Friday 28 October 2016

Economic bright sparks still dazed from effects of the crisis

Published 10/05/2015 | 02:30

American economist Alan Greenspan has described economic inequality as 'dangerous'
American economist Alan Greenspan has described economic inequality as 'dangerous'

Economics has come in for no little criticism in recent years. It is easy to see why.

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A decade ago, economists involved in managing economies thought they had it cracked. Apart from a shallow recession in the early years of the new century, most developed world economies had been enjoying low inflation with steady, if usually not spectacular economic growth.

This 'Goldilocks' scenario (not too hot, not too cold) had pertained since the early 1990s, by which time a long period of very high inflation had been tamed.

The supposed end of boom and bust was mostly attributed to the sage use of macroeconomic levers - monetary and fiscal policy. Macroeconomists in general, and those who worked in central banks in particular, lauded themselves for the wonderful work they were doing. They described the age over which they presided as the "Great Moderation".

Nobody personified the cadre of self-assured macroeconomists better than Alan Greenspan - the man who ran America's central bank for almost two decades. When he stood down from the position in early 2006 the plaudits rained down.

His subsequent fall from grace mirrors perfectly the exploding of the false certainties in macroeconomics. The financial crash that started in 2007, the subsequent Great Recession and the slowest recovery from any downturn in the post World War II era, have all left macroeconomists reeling. Perhaps even more damaging is how the Great Moderation is now viewed. In fact, it never existed because in reality a supper bubble was inflating unobserved during the period.

All of the new uncertainties among macroeconomists were on display in Washington DC at a meeting last month. The IMF's chief economist, Frenchman Olivier Blanchard, has written a rather excellent essay-length blog on the issues raised.

The session was titled Rethinking Macro Policy III: Progress or Confusion? and, as the discussion below makes plain, there is a lot more confusion than progress. Here are some of the questions raised and matters discussed.

What will be the 'new normal'?

With Europe in particular struggling (eurozone GDP remains lower today than in 2007), a huge question is whether the current protracted period of low growth is a hangover from the super bubble or something even more profound.

"Larry Summers [former US finance minister] expanded on his secular stagnation hypothesis, arguing that, in the context of a chronic excess of saving over investment, keeping the economy at potential may well require very low or even negative real interest rates. He pointed out that real interest rates had started declining long before the crisis," writes Blanchard.

Many economists disagree with Summers, believing that the current period is just a very bad hangover after a long period of excess. The Frenchman hedges his bets, coming down somewhere in the middle.

"My own sense is that debt overhang is indeed playing a role but that the decrease in real rates is likely to persist in the future," he writes.

On interest rates at least, we in Ireland must hope he is right. Such is the debt overhang in the government, household and corporate sectors that any normalisation of rates over the next five years would have profoundly negative effects on Irish demand conditions.

Can we hope to limit systemic financial risk?

Perhaps the greatest failing of economists internationally and in Ireland before 2007 was a blindness to how big an impact the financial system has on the real economy. While this failing is now well recognised, economists are still in the early days of designing policies to limit the damage finance can do. Increased financial regulation plays a role for all but the most ideological of free market types, but more proactive measures are needed too.

In addition to stricter rules on all aspects of finance, a new buzzword has emerged - "macroprudential".

These are non-interest rate levers that can be pulled to stop asset price bubbles inflating. These macroprudential tools include the kind of measures the Irish Central Bank has recently introduced which are aimed at reducing the risks of another property bubble. They include ceilings on loan-to-value and loan-to-incomes ratios. Because those ceilings can be lowered if the market looks to be overheating they have a "dynamic" element that standard financial regulation lacks.

While the Central Bank was right to put these measures in place (and should have done so a few years ago when political resistance would have been much less), there remains a real issue in deciding when overheating is taking place.

Reflective of the more humble nature of macroeconomists, another former US treasury secretary at the Washington meeting said: "We were not very good at telling when times were exuberant rather than normal."

That observation remains true.

Little progress on the design of fiscal policy

"The traditional objection to using fiscal policy as a macroeconomic policy tool was that recessions did not last long, and by the time discretionary fiscal measures were implemented, it was typically too late," writes Blanchard.

But so deep was the Great Recession that an old Keynesian instinct was revived, particularly in the Anglophone world. Elsewhere, the notion that government stimulus yields short- or long-term benefits is not given much credence.

That view is particularly strongly held in the German-speaking world.

The divergent views on the matter, which are more about gut instinct than a dispassionate assessment of evidence, means that surprisingly little thought has gone into the most effective ways of using fiscal policy as an economic management tool.

Blanchard observes: "I am still struck by the lack of action on this front. The likely reason is that, for the time being, the focus on most governments is on debt reduction, on the right speed of fiscal consolidation."

Even there, however, there has been little work, and even less action on the design of fiscal rules apart from in Europe.

And in respect to those rules, Marco Buti - one of the most senior Eurocrats involved in euro-area economic governance - made a particularly interesting remark, noting that "the excessive number and complexity of the European Union rules reflects in part the relative weakness of the European commission in making sure countries actually implement them".

He may have had in mind a national capital noted for a large 19th century tower and good wine.

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