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Re-thinking Macroeconomic Theory and Policy

Raj Nallari's picture

If you think the US financial system is broken, then you don’t know how much more broken the macroeconomic theory is. The traditional Keynesian model of ‘depression economics’ where increasing government spending could stimulate the economy was misused by governments, particularly in developing countries, for decades during the 1950s to the 1980s. The result was the ‘commanding heights’ which expanded the role of the public sector in production, distribution, marketing, job creation, in almost all economic activities. Low economic growth and high rent-seeking by bureaucrats (through regulations and licensing systems) in developing countries was recorded during 1960-85.

The more recent version of Keynesianism which searched for ‘market failures’ and ‘missing markets’ with an emphasis on wages and prices adjusting slowly to shocks to the economic system also provides a rationale for government intervention in various markets, albeit relatively limited when compared with the traditional Keynesianism. Keynesian economists believe that the capitalist system deviates from the path of prosperity from time to time, and needs the steady hand of a strong government to monitor, regulate, and intervene to bring it back on rails. The recent global crisis has exposed the government weaknesses in developed and developing countries in regulating the financial system and in not maintaining prudent macroeconomic policies. Moreover, government is not a monolith – politicians have an interest to stay in power, the bureaucracy has its own interests, and the army may have a totally different objective.

The new classical framework asserts that economic agents, such as households and businesses, form expectations about the future in a rational way and then follow up to act rationally to maximize utility. Markets, if left to operate on their own, will function efficiently and will ‘revert to mean’ if they deviate too much away from the fundamentals. The recent crisis belies the rational expectations assumption because the financial firms and individuals exhibited more of a ‘herd behavior’ by assuming that housing values and asset prices will continue to increase forever. The demand and supply of housing and assets did not adjust to price changes. Moreover, it revealed that interest rates, exchange rates, energy prices, commodity prices, among others are largely influenced by governments, financial markets, and large institutional investors in these markets. The forgotten lines of Keynes that expectations about future are uncertain and therefore economic agents fall back on raw emotion or ‘animal spirits’ are now resurgent (Akerlof and Shiller 2009). Sudden stops in capital flows across countries as evidenced during the 1997-98 Asian crisis and the 2008-09 global crisis vouch to the existence of animal spirits.

The Austrian Economics School is of the view that Keynesian stimulus are likely to have short term benefits but in the medium to longer term they may be counterproductive especially if the adjustment between production (supply) and demand for goods and services is impeded by the short term policies. Moreover, failure to adjust quickly would have the result of fiscal stimulus leading to a surge in aggregate demand (with supply being slow to adjust) and quickly feed into inflationary pressures.

Modern macroeconomics does not incorporate the role of financial intermediaries in their models. The structure of banks and financial intermediaries does not matter in current economic models. Banks used deposits (which we protected by deposit insurance) as a base to generate loans and provide credit. Monetary policy also affects the economy through the quantity of bank reserves and thereby bank credit. We know that financial firms create financial instruments, particularly during a boom, that provide credit to finance the boom. Minsky (1982) outlines that at the beginning of the credit cycle, the duration of the loans is longer but get shorter and shorter during later stages of this credit cycle as new loans are basically given to service the interest on previous loans (the so-called greening of loans). In such a way, the Minsky-Kindleberger theories emphasized irrational myopia and herd-like behavior causing endogenous cycles as greed and fear dominate banking and investment behavior rather than rational, long-term projection of fundamentals. While greed leads to under-pricing of risk, fear leads to over-pricing of risk. While the U.S. mortgage crisis can be partly explained by greed and fear, it does not explain the timing of the crisis, the duration of credit cycle in the US and why it is of different durations in different countries, and how long will a financial collapse last.

The current state of the art economic models, such as dynamic stochastic general equilibrium, include rational expectations and the ‘sticky price and wage’ hypotheses – the new Keynesian-Neoclassical synthesis version – and assets that private consumption and investment are dependent on income and asset values (wealth in the form of housing and stocks among other assets).

Since the mid-1980s, fiscal policy as a counter-cyclical policy tool faded in part due to excesses of government but also because financial sector development in the Western world coincided with more use of monetary policy in economic management. Moreover, fiscal policy was estimated to have long lags (12-18 months) while monetary policy took shorter time to have an impact on output.

In line with this new synthesis, monetary policy rule (so-called Taylor rule) is based on the deviation of the actual inflation from its expectations, the output gap (deviation of the current output from its natural or potential level). Monetary policy targeted inflation with policy interest rate (the short term interest rate that the central bank can directly control through open market operations) as the key instrument. The objective was to keep inflation low and stable with the expectation that this policy will keep output gap small. In line with this approach, inflation targeting of 2% or so was considered optimal and it was assumed that real effects of the policy occurred through market interest rate and asset prices. As long as there was enough liquidity in the economy there was no problem. Deflation was considered a distant possibility.

