crisis of 2008-09, established certainties broke down (again) and new approaches to policymaking came to the fore. What produced these imbalances?
Since the mid 1990s the world economy has become increasingly integrated, owing to the removal of trade barriers, the liberalisation of capital flows, the spread of new technologies and the fall of the Iron Curtain. The case of China, now the second largest economy in the world, deserves separate mention.
Since its accession to the World Trade Organisation in 2001, China has been running large current account surpluses, as have several other economies, including the oil exporting economies. The global “saving glut” allowed the US and other external deficit countries to finance their current account deficits at favourable terms and to keep bond yields low—especially since globalisation meant a massive increase in the global supply of lowskilled labour that kept core measures of inflation low. This allowed monetary policy to be supportive which, along with misguided “financial innovation”, contributed to excessive risk taking and leveraging.
The dotcom bust in 2000-01 should have been taken as a warning that systemic risk was unduly increasing. However, the potential for systemic financial risks was not effectively monitored. And policy decisions failed to incorporate the implications of the rapid pro-cyclical growth in financial leverage and risk taking, the concentration of risk, and the increasing potential for shocks to cross borders and markets.
This explains how problems in a small corner of US financial markets (subprime mortgages accounted for only 3% of US financial assets) could infect the entire global banking system and set off an explosive spiral of falling asset prices and bank losses. The financial crisis thus exposed a number of serious flaws in the predominant paradigm.
First, while monetary policy won the battle against inflation, it did so with support from globalisation, damping inflationary pressures amid buoyant economic conditions. This arguably led to excessive accommodative policy.
Second, fiscal policy rules failed to provide incentives for building up buffers in good times or to factor in the implications of rising private sector imbalances for sustaining public finances, thus producing sovereign debt crises.
Third, financial market supervision paid too little attention to systemic risks arising from leverage and the potential implications of rapidly increasing financial globalisation for the transmission of shocks across borders.
And finally, while structural policies were undertaken in many countries, there was little international co-ordination of policy choices, contributing to a persistence of cross-country imbalances in savings and investment.
These flaws are widely acknowledged and will prompt another paradigm shift. What the paradigm will look like is hard to tell with precision, but it will surely contain the following elements.
In order to preserve and build on the wide-ranging benefits of globalisation, it should seek to maintain financial stability amid sustainable, fair and green growth. Structural policies are pivotal and should pursue goals beyond such longer-term growth objectives, including facilitating fiscal consolidation, helping to narrow global imbalances via their impact on current accounts and capital flows, and supporting activity in the short run. But of course all strands of economic policy— prudential, fiscal, structural and monetary—have a role to play, each within their remit and proper assignments, but always in an integrated fashion for maximum impact.
Importantly, mechanisms need to be found to allow different policy settings to co-exist across the globe in a way that promotes economic stability and growth. This will require international co-operation, surveillance and communication in setting priorities and in minimising any potential adverse side-effects that can arise from the resulting geographical constellation of policies. One aspect of this is the international effort underway to strengthen prudential frameworks around the world. Beyond this, the role of the G20 Framework for Strong Sustainable and Balanced Growth is to identify a combination of macroeconomic, structural and exchange-rate policies that would both strengthen growth prospects and help to achieve more sustainable fiscal positions while minimising the risks of newly widening global imbalances.
Co-operation is also necessary to strengthen the international monetary system. Over time we could expect emerging market economies to experience a real appreciation. If the nominal exchange rate is fixed, the required changes have to come through adjustments to wages and prices, which can be costly as it risks raising inflation expectations. Persistent currency misalignments can also generate unsustainable external imbalances. Hence reforms need to facilitate the movement of exchange rates in line with economic fundamentals so as to ensure that nominal exchange-rate adjustments act as a safety valve. On the other hand, of course, excessive exchange-rate volatility can also have its costs.
Finally, a factor to take into account is that large yield-seeking capital flows to emerging market economies can increase the risk of a currency appreciation depressing competitiveness (or “Dutch disease”), reckless risk-taking and sudden stops or reversals. To smoothly channel and absorb capital inflows, emerging market economies should aim for an appropriate mix of macroeconomic policies. They must also reduce banking sector vulnerabilities by strengthening macroprudential frameworks, in order to further contain the risk of financial instability. The OECD has identified a possible way for structural policies to attenuate the financial stability risks associated with capital inflows—by encouraging more stable and productive forms of financing such as foreign direct investment. Capital restrictions should be a last resort and undertaken in a manner that preserves a level playing field.
© OECD Yearbook 2012