Good Policy Pays Off In Emerging Markets

“Lessons from the Financial Crisis for Monetary Policy in Emerging Markets” was the title for the 2010 L.K. Jha Lecture, which I gave this week at the Reserve Bank of India in Mumbai. Jha was one of the truly outstanding economists and public servants in Indian history, and the biennial lecture series in his honor was created by the RBI two decades ago. This week’s Jha Lecture was the first since the panic of fall 2008 which hit emerging markets severely. The previous lecture was given in November 2007 by Jean-Claude Trichet, President of the European Central Bank.

One cannot exaggerate the size and speed of the shock to emerging markets in the fall of 2008. International stock indexes fell in tandem with the S&P 500. Consumers and businesses pulled back, largely out of fear. Exports and imports fell sharply throughout the world, with production declines accelerating as firms cut their inventories. The drop in exports was an especially major hit to emerging market economies.

The big surprise, however, was the amazing resiliency of many emerging market countries, including India, in the face of these shocks. The contrast with the 1990s, when emerging markets were suffering their own crises, was stark. For countries such as Brazil and Turkey, which were in crisis as late as 2003, the difference was especially stark. Why were these emerging markets so resilient? In my view the most important reason is that they had moved toward better macroeconomic policies and they stuck to those policies during the crisis. They were careful not to borrow in foreign currencies, and here Indian regulatory policy deserves special credit in discouraging such borrowing by Indian banks. They built up their foreign reserves so they could intervene in the case of a big shock, like the one they received. They kept inflation relatively low and were more careful with public sector deficits. (The reason they moved in such a good direction will be the subject for a later post.)

The policy implications of the crisis are that those central banks which were following sounder policies—and here credit should be given to India and other emerging market countries—should continue to do so. There is no reason to change their reform efforts. There is no reason to raise inflation targets. There is no reason to start trying to burst bubbles. But those central banks which deviated from good policies (I discussed these in the lecture) should get back to what they were doing before the crisis. They need to earn back credibility and preserve their independence. Systematic monetary policies focusing on a credible goal for inflation worked well in the past and they will work well in the future.

But the crisis does reveal some potential new fault lines for emerging markets, largely related to the high degree of international connectedness between markets, so evident during the panic. These interconnections raise questions about the impact of central banks on each other. In the period leading up to the crisis there is evidence that some central banks held interest rates lower than they otherwise would have because the Fed set its interest rate so low. The reason, of course, is the exchange rate. A lower interest rate abroad would cause the exchange rate to appreciate with adverse consequences on exports.

Is there a better way? Making interest rates less erratic in the developed countries would help the emerging market countries. For the most part deviations from policy rules, such as the Taylor rule, have increased interest rate volatility, so keeping policy interest rates more on track will have the added advantage of reducing their erratic nature. Another possibility is a global target for the inflation rate. If such a target was considered in the deliberations of each central bank, then there would be less of a tendency to swing individual policy interest rates around by large amounts.

Macro Model Disagreements and Reality

Last Friday Macroeconomic Advisers (MA), a forecasting firm, posted a blog entry responding to empirical work by me and others on the “stimulus act” of 2009. I welcome the discussion, but unfortunately the blog seems to have missed the main points of my work along with John Cogan, Tobias Cwik, and Volker Wieland, which showed that (1) findings that the stimulus would have a large impact were not robust and (2) the data so far indicate that the actual effects on GDP or employment are not significant. Here is our working paper of a year ago and an oped.

First, we did not say or imply that “macro modelers such as MA were unaware of the ‘modern’ life-cycle (or permanent income) theory” or anything else of a personal nature. Instead, we showed that the temporary tax and transfer payments, which were a large part of the stimulus packages of 2008 and 2009, did not jump start consumption contrary to the claims of many. When you look at the evidence from 2009 (or 2008) you see that the theory holds up remarkably well. I am glad that the MA model incorporates that view.

Second, the MA blog claims that we relied on “small multipliers often found in reduced-form models” and that we used an “a-theoretical” approach. I see no way one could come to that conclusion from reading my work with Cogan, Cwik, and Wieland. Instead of reduced-form models we stressed the importance of using empirically-estimated structural models. We focused on the kind of models that have been taught in most graduate schools in economics in recent years and about which there has been a consensus in research, as emphasized by Michael Woodford of Columbia. In particular, we used a structural model estimated by Frank Smets, Director of Research at the European Central Bank, and his colleague Raf Wouters. We also looked at my own structural model, but we did not focus on that model so as to be more objective. Our structural approach predicted an impact of the stimulus which was only 1/6 what the administration claimed.

