Transcript XIV. Current issues in economic policy

IX. Stabilization policies
1980 - 2007
IX.1 Disinflation in 1980s
beyond the USA
Example 1: Israel
• June 1985
– Monthly inflation 10-15%
– Rapid decrease of foreign reserves due to
capital flight
– Stagnation of real growth and productivity
– Continued growth of consumption and public
expenditure - increase of foreign debt
– Reduction in investment
Genesis (1)
• Main roots
– Deterioration of BoP (at the beginning, namely
deterioration of current account) and growth rates,
since 1973
– Large public sector (not only military expenditures),
deficit financing and increase of public debt
• All kind of subsidies – export financing, production prices, etc.
– Wage and other indexation
• COLA, even credit indexation
• Pre-1985 policies
– To improve BoP: devaluation
– To alleviate public finance deficit: subsidies cuts, but
not too successful in wage taming,
Genesis (2)
• Pre-1985 policies fueled the inflation further on
• Loss of foreign reserves continued even after
current account deficits substantially improved
– Capital flight continued
• Two major sources of almost-hyperinflation in
1985:
– Large government deficit, persistently increasing both
internal and external debt
– Automatic linkage the nominal value of wages, but
also other liquid assets (credits, etc.) to inflation and
automatic adjustment of ExR (devaluation) – loss of
nominal anchor
Solution
• Budget deficit reduction
• Initial further devaluation, but immediate
freezing of all nominal aggregates
– Combination of two nominal anchors: USD
exchange rate and nominal wages
• Central bank: nominal credit restriction
• Ministry of Commerce and Industry: price
controls
• Avoiding indexation
Very quick stabilization
Israel - summary
• Main stabilization tools: nominal anchor
and fiscal austerity
• Quick stabilization of all main
macroeconomic parameters
• Credible program, compared with
previous attempts
Example 2: Bolivia 1984-1985
Hyperinflation it was
• Strongest hyperinflation since 1947, no match with other
rapid inflations
– Between May and August 1985, inflation surged to
annualized figure of some 60.000%
• Roots: political situation and shift in external conditions
– Relative economic stability under military regime in 19711978: favorable terms of trade, strong (and relatively cheap)
international borrowing, strong direct foreign investment
– Difficult transition to political democracy: unstable and
ineffective governments, under populist pressure
• Pressure for increases in social spending, public sector employment
and pay, without mandate to increase taxes
– At the same time, much more difficult external conditions:
higher interest rates, falling commodity prices, tight credit
Three fundamental causes
• Cutoff in international lending and increase of
international interest rates
– Need to repay the debts without new borrowing
led to outflow of financial resources form the
country
– As a reaction, since January 1985 Bolivia stopped
every debt repayment, including the debt
servicing
• As a consequence, recourse to inflation tax
(seignorage), resulting in further inflation
acceleration
• Collapse of the tax system
Four stabilization steps
• Devaluation, managed ExR floating,
convertibility of both current and financial
accounts
• Fiscal deficit reduction, achieved mainly
through sharp increase of public sector
prices and wage freeze in public sector
• Tax increases: broadening tax base and tax
rates increase
• IMF stand-by arrangement and Paris club
debt rescheduling
Sudden end of hyperinflation
• Stabilization launched on August 29, 1985
• Price level stabilized almost immediately
• Main reason: stabilization (at least
temporarily) the USD ExR
– During the hyperinflation, prices were set in USD,
people used USD as a store of value, inly
transaction were carried in Bolivian peso, according
spot (black)market rate
• Credibility: achieved later, when government
convinced people that it is serious about fiscal
austerity and fiscal adjustment
Bolivia - summary
• “Simple” solution: given specific role of
USD, stabilizing dollar ExR was necessary
condition for immediate drop of Bolivian
inflation to the US one
• Long term stability: convince the public
about credibility of fiscal stabilization
– Maintain political support
Disinflation - summary
• Examples above - Israel, Bolivia, even US in 1980, but many other
countries (Argentina, Brazil, etc.) suffered with the same disinflation
problem as well
• High inflation (Bolivia even hyper-), in each case disinflation policies
differ to some extent, but some general lessons:
– Nominal anchors: need to stabilize decisive nominal values (Bolivia one
anchor - USD ExR, Israel even two - USD ExR and nominal wages)
