New Approaches to Economic Challenges: Reflection and Horizon Scanning

 

Until 2007, large parts of the world had enjoyed a long and sustained period of relatively strong economic growth and stability, the so-called “Great Moderation”. While there were signs of weaknesses and risks, most observers tended to underestimate these threats. The OECD was not alone in failing to connect or missing the warning signs. Other institutions involved in international surveillance, many finance ministries, credit rating agencies, national and supra-national financial regulators and financial institutions themselves had been lulled into a sense of complacency during the Great Moderation. Given the analytical models used to examine the financial sector, the extent of the crisis and the subsequent global recession were consistently underestimated, which contributed to significant policy failures. Five years since the crisis began many advanced economies remain fragile, with significant downside risks and high unemployment. In short, OECD countries were generally not prepared for the crisis and were poorly positioned to withstand it.

 

In light of work already undertaken by the OECD, as well as the extensive scholarly literature on the causes and lessons from the crisis, the proposals for further work under this category are necessarily selective and targeted towards addressing key gaps and priorities. This work includes:

  • Drawing lessons from the crisis and economic history and evaluating OECD forecasting and surveillance;
  • Examining the role of the financial system in the crisis and the reforms required for sustainable growth (including fostering long-term investment and responding to the challenges of ageing and longevity, and exploring new approaches to SME financing);
  • Revisiting policy instruments for achieving growth- and equity-friendly fiscal consolidation; and exploring new economic tools and approaches (such as behavioural economics, complexity science, and increased use of micro-data) and reviewing country experiences.

Lessons from economic history and previous crises


A1   The crisis: Drawing lessons from history and past policy experiences
   
A2   Forecasting in time of crisis: post-mortem of OECD projections [NEW REPORT AVAILABLE!]

 

Role of the financial sector in the crisis and future reforms


A3   The role of the financial system in the crisis and reforms required to promote sustainable growth
   
A4   Fostering long-term investment and responding to the challenges of ageing and longevity [NEW REPORT AVAILABLE!]
   
A5   New approaches to SME and entrepreneurship financing: broadening the range of instruments

 

Revisiting policy instruments for achieving growth- and equity-friendly fiscal consolidation


A6   How much scope to achieve growth- and equity-friendly fiscal consolidation?

 

Horizon scanning for new economic tools and approaches


A7   Applying new tools and approaches for better policy making



Description of Projects

A1.

The crisis: Drawing lessons from history and past policy experiences

Summary

Despite a number of idiosyncratic elements, the current crisis shared many broad characteristics with its predecessors. Lessons from the current crisis therefore cannot be drawn in isolation but need to be put in the broader context of insights from the history of economic thought. The proposed synthesis paper of existing literature will draw lessons about the origins and the resolution of the current crisis from economic history and the history of economic thought. The paper will be based on a high-level overview of the key crisis episodes and experiences internationally, including around the Great Depression, covering the run-up to the crisis, the crisis itself, as well as its aftermath. This would include more recent crises such as in Japan, the Nordic countries, and emerging markets in Asia and Latin America.  Insights from a longer-term perspective, covering pre-1914 experience, could also be included.

The paper will examine key lessons learnt from the functioning of the economy and financial system during that period, as well as prolonged periods of weak growth, investment and high unemployment in the wake of crises. In addition, the role of debt in triggering crises, the ensuing evolution of debt and the mechanisms for resolution of unsustainable debt across different economic sectors will be discussed. The paper will also review competing explanations of the crises, both current explanations and contemporary or earlier economic thinkers. Lessons will also be drawn from that experience in terms of policy to avoid worst impacts crises and how to resolve the current crisis.

 

A2.

Forecasting in time of crisis: post-mortem of OECD projections

Summary

The OECD, like most other forecasters, failed to predict the financial crisis in 2008/09, which affected OECD policy recommendations. In order to improve the relevance and quality of the OECD policy advice and surveillance, it is important to assess the reasons for forecasting errors and draw lessons for the projections in the future. In this context, it will be vital to identify shortcomings in the OECD projection practices in the lead-up to the crisis, and subsequently, in order to strengthen OECD future forecasting capabilities.

As a first step, the project will assess performance of OECD projections for Member and Partner countries from 2007 to 2012, comparing how they perform relative to the historical track record prior to 2006 and relative to projections by other organisations. Second, in contrast to previous post-mortems an important part of the study will be to assess whether available information was utilised fully in the OECD projections. This will involve attempting to explain the errors in the projections with a host of variables, including financial indicators, commodity prices, survey indicators and the fiscal stance. Third, the project will review recent developments in forecasting methodologies and procedures in other global and regional institutions in response to the crisis, as well as how past financial crises have influenced national forecasting practices. This will bring new insights into how forecasting institutions, including the OECD, have adapted to perceived shortcomings in their forecasting operations.

