José De Gregorio: Macroeconomics, policymaking and the crisis
Keynote speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the Bank
of Finland and Bank of Italy Conference on Challenges of the Global Crisis to
Macroeconomic Theory and International
Finance, in honour of Pentti Kouri, Helsinki,
11 June 2010.
* * *
I am grateful for useful discussions and comments from Mariana García and Pablo García.
It is an honor to participate in this tribute to Pentti Kouri. I did not have the pleasure to be
close to him, but I not only know well who he was and his work, but we also share some
things in common. We both study at MIT and did international finance. We were very close to
Rudi Dornbusch. There is a group of economists from all over the world, Chile and Finland
for example, which had the privilege to work close to him, as students or as colleagues, and
to enjoy his unconditional friendship and intellectual influence. In this conference there are a
few of this fortunate group.
Kouri and Dornbusch had pathbreaking work explaining exchange rate fluctuations as
movements of asset prices. Kouri's papers were always an important reference in our
course's work. By the time I was student, late 80s, reading Kouri's papers, he was a
successful investor living in Connecticut. I remember a couple of times when Rudi told me
that he would visit this great friend, economist and successful investor to get some funds for
the department. He succeeded, proof of which is that the department now has the Pentti J.K.
Kouri Career Development Associate Professor of Economics.
Today, rather than attempting to elaborate on Kouri's contribution, I think this is a good
opportunity to address some issues on the state of macroeconomics and policymaking,
which is the purpose of the conference, and are two aspects to which Rudi and Pentti
contributed a lot. If they were here with us today, their deep insights and provocative ideas,
regardless of whether we agreed with them or not, would certainly make us think.
Changes in the world economy, macroeconomics, and policymaking
More than 30 years after Kouri's influential work, the world has changed dramatically, and so
have economic theory and policymaking, especially in emerging market economies. There is
a growing role of markets in the determination of prices, in particular interest rates and
exchange rates. There is much greater trade and financial integration, which is a source of
greater interdependence cross economies, but is also a source of much greater opportunities
for developing countries. Finally, financial markets are much more sophisticated, which is
also a source of vulnerabilities and opportunities.
There has been also a profound evolution of macroeconomics. Developments, such as
rational expectations and dynamic inconsistency, changed the views on what
macroeconomic policies could achieve. They were also the basis for the discussion of rules
versus discretion, and the general preference for the conduct of policies under flexible rules,
or constrained discretion.
The possibility of expectational inefficiencies has also become an important insight for
policies. Contagion, self-fulfilling prophecies, coordination failures and multiple equilibria, are
just some of the phenomena from which market inefficiencies arise, and there are many
examples in the real world. However, one has to be careful when the failure of bad policies is
attributed to phenomena outside the control of authorities. Many crises that some may want
to classify as bad-expectational equilibria are simply the result of bad policies. Indeed, there
is no crisis that has struck a country without an associated fundamental problem. What
expectational inefficiencies do is that they amplify the probability of occurrence and the cost
of crises.
Other important development has been the understanding of policymaking, in particular
monetary policy, as a rule rather than changes in policy variables without reason. Thus,
rather than thinking of changes in the policy variables, it is more realistic to think of changes
in the determinants of policies. Finally, we have learned that credibility is central for the
effectiveness of policies.
All these developments have also led to changes in the way monetary policy is conducted.
However, an important caveat has to be made. There is a two-way relationship between
theory and policy developments. It would be presumptuous to argue that theory has changed
policies. Indeed, the development of inflation targeting came before it was seriously
discussed in academic circles. New Zealand implemented its inflation targeting regime in the
early 1990s, before the main analytical developments took place. Along the same line, the
Taylor rule was, obviously, used before John Taylor estimated it.
Regardless causality, monetary policy and central banking have changed significantly. The
movement toward granting central bank independence around the world has been a positive
one. Of course, this comes with the challenge for central bankers to demonstrate that this is
really a good thing, something that certainly has been questioned in some countries during
the recent crisis.
Although central banks were created to address problems in the banking sector, over time,
their objectives moved to more general aspects such as economic development or growth.
Then, since the 1980s, and with the success of the Great Moderation, central banks
increasingly, and rightly so, focused on price stability. Unfortunately, financial stability,
another issue at the core of central banking, was overlooked.
