2. Economic policy in the modern time
2.3.1. Pre-crisis consensus in theory and practice of economic policy
In view of the evolution of the theory and practice of economic policy presented in Sections 2.2.1 and 2.2.2, it is possible to determine major economic policy pre-cri-sis features. Mainstream policy was founded on the assumption that despite their
doubtless imperfections, fi nancial markets and, to a smaller extent, commodity and labor markets display both static (allocative) effi ciency, as well as dynamic, Schumpeterian effi ciency. In such conditions, the basic task of economic policy authorities was to eliminate impediments to effi cient operation of markets, and thus supporting autonomous market processes, primarily through deregulation [Sweeney 2005; Castles 2007]. Deregulation, and in consequence gradual reduc-tion of modern state funcreduc-tions to a set of basic responsibilities, might be inter-preted on the one hand as a deliberate broadening of the operative scope of the private sector – by allowing more fl exible adjustments to changing market con-ditions, and on the other hand, as a natural and logical reaction to the previously activated globalization processes. Th us, the instruments of direct control (see Sec-tion 2.1) have been recently used for implementing the concept of deregulaSec-tion.
Other important attributes of economic governance were changes in exchange rate practice and policy. Th ey had a major impact on the functioning of national economies. Governments together with central banks were gradually abandon-ing the fi xed exchange system, which eventually led to creation of a new envi-ronment for national economic policies.26 Th e fl exible exchange rate system that crowded out the Bretton Woods regime created a new environment for design-ing and implementdesign-ing national stabilization policy.
Th e main shift in focus as compared to the period of fi xed exchange rate domi-nation, however, was based on a gradual switching from discretionary fi scal poli-cies to automatic fi scal stabilizers, and, above others, the prominent role of central bank monetary policy (Table 2.5 and 2.6). Th ese tendencies were accompanied by growing political approval for choosing to fi ght infl ation as the main target of national economic policy. In practice it meant a higher political readiness to en-hance the economic policy horizon, because infl ation fi ghting requires painful actions and is always a longer-term endeavor.
In an open economy, under fl exible exchange rates and capital mobility, what undergoes major change is the power and competence confi guration regarding target selection and, consequently, economic policy instrument implementation.
As Table 2.5 and 2.6 show, under a fl exible exchange rate, central banks had be-come an institution of major signifi cance. Under the fl exible exchange rate system discretionary fi scal policy is no longer an effi cient instrument of aggregate de-mand management. Fiscal expansion triggers national currency rate appreciation on the one hand, and causes an international crowding-out eff ect on the other.27
26 Th e theoretical bases for formulating contemporary economic policy in conditions of capital mo-bility were set by M. Fleming and R. Mundell at the beginning of the 1960s. See: [Fleming 1962; Mundell 1963]. In recent literature see: [Rodrik 1996, 2007, 2011]. See Section 2.2.2.3 and 2.2.2.4.
27 Th e effi ciency of fi ne-tuning economic activity by means of discretionary fi scal policy becomes questionable also because of the uncertainty of this policy’s time lags and due to a diff erentiation of the expectation formation mechanism.
Th e fl exible exchange rate system, if it does not fully exclude an active, discre-tionary fi scal policy, certainly substantially reduces its effi ciency. Consequently, the area of feasible selection of fi scal policy contracts signifi cantly, also reducing the risk of government using fi scal policy instruments for election purposes. Th e rising position of central banks was gradually maintained by their strengthening of political and functional independence [see e.g.: Cukierman, Webb & Neyap-Table 2.5. Impact of fi scal expansion under capital mobility
Fixed exchange rate system Flexible exchange rate system Short-term:
Increase in interest rates accompanying fi scal ex-pansion is lower than it would be in the case of a closed economy, as the infl ow of capital (portfo-lio) takes place
Interest rates’ reaction is the function of capital mo-bility and local fi nancial market specifi cs In conditions of full capital mobility, especially in a small economy, interest rates do not undergo change In eff ect, foreign agents fi nance the additional, na-tional demand for credit stemming from fi scal ex-pansion
Th e scale of the crowding-out eff ect will thus be small or non-existent. Monetary policy is, however, ineff ective; the supply of money has to increase. Th e scale of its growth depends on central bank’s ability to run sterilization operations. Growth of the ag-gregate demand and gross domestic product will be a total eff ect in the real sphere. However, the scale of the unemployment rate reduction depends on the specifi cs of the particular labor market institutions
Short-term:
Portfolio capital infl ow in general leads to domestic currency appreciation. Appreciation reduces for-eign demand for domestic goods and thus shatters the initial aggregate demand growth triggered off by expansionary fi scal policy. Th e domestic currency appreciation also leads to import revival, and trade balance deterioration. As a consequence, there emerges a crowding-out eff ect triggered off by the exchange rate appreciation. Fiscal policy as a means of stimulating the economic situation is ineffi cient
Long-term:
If, as a result of fi scal expansion, the actual prod-uct approaches the level of or exceeds the potential product, infl ationary pressure will emerge. Th e ac-tual product and the unemployment rate return to the previous level. If the public sector’s borrowing requirement continues to be high and is accompa-nied by a decreasing aggregate product, tax rev-enue decreases
In consequence, fi xed budgetary expenses will in-crease their share in budgetary expenditure. What might arise is a threat of discontinuing the debt service and/or the necessity of devaluation. Such a forced devaluation might be interpreted as a proof of earlier mistakes and the economic policy’s failure.