An augmented version of the Taylor rule could include the central bank reacting to the housing prices, stock prices and credit frictions. The idea behind credit friction is that the optimal monetary policy rule should be designed in such a manner where the policy interest rate should be lowered when credit spreads increase. This avoids the potential increase in credit spreads from “effectively tightening monetary conditions” which are not justified by the deviation of the inflation expectations, the output gap, and the other variables included in the monetary policy rule.

The recent crisis also showed that (i) countries also use monetary policy for stabilizing exchange rate volatility; therefore the Taylor rule needs to have exchange rate stability in its objective function; and (ii) asset prices tend to deviate from fundamentals, not for liquidity purposes but due to heightened speculation.

The failure of economics as a profession to anticipate the global financial crisis has brought about renewed interest among academics and policymakers on Keynesianism, particularly on Keynes’ views on multipliers. The Keynesian multiplier is the impact of traditional macroeconomic policies, such as an increase in government spending, that is “multiplied” by boosting private consumption by households and capital investment by firms as they receive income from the initial round of fiscal stimulus. The multiplier effects are important to assess the strength and speed of economic recovery in a country.

Krugman (2008) explains the current financial crisis using the approach of Calvo (1998) and Kaminsky (2003) where contagion spreads through balance sheet effects on financial intermediaries. A lot of episodes of financial crisis during recent decades involve a ‘leveraged common creditor’ where different countries are connected financially. The issue is not one of liquidity but one of under-capitalization. For example, when the Russian crisis hit in 1998, hedge funds that had large exposure in Russia plugged massive amounts out of Brazil as well, thereby creating financial problems in Brazil. During the current crisis, highly toxic assets such as mortgage-backed securities were held by several highly leveraged financial institutions in the US, Europe, Brazil, China and a few other countries. A large decline in housing prices reduced the general public’s demand for mortgage-backed securities (assets) and leveraged institutions had to cut back sharply on the supply of mortgage-backed securities (assets). This initial effect is magnified as the falling asset prices force the leveraged institutions to further contract their balance sheets leading to further fall in asset values and so on. When housing prices declined not only in the US, but a large number of countries in Western and Eastern Europe, and several emerging economies, the global financial multiplier is further magnified in a vicious spiral downward. The same multiplier can also work in a virtuous circle, say when the next great financial innovation occurs, for example, when life-insurance policies or pension funds or some other assets would replace the mortgage backed securities.

Policy Implications

In short, economic theory is incomplete but still evolving as more and more structural, institutional, and behavioral characteristics are incorporated to depict a modern economy. Basic assumptions about human behavior and globalization have to be understood and re-thought, while policy functions have to be improved to reflect a modern economy. Modern macroeconomics is embroiled in debating false dichotomy and theoretical issues while neglecting to incorporate practical realities such as financial intermediaries and their regulation in their macroeconomic frameworks, as well as including political economy constraints, such as ‘state capture’ by the elites, where policy is an outcome of a collusion between ‘big business/finance’ and ‘big government.’

For developing countries in particular, while they should continue to have restrained role for government in productive activities, they need to ensure some fiscal space at all times to deal with exogenous shocks, such as the food, fuel and financial crises of 2006-09. More importantly, developing country governments need to expand the coverage of social protection, including automatic stabilizers to protect the poor and the vulnerable. Fiscal policy as a tool needs to be re-asserted. Premature withdrawal of fiscal stimulus policies could result in reversing an economic recovery and increase unemployment rate.

As Blanchard et al (2010) point out, inflation targeting could be more relaxed because the economic cost of driving inflation to 2% and keeping it there has been shown to be expensive. Not only a higher inflation could be targeted, a more flexible inflation regime could be devised. When inflation is close to two should monetary policy err on the side of laxity rather than tighten policy further to wring out the already low inflation at exorbitant output costs to avoid the risk of deflation?

Shouldn’t monetary policy deal with asset price booms and excessive credit or leverage ratios? The policy interest rate is a blunt tool to deal with the housing and asset price booms and would need prudential regulations. This will require close coordination between the regulatory authorities and central bank authorities.
To minimize credit bubbles in the future, there is a need for policy makers to develop a system of monitoring leverage ratios among financial firms. In addition, there may be a need to regulate pockets of leverage for certain firms or types of transactions, including ensuring more capital for such highly-leveraged firms or by increasing margin requirements or by restricting the use of loan-to-value ratios for housing loans.

Re-thinking exchange rate regimes and use of capital controls is another area for study. Much needs to be done to upgrade macroeconomic theory and policy.



Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro (2010), Rethinking Macroeconomic Policy. IMF Staff Position Note. SPN/10/03 February 12, 2010.

Paul Krugman (2008), A Note on International Financial Multiplier, Mimeo.

William White (2009), Modern Macroeconomics is on the Wrong Track. Finance and Development, December, pp 15-18.

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