Related documentation:

The forthcoming report 'OECD forecasts during and after the financial crisis: a post-mortem' was launched on 11 February 2014. Based on the work carried under this project and presented at the NAEC Seminar on 20 November 2013, the report reviews the Organisation’s performance over the 2007-12 period, looks back at the forecasting errors, identifies the key economic factors behind these errors and looks forward to how economic modelling and forecasting practices can be improved.

 

A3.

The role of the financial system in the crisis and reforms required to promote sustainable growth

Summary

The crisis arose as a consequence of deregulation, innovation and regulatory and tax distortions that led to excess leverage, too-big-to-fail interconnectedness and conflicts of interest. Business models for larger banks focused on increasing the return on equity via securities businesses, excess leverage, over-the-counter derivatives and products with non-transparent spreads not subject to market competition. Leverage became extreme in derivatives products with re-hypothecation pyramids leading to a fundamental shortage of collateral that has required central banks to play a massive and unconventional monetary policy role in order to avoid liquidity issues (particularly margin calls) arising from shortening of the path to default. Such disequilibria will lead to changes in business models of banks, and the entry and exit of firms and products into and out of the shadow banking system. In this increasingly complex financial world, unsophisticated consumers need to be educated about risks and better protected.

The project aims to strike the right balance between simplified and transparent rules that help to deal with complexity and interdependence in the financial system and address major challenges such as destabilising levels of leverage, financial contagion, too big to fail problems, and conflicts of interest. The project will make specific proposals to ensure that the business models of financial firms help foster SME lending and long-term investment to support a better financial environment for growth. The project will use descriptive analysis (a data focus), analysis relating to incentive structures and wedges within regulations and the financial system and econometric testing of leverage rules and the impact of business structures on lending. It will address developments in OECD countries as well as selected non-OECD economies with large financial systems.

The project will also address the internationalisation of the financial system and the need for macro-prudential policies that do not unnecessarily restrict the cross-border movement of capital.  The OECD Codes of Liberalisation should be reviewed as part of this exercise to ensure that they play their full role as instruments of cooperation on capital flow measures. A third component of the project will address the policy implications of the risk transfer to households in the financial system (in particular, in mortgage markets, insurance and pensions). The project will combine qualitative and quantitative analysis on the contribution of financial inclusion, financial education, and financial consumer protection to growth and financial stability.

 

A4.

Fostering long-term investment and responding to the challenges of ageing and longevity

Summary

Prior to the crisis, tax and regulatory distortions accentuated financial and technological innovations to increase leverage and to change the role of intermediaries and relative prices in the funding of investment. It became possible to engineer more tax-efficient financial structures and improve the availability of financial capital for more speculative and risky investments. This, in turn, drove a less efficient allocation of society’s real economic resources (labour and materials). In essence, financial resource allocation became more complex, separating fundamental borrowers from ultimate investors. This created information asymmetries and made it more difficult for investors to appraise risks. The crisis has subsequently led to unusually low interest rates and a variety of other unusual factors. Because interest rates are low, debt is cheap. But the low interest rate environment tends to work to the detriment of companies that embark on long-term investment, as long-term investors searching for yield tend to sell their shares in favour of companies that give cash back to shareholders. This behaviour might be encouraged by rules governing pension funds and insurance companies which can favour mechanisms that result in short-termism and low investment. Thus, despite high cash flows in the corporate sector, long-term business investment remains subdued.

The project will therefore seek to identify the main drivers of growing cash piles and subdued investment at corporations and suggest ways to increase the use of cash flow for investment. It will also study the main barriers to the use of equity financing and find ways for corporate governance and market rules to help to improve price discovery and strengthen equity markets. The project will also consider policies affecting the ability of investors to engage in long-term investment in a low interest rate environment. It will therefore identify how regulatory frameworks and market practices can be adapted to facilitate investment by institutional investors in long-term assets, including less liquid markets such as unlisted infrastructure projects. Finally, the project will examine the implications of ageing and longevity risk for long-term institutional investors and ask what role governments might play in fostering incentives to postpone retirement, to increase participation in funded schemes (e.g. auto enrolment, matching contributions) and to promote capital market solutions to hedge longevity risk. Finally, the project will identify the problems in financial product markets—such as annuities in the payout phase—that impede hedging of longevity risk.

Related documentation:

 

A5.