Third, the crowding out of investment and consumption by the stimulus in our analysis does not depend on the Fed increasing the interest rate in the short run. Our model simulations held the interest rate at zero for one or two years.

Fourth, the MA blog seems to miss the main point of my criticism as emphasized on Economics One for the past six months: There is no consensus among structural models about the forecasted impact of the stimulus: some models, such as ours, forecasted little or no impact; others models, like MA, forecasted a larger impact. The results of MA are thus not robust to different modeling assumptions. Menzie Chinn over at Econbrowser is right to say that “Something like [the Brookings Model comparison project of the 1980s] is desperately needed these days, so that those people who are concerned with seriously considering policy problems can sort out why the simulation results differ.” Indeed Volker Wieland has assembled a model database for exactly this reason.

In the meantime, I have argued that it is time to go beyond the models and see what actually happened rather than repeat the same model forecasting exercise over and over again with the path of government purchases, taxes, and transfers in the stimulus. In fact, many in the press perceive that these repeated forecast simulations are new evidence, even though they are essentially the same evidence provided before the stimulus was passed a year ago. I illustrated this misperception with a New York Times article from which I copied a chart from MA and other models. (Incidentally, this indirect reference to the Times’ MA chart is the only mention of MA in all our work). I have no disagreement with the MA blog about what the actual path of government spending, transfers, or taxes was. It has been very close to what Cogan, Cwik, Wieland and I assumed a year ago when we first circulated our analysis.

The MA blog does not refer to such evidence. For example, it does not analyze the contributions of the various components of real GDP growth in the past year to see if they are consistent with the stimulus having an effect. I have provided evidence using those numbers that government purchases did not contribute a noticeable amount to the change in real GDP growth. Likewise the evidence shows that the temporary tax changes or one-time transfers did not impact consumption or GDP significantly.

Stimulus Anniversary Blogs

With the one year anniversary of the signing of the stimulus it is useful to review the facts and data as they came in during the year. Here are the relevant posts from Economics One. Most look at actual data and find virtually no impact. The data include the contribution of GDP growth from government purchases versus investment and a comparison of the change in personal disposable income and personal consumption expenditures. The seventh post shows that most people who claim that the stimulus is working actually use the same models they used before the stimulus was passed with no new data.
Is the Stimulus Working? September 20, 2009
Despite Claims, Data Continue to Show Small Impact of Stimulus, October 23, 2009
National Accounts Show Stimulus Did Not Fuel GDP Growth, October 30, 2009
Jobs Saved, PR or Fact? November 6, 2009
From Fiscal Stimulus to Fiscal Anti-Stimulus, January 11, 2010
One Year Later and More Evidence that the Stimulus is Not Working, February 2, 2010
Measuring the Impact of the Stimulus Package with Economic Models, December 30, 2009

More Economists To Meet with Financial Crisis Inquiry Commission

The Financial Crisis Inquiry Commission (FCIC) will meet with more economists on February 26-27 to delve into causes of the crisis, considering in particular: monetary policy, derivatives, shadow banking, GSEs, and bailouts of "too big too fail" institutions. The forum is part of their “ongoing efforts to hear from academic experts and economists on issues related to the crisis.” Many of these issues were also covered in an FCIC hearing last October in which I was joined by Luigi Zingales and Joe Stiglitz. Here are my written answers to some of the FCIC questions, in which I stressed the role of monetary policy, GSEs, and bailouts in causing and prolonging the crisis.

New Book on How to End Government Bailouts

America is sick of bailouts. As President Obama called out in the State of the Union “we all hated the bank bailout. I hated it. I hated it. You hated it.” But the bailout mentality continues, and hate alone will not make it go away. So how can we end bailouts?

“Make failure tolerable” is George Shultz’s answer, as he explains in the lead essay of a new book in which a dozen policy makers, economists, and lawyers delve into the problem and come up with answers. The book is Ending Government Bailouts as We Know Them and is edited by Ken Scott, George Shultz and me.