– Credibility: abrupt exit from deficit financing and seigniorage (inflation tax)
• Macroeconomic remainder: seigniorage
• In some countries less dramatic situation, but given the stagflation
experience from 1970s and Phillips curve fallacy in 1960s, US, Europe
and Japan faced similar questions
– how to stabilize business cycle after dramatic 1970s and first half of 1980s?
– Accepting the concept of natural unemployment, policies need to steer the
economy close
– Short term inflation x unemployment exists, but long term need to avoid
high inflations
– Basic question: what should be the workable concept of “desirable”
unemployment?
NAIRU
• One possibility: try to specify an unemployment
rate that keeps inflation constant
• Remember expectations-augmented Phillips
curve:
π = π-1 – ε(u-u*) or π - π-1 = - ε(u-u*)
• If u*= u, then inflation is constant (π - π-1 = 0)
• Possible interpretation of natural rate of
unemployment: Non-Accelerating Inflation Rate
of Unemployment (NAIRU)
IX.2 Inflation and output
volatility
New trade-off
• Prior 1973 (1st oil shock), stabilization policies
focused on demand management
– Keynesian vs. monetarist arguments about efficiency of
stabilization policies
• Oil shocks in 1973/1979 – shocks to aggregate
supply
– Increasing price level and, at the same time, depressing
output and employment
– Policy makers had to choose between stabilizing either
output or inflation, i.e. to consider a compromise
between volatility of output (and (un)employment) and
of inflation – a different trade-off compared to Phillips
curve
By the way – what’s so wrong
about inflation? (1)
• At the first sight, if both prices and wages increase
with the same rate, not much
– However …
• Difference between expected and unexpected
inflation
• Expected:
– money becomes inferior measure of future economic
transactions
– distortion of tax system
– due to change in relative costs, firms must change prices
more often (“menu costs”)
– due to reduced real value of money, larger number of
bank withdrawals (“shoeleather costs”)
By the way – what’s so wrong
about inflation? (2)
• Unexpected
– Wealth redistribution among people
– Higher inflation – debtors gain, creditors loos,
but fixed income recipients (pensioners, etc.)
suffer, state gains
– Lower inflation – vice-versa
– In general: problem of nominal contract,
indexation (see case of Israel above)
Difficult legacy
• 1960s and 1970s
– excessive optimism as to policy effects on output: by
(namely) monetary policies, permanently low
unemployment levels can be achieved
– Inflation, on the contrary, believed to be driven by
non-monetary factors (supply shocks, oligopoly,
trade unions) – policy makers underestimated their
ability to cope with inflation
• Both assertion above proved to be wrong, stop
and go policies increased volatility
– High- and hyperinflations appeared much more
often, calling for emergency type of policies – see
above
IX.3 Inflation targeting
• The most important monetary policy lesson
from stagflation period
• Neither rule or discretion
– The central bank estimates and announces a target
for inflation (kind of a rule)
– Steering the actual inflation towards the target by
changing nominal basic interest rate and/or using
other tools (open market operations, etc.)
– It is expected to perform policy credibly to achieve
this target
– Target within an interval to give the Central Bank a
certain level of discretion
• Independence of the Central Bank
Advantages
• Clear accountability of Central Banks
• Transparency and predictability
• Stability for the investors: relatively easy
to predict future interest rates
• No link to political cycle
• Emerging countries: safeguard against high
and hyper inflations
Shortcomings (1)
• Targeting CPI and assumption of causal link:
growth of money supply → CPI
– CPI accurately reflects money supply (?)
– In case of exogenous shock (e.g. oil or food price
shock) → sharp increase of CPI possible, but no
relation to domestic economic events → Central
Banks acts against inflation → needless slowdown of domestic economic growth, deepening
of the negative effect of exogenous shock
Shortcomings (2)
• Inflation targeting is not consistent with
any long term growth theory/strategy
– Policy just smoothes the cycle
• No explicit set of monetary policy
recommendations
– One attempt – Taylor rule, see next slides
Taylor’s rule
(1)
• Rule, stipulating how much Central Banks should
change nominal interest rate, reacting to two
important signals:
– Divergence of actual inflation from target inflation
– Divergence of actual GDP from its potential
• π* - inflation target, r* - equilibrium real
interest (i.e. consistent with inflation
target and implying desired nominal
interest i*), y and y* - log of actual,
respectively potential output
Taylor’s rule
• The rule