New approaches to SME and entrepreneurship financing: broadening the range of instruments

Summary

SMEs have long been heavily reliant on traditional bank finance to fulfil their start-up, cash flow and investment needs, and policy interventions have largely been devoted to easing access to credit, for example through guarantees, or subsidies to provide credit on preferential terms. However, today there is an increasing recognition that the financial sector reforms undertaken in response to the crisis are likely to have a long-lasting effect on the availability and terms of credit for SMEs and entrepreneurs, going beyond the transitory implementation period. At the same time, governments now have a more limited ability to provide direct funding for these enterprises. There is growing concern among both financial institutions and businesses that credit constraints will simply become “the new normal” for SMEs and entrepreneurs, exacerbating an already long-standing structural problem. It is therefore necessary to broaden the range of financing instruments available to these businesses, in order to enable them to continue to play their role in growth, innovation and employment. For sustainable recovery and long-term growth, financial stability, financial inclusion and financial deepening should be considered as mutually reinforcing objectives.

This project aims to help broaden the finance options available to SMEs and entrepreneurs, by mapping – for the first time – the full range of potential financial instruments and conducting in-depth analysis on the potential and challenges for new approaches. The analysis will consider in particular innovative policies that build on public-private partnerships and focus on pilot experiences from which transferable lessons can be learned. Analytical studieson financing instruments alternative to straight debt will be carried out based on a literature review, surveys, case studies and policy evaluations. A specific effort will be devoted to improving the evidence base, as a lack of comprehensive data is a major obstacle to the analysis in this field. Expert meetings and workshops will provide the opportunity to discuss assumptions and findings with policy makers, practitioners and representatives of SME associations and financial institutions. The project is expected to make a tangible contribution to government efforts to ease finance constraints, by helping them develop and implement new policy approaches and support well-functioning markets in offering a broader range of finance instruments for SMEs and entrepreneurs.

 

A6.

How much scope to achieve growth- and equity-friendly fiscal consolidation?

Summary

Most OECD governments face large fiscal consolidation needs to reduce current elevated debt ratios to more prudent levels and keep them stable thereafter, despite long-term spending pressures on pensions, health and long-term care. In this context, it is important to examine policy options to meet these needs while preserving prosperity, minimising short-term economic and social hardship and avoiding increases in income and wealth inequality.

The project will look at fiscal consolidation instruments from a new and broader perspective, by simultaneously assessing their effects on growth and equity in the short term and over the longer term in a consistent fashion. A further novelty is that the choice and mix of preferred consolidation instruments  varies across countries depending on their starting point (e.g. in terms of their initial fiscal position, the composition of their budget, their vulnerability to hysteresis effects, their income distribution) and constraints (such as the current account position and the scope for monetary support). The project will also examine the margin of manoeuvre that countries possess within different broad tax- and spending areas compared to other OECD countries. Given the available leeway for each instrument and consolidation needs, the project looks at the extent to which substantial trade-offs between consolidation, growth and equity objectives may arise. The project will bring together results from previous empirical analyses and model simulations accumulated through work by the Economics Department in this area and apply them in a new manner, so as to take into account the characteristics of individual countries.

 

A7.

Applying new tools and approaches for better policy making

Summary

The crisis has revealed serious limitations of our existing economic and financial models in understanding and anticipating events and in helping to put economies back on sustained and sustainable growth paths. In addition, long-term global trends and the rise in interconnectedness and complexity also pose challenges for policy that may need to be met with a broader set of analytical frameworks and tools to better examine the trade-offs and complementarities.

NAEC will therefore explore new economic tools and approaches, as well as their current and potential future application in policy making. These new approaches include behavioural and experimental economics, complexity science (including agent-based modelling), and the more systematic use of micro-data. The intent is not to develop new economic theories, but to draw on developments in academia that could better inform policy analysis. One field that may be of particular relevance is behavioural economics. The OECD work programme touches upon a number of areas in which insights from behavioural economics can inform policy design, e.g. in the context of environmental policy, competition policy, pension contributions, consumer policy, taxation, nutrition choice and obesity. NAEC can facilitate greater cross-fertilisation and avenues for deepening work in this area. More generally, experimental economics can be a cost-effective tool for ex ante policy evaluation.  Sharing country experience on areas in which laboratory or - preferably field - experiments have been successfully implemented and informed policy choices could be reviewed.

Closely linked is the more systematic use of micro-data to better reflect the heterogeneity among economic actors and to facilitate more precise policy recommendations. Micro data can provide much richer insight into the mechanisms underlying trends and correlations at the macro and sectoral level, in particular when the aggregate data reflect large reallocations, e.g. between firms and workers, or important contributions of entry and exit. While the OECD has been at the forefront in using comparable micro-data for policy analysis, there is a need and an opportunity to better integrate them into OECD work in a cost-efficient way. Finally, some governments have already applied new approaches, such as experimental policy and evaluation to government learning. NAEC provides an opportunity to take a closer look at these new approaches to policy making and to learn from best practices to improve policy design and implementation. In this context, meetings with policy makers and other leading experts with experience in the application of these new economic tools and approaches can be held, and papers and/or case studies conducted to inform policy making.

 

 

Related Documents

 

NAEC

Policy Trade-Offs and Complementarities

Institutions and Governance

 

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