If you look through the book, you’ll find

Paul Volcker explaining why his plan to further limit banks will reduce bailouts
Nick Brady reminding us that it wasn’t this way when he was on Wall Street or in the Treasury
Kimberly Summe telling the story of the Lehman Brothers bankruptcy (she was a lawyer there)
John Taylor confessing that systemic risk is not a well-defined concept after all
Darrell Duffie showing how contingent convertible debt is part of the answer
Richard Herring developing wind-down plans for big global financial firms
Joe Grundfest comparing such plans with pre nuptial agreements and Tiger Woods travails
Bill Kroener reviewing the pros and cons of an expanded FDIC operation (he was at the FDIC)
Tom Hoenig (with Chuck Morris and Ken Spong) laying out the rules-based Kansas City plan
Tom Jackson designing a disruption-free Chapter 11F bankruptcy plan for financial firms
Ken Scott evaluating whether the proposals work in theory and in practice

You will also find Gary Stern, Peter Wallison, Monika Piazzesi, David Skeel, Ernie Patrikis, Bob Hall and many others critiquing . With the Obama administration’s bringing Volcker’s ideas into the spotlight and Congressional Republicans finding new support for their bankruptcy ideas, it looks like the book is as timely as it could be.

An Exit Rule as an Exit Strategy for Monetary Policy

Today’s hearing at the House Committee on Financial Services on “Unwinding Emergency Federal Reserve Liquidity Programs and Implications for Economic Recovery” was cancelled because of snow. The hearing was to focus on whether the Fed’s extraordinary measures have worked and on an exit strategy from these measures. Ben Bernanke was to testify at the hearing and according to press reports he was to discuss the Fed’s exit strategy. His testimony will be posted on the Fed’s website.

I was asked to be a witness at the same hearing on a panel following Ben Bernanke’s testimony. Witnesses were asked to give an assessment of whether the extraordinary measures have worked and what is an appropriate policy for unwinding them. Here is the paper which I originally prepared for the hearing; it represents what I would have presented.

The term “exit rule” emphasizes that an exit strategy should describe how reserves and the Fed’s portfolio composition are to be adjusted over time in a predictable way in order to achieve the exit, much like a policy rule for the interest rate. I also propose a particular exit rule that might help policymakers develop such a strategy. It will be interesting to see whether the exit strategy in Ben Bernanke’s testimony has such predictable features.

The Macroeconomics of Education

The new study by my colleague Rick Hanushek and his coauthor Ludger Woessmann shows that bringing US education levels up to the level of Finland would raise real GDP by over $100 trillion measured in present discounted value terms over the next 80 years. Here is the chart from their paper with billions of US dollars on the vertical axis. Even in these days of trillion dollar rescue packages and growing debt burden on our grandchildren, $100 trillion is a lot of income, and the comparison with Finland shows that it is feasible.

One Year Later and More Evidence that the Stimulus is Not Working

Friday’s data release from the Bureau of Economic Analysis (BEA) shows that real GDP growth rebounded to 5.7 percent in the fourth quarter from 2.2 percent in the third quarter of last year. The rebound was sharper when compared with the -6.4 percent decline in the first quarter and -0.7 percent decline in the second quarter.

How much of the rebound was due to the “stimulus package" passed in February of last year? I have shown in a previous post that the increased transfer payments to individuals and temporary tax rebates had virtually no impact in jump-starting consumption. But what about the increase in government purchases in the stimulus package? A look at the details in the GDP report of Friday shows that changes in government purchases have had virtually no effect. The turn-around in growth has been mainly due to private investment. Four simple graphs illustrate this.

Recall that GDP is the sum of Consumption plus Investment plus Net Exports plus Government Purchases. Thus the growth of GDP can be decomposed into contributions due to each of these four components. Table 2 of the BEA data release reports these contributions, and I summarize them in the four charts. In each chart the blue line shows the growth rate of real GDP from the start of the recession. You can clearly see the decline in growth in the recession and then the start of the rebound. In the first chart the red line shows the contribution from investment. It explains most of the recession and the rebound. In the next chart you see the contribution of consumption, which plays a noticeable but considerably smaller role. The third chart shows the contribution of net exports, which explains some of the smaller movements in early 2008. The fourth chart shows the contribution of government purchases. I have focused on non-defense federal plus state and local purchases because defense spending was not part of the stimulus (adding in defense does not change the story). Note that none of the action in real GDP growth is due to government purchases. In other words during the entire first year of the stimulus package, the contribution of government purchases to change in real GDP growth is virtually nil. There is no evidence here that the stimulus has worked either to raise GDP growth or to create jobs.