Monetary policy has abandoned money supply and exchange rates as nominal anchors, to
target directly inflation and anchoring nominal variables via inflationary expectations. To
reinforce credibility and to gain legitimacy, communication has become central to the conduct
of monetary policy. Many challenges remain; in particular how to incorporate the financial
stability goal into policy making, but the evolution of policy making has been enormous, in
particular for emerging economies.
However, progress in economics has not been completely successful, and many challenges
remain to make economic analysis more helpful to guide policies, and that is the issue I want
to discuss next.1
On models and theory
Macroeconomics has increasingly moved towards models more rigorously specified, with
sound micro-foundations, with all general equilibrium interactions, and explicit informational
constraints. However, there will always be tensions between rigor, realism and flexibility.
There are many tradeoffs.
The costs of these tradeoffs are often subtle. The tendency to base models on ever more
rigorous grounds, although a logical trend, has undesired effects. The incentives for younger
academics - the very ones who are supposed to push the borders of knowledge, and who
must publish or perish - limit their capabilities for innovation. The required rigor ends up
necessarily threatening realism. Nobody expects a model to explain all the complexities of
the real world, but the problem is that it can overlook elements that are crucial to
understanding and preventing economic disasters like the one we faced some years ago. It
may be more rewarding from an academic standpoint to write an equilibrium model
explaining some particular phenomenon, than trying to formulate a model that properly
represents all the distortions of said phenomenon. It is harder and less rewarding for an
academic to formulate distortions - of which the real world has plenty - than to use elegant
general equilibrium competitive models to explain important stylized facts with a minimum
number of new ingredients. Only a handful of academics are able to think rigorously out of
the box, and Kouri was one of them.
Complexity also jeopardizes the capacity to move from scientific research to economic policy
proposals. For academic ideas to be useful in economic policy making, they must be
persuasive. Perhaps that was the virtue of the IS-LM model that was used for many years in
macroeconomic policy discussions, or of Solow's growth model that to this day remains the
cornerstone of economic growth analysis. Fortunately, this is not a time where prescriptions
are taken by policymakers without scrutiny - and are later labeled as orthodox - and
therefore, the capacity to intuitively explain a result is essential. Models are only a part of the
reality that allows us to organize our ideas before diagnosing and prescribing. The
arguments' logic and a good deal of judgment are also critical when it comes to making
economic policy decisions.
Indeed, the current crisis has revealed that models have a limited ability to deal with all the
complexities of the real world. Even current state-of-the-art DSGE models, used in many
central banks, have been unable to consider in a manageable and explicit way all the
intricacies associated with financial markets' distortions and imperfect arbitrage, let alone the
existence of default and credit losses.
This brings me to the theory of finance. If there ever was one discipline that should have
anticipated the vulnerabilities that were building up in financial markets, it was finance. Had
the origin of the problem been inflationary, then the problem would have been
macroeconomics, but the origin was financial.2 The origin of the crisis was closely related to
financial innovation and the creation of instruments that should have diversified risks. Most of
financial innovation was used to circumvent regulation, allowing credit expansion with a weak
capital base. Low interest rates, search for yields and a monetary policy that promised to
rescue after severe falls in asset prices prompted the creation of a housing bubble.
Enormous efforts were made to price many extremely complex financial instruments, but
even those efforts failed to build valuation models that realistically considered the
instruments' insolvency probabilities. No evidence is necessary to assert that these methods
failed because of an extreme event that struck everything. These failures were exacerbated
by severe liquidity shortages and widespread panic in the markets.
It is paradoxical that while asset price theories, and their application to the real world, are
based on the existence of full arbitrage (consider, for example, the CAPM), corporate finance
theories are essentially dominated by information asymmetries and are plagued by frictions
from principal-agent problems. This dichotomy will have to be corrected over time to ensure
that more realistic models of how financial markets work become available, models which will
shed more light on economic policy recommendations.
On crisis prevention and management
A pervasive question for the past and current crises is whether they could have been
anticipated. On the one hand, it is tautological to say that crises are unpredictable, or else
they would never occur. History is plagued with crises. Moreover, crises have become more
frequent in recent decades as compared with the Bretton-Woods period, although their
severity and duration have not changed significantly (Bordo et al., 2001). Crises must be
avoided, but the only way to make sure they do not happen is to eliminate financial
innovation and development altogether, which we know is not a good prescription. Therefore,
crises will still occur, and the role of policies is not to be the cause of them, but to increase
resilience of financial systems and minimize their cost.3 Of course, all these elements were
absent in the global financial crisis and for this reason we need to devote more thinking to
reforms.