(2)
 
i    r  a  -  b y - y
*
*
*

• a, b > 0
• Originally Taylor: a=b=0.5
• In case of stagflation, when monetary policy
goals may conflict, Central Banks should
change the weights for reducing inflation vs.
increasing output ad hoc (according the
situation)
Taylor’s rule
(3)
• Alternatively (natural unemployment u*):

 

~
*
~
i  i  a  -  - b u - u*
~
~
1  a  a  1, b  0  b  0
*
• Why a>0 ? – for spending, real interest rate is
important, i.e. when inflation raises, then
real interest should raise to slow-down the
economy
• Following the rule: increase of π by 1%
implies that Central Bank increases nominal
interest by more than 1%
Application and performance
• Since 1990, many countries, both developed
and developing, use Taylor rule
– First country: New Zealand 1990, Czech Republic
since 1999
– Not FED (different role, given by US Constitution)
• Till the crisis in 2008, Taylor rule produced
seemed to work satisfactorily
• One seed of the crisis?
– See Lecture XII
IX.4 Deficits, debts and fiscal rules
• Simultaneously, albeit in different (but not
always) countries, problem of permanent
public finance deficits and mounting public
debts emerged
– Welfare state, health systems, demographics
• Europe as a particular example
– See also next Lecture
• Creeping problems that persist till today
Is deficit and/or debt wrong?
• No, especially in a growing economy, when
deficits serve as a financing tool to increase
future productivity and competitiveness
• Balanced budget deficit
– Sometimes popular, but not a good idea for today’s
economies
– Need for higher flexibility
• Stabilization role
• Tax smoothing
• Inter-temporal solutions
Basic concepts
• Actual budget deficit (BD) = government
revenues minus government expenditures
• Primary deficit – BD minus interest payments
• Structural deficit (actual or primary) – adjusted
for short-term fluctuations of economic cycle
(determination of potential output required!)
• Financing of deficit = government borrowing
• Government debt = accumulation of past
borrowings
Fiscal sustainability
• More useful concept than balanced budget
• Different definitions
–
–
–
Ratio of government net assets to GDP remains
constant
Debt/GDP over time repeatedly converges to a
constant value
Fiscal sustainability is not consistent with
permanently increasing tax rate
• Prevailing practice today – intertemporal
definition of solvency of the country:
–
Given starting debt, discounted value of current
and future primary expenditures today does not
exceed discounted value of current and future
revenues today
Fiscal rule
•
Permanent restriction of fiscal policy through simple numerical
limits for budgetary aggregates
Features:
•
–
–
–
–
•
Taxonomy of the rules
–
–
–
•
Long term – numerical target for long period
Tool for fiscal policy control
Fiscal indicator for practical application
Simple - easy monitoring and communication with broad public
Budget deficit limits
Debt restriction, e.g. limit for a maximum debt, legally binding (e.g. 60%
GDP, given by Constitution in Poland today)
Rules, restricting maximum expenditures or minimum revenues
Most widespread: budget deficit limits:
primary deficit > (nominal interest – nominal GDP growth) * (debt/GDP)
IX.5 Great Moderation
Post-1980 decline of volatility
• See previous slide: variability in quarterly
growth of main macroeconomic
parameters was substantially reduced,
sometimes even by one half
• This applies not only to output, but to
inflation as well
• Economists and policy makers started
even to ask “is the business cycle dead?”
Volatility decline - data
GDP growth, q-data, yoy, %
GDP growth contributions – durables
q-data, yoy, %
GDP growth contributions – nondurables
q-data, yoy, %
GDP growth contributions – services
q-data, yoy, %
Three basic reasons – Bernanke 2004
• Structural changes
– Better functioning of economic institutions,
improvement in technology, business practices,
inventories management, increased openness to
trade and capital flows
– Stronger shock absorption capacity of modern
economies
• Better macroeconomic policies
– All lessons from previous Lectures
– Better understanding of short term stabilization
policies, namely a monetary one
• “Good luck”
– Less hostile external environment, lack of profound
external shocks, like oil shocks in 1970s
Mistake of the century?
• Hard to say, we are just at the beginning
of second decade …
• … but see Lecture X
Literature to Lecture IX
Textbooks
•Mankiw, Macroeconomics, Ch. 14-15
•Blanchard, Macroeconomics, Ch. 25-27
Disinflation – Israel
•Bruno, Michael, Generating a Sharp Disinflation: Israel 1985, NBER
working paper 1892, January 1986
Disinflation – Bolivia
•Sachs, Jeffery, The Bolivian Hyperinflation and Stabilization, NBER
Discussion Papers Series 2073, November 1986
Inflation Targeting
•Bernanke, Laubach, Mishkin, Posen: Inflation Targeting, Princeton
University Press, 1999
– Mostly case studies, but very useful general chapters 1-3.
Great Moderation
•Speech of Governor Bernanke, 2004:
http://www.federalreserve.gov/Boarddocs/Speeches/2004/20040220/