Although crises will continue to happen, we must not conclude that since crises are
unavoidable, there is nothing we can do about them. Instead, the proper way to act is to
strengthen the financial system and macroeconomic policies, in order to minimize their
probability of occurrence and their consequences, and to set up a proper crisis-management
strategy once they hit.
As in the case of natural disasters, or accidents, the fact that crises will continue to happen
does not mean that we must allow no regulation of economic activities (such as building
codes, or driving standards). Countries with better building codes are better at facing
earthquakes. In the case of financial crises, it is reasonable to improve regulatory
mechanisms, particularly to allow financial innovation while keeping vulnerability at bay.
Meanwhile, it is necessary to continue devoting efforts to the detection of early alerts,
although unambiguous indicators are impossible to find. But there are symptoms of fragility,
very common in emerging economies. High and persistent current-account deficits,
misaligned exchange rates, currency mismatches in the financial and corporate sectors,
excessive increases in the prices of assets and credit, all signal a potential problem, although
they do not necessarily result in a crisis. Therefore, a look at the indicators is not enough; it is
important to put them together to detect fragilities. This is precisely what we try to do in our
financial stability reports, which allow us to gain an overall vision of vulnerabilities, although,
once again, it does not provide a final verdict.
Final remarks
The world has gone through the worst crisis since the Great Depression. The initial shock on
the global economy did not differ much from the one that hit in the 1930s. There were many
similarities between the Great Depression and the Great Recession. Worth noting are the
initial fall in manufacturing output and trade, the collapse of stock prices and credit, and the
increase in bond spreads (see Eichengreen and O'Rourke, 2010). These remarkable
similarities in the first months of the crisis were alarming. The questioning of the profession
was also worrisome.
However, the subsequent evolution of the global economy was quite different from that of the
Great Depression, and it was certainly the result of good macroeconomic management.
There was a failure in crisis prevention, but the policy response has been good so far. More
remarkable has been the response of emerging market economies. In particular, Latin
America, a region that historically magnified the global cycle, this time will perform better
than the world economy's average.
The world has still many macroeconomic problems to solve before we can declare victory.
Indeed the same policies that averted a collapse require careful review to avoid planting the
seeds for the next crisis.
First, there is a need to think seriously about moral hazard. It is true that during the crisis this
was a second order problem. But, in the gestation of asset price bubbles there was the
commitment that if and when the bubble burst, the Fed would take care of the mess. This is
exactly the same as the build up of currency mismatches in emerging markets when
authorities promise to ensure exchange rate stability. In addition, we have witnessed a
messy bail out of banks, and more recently, and more worrisome, bail out of countries with
weak public finances.
The issue of sustainability has become very relevant, in particular on the fiscal sphere.
Economies cannot live forever beyond their means, and a serious effort of fiscal
consolidation must be made, in particular in fragile industrial economies. It is ironic that after
going through a very complex financial crisis, we are now worried about a very traditional
crisis, caused by fiscal imbalances in the context of a fixed exchange rate regime, with
potentially serious financial ramifications. The type of crisis that was analyzed and modeled
in international finance at the most intellectually prolific time of Pentti Kouri. He would
certainly have a lot to say about this.
References
Bordo, M., B. Eichengreen, D. Klingebiel and M.S. Martinez-Peria (2001), "Is the Crisis
Problem Growing More Severe?" Economic Policy 16(32): 51-82.
De Gregorio, J. (2009), "La Macroeconomía, los Economistas y la Crisis", Cuadernos de
Economía, Latin American Journal of Economics 46(134): 149-159. English version,
Economic Policy Paper No. 33, Central Bank of Chile.
De Gregorio, J. (2010), "Monetary Policy and Financial Stability: An Emerging Markets
Perspective", International Finance 13(1): 141-156.
Eichengreen, B. and K.H. O'Rourke (2010), "A Tale of Two Depressions: What do the New
Data Tell Us", in http://www.voxeu.org.
Quarterly
Rancière, R., A. Tornell and F. Westermann (2008), "Systemic Crises and Growth",
Journal of Economics 123(1): 359-406.