A complicated and varying structure of economic policy time lags means that the likelihood of an ef-fi cient ef-fi ne tuning of the economy is low
Long-term:
If the public sector borrowing requirement is con-stantly maintained on an excessive level in relation to the supply of domestic saving, the ability to re-pay foreign debt is undermined.
Th e market appraisal of domestic currency will de-teriorate. It might be an early warning of a fi nancial and exchange rate crisis
Source: author’s synopsis of mainstream macroeconomic literature, based on: [Kowalski 2001, pp. 164–165].
ti 1992; Masciandaro & Spinelli 1994; Capie et al. 1994; Blinder 1998; Wojtyna 1998; Hochreiter & Kowalski 2000].
Fiscal policy was either restricted to formal rules,28 or was shift ed to the back-ground. Th is feature stems from the fact that in open economy conditions, the fi scal multiplier is reduced, and moreover, in currently dominating fl exible ex-change rates active fi scal policy is ineffi cient (Table 2.5 and 2.6). An additional factor limiting the potential scope of fi scal expansion might be the way it is fi -nanced. Typically, budget defi cits are partly fi nanced abroad; if fi scal expansion receives an unfavorable foreign assessment it might become unfeasible or could require special risk premiums on treasuries.
Aft er EMU formation, the exchange rate policy within this grouping ceased to have any importance. In relations with third countries, the EMU decided to apply the fl exible exchange rate system. Th e USA has been using the fl exible ex-change rate system practically since 1971.29 Such a combination of the main
28 For example convergence criteria as a necessary condition for joining the EMU, or Sta-bility and Growth Pact as a set of rules for the EMU members. Interestingly, the requirements concerning defi cit and level of public debt in relation to GDP formally apply to all EU mem-ber states.
29 Among the major economies, only China maintains a system of fi xed exchange rates with elements of regular correction towards appreciation.
Table 2.6. Impact of monetary expansion on the economy under capital mobility Fixed exchange rate system Flexible exchange rate system Short-term:
Impact of monetary expansion on domestic inter-est rates is negligible when a free fl ow of portfolio capital and direct investment is maintained. Th e economy’s reaction is marked by domestic and for-eign investors pulling out from the country; outfl ow of capital contributes to a signifi cant neutralization of the original monetary expansion. As a result, the effi ciency of monetary policy expansion is low or, in extreme cases, even zero
Short-term:
Outfl ow of capital triggers domestic currency de-preciation. Th e depreciation decreases the demand for imports and increases competitiveness of do-mestic products and exports. As a consequence, aggregate domestic demand and gross domestic product increase. Monetary policy is eff ective.
If a basic fl exibility of the labor market is main-tained, the unemployment rate also decreases. If, however, labor market is rigid, the phenomenon of hysteresis occurs and the unemployment rate remains unchanged
Long-term:
Outfl ow of capital neutralizes the growth in money supply. In the economy, the level of production ca-pacity utilization will not change, and in the long-term, the real eff ect of money supply expansion will be non-existent. In the long term, money is neutral
Long-term:
Th ere is a risk of infl ation growth. A rise in prices gradually neutralizes the eff ects of currency depre-ciation. Th e gross domestic product and employ-ment (if it has risen) return to the long-term level.
Th ere are no longstanding real eff ects in the econ-omy. Monetary policy is not eff ective. In the long term, money is neutral
Source: author’s synopsis of mainstream macroeconomic literature, based on: [Kowalski 2001, pp. 164–165].
rameters of fi scal policy and exchange rate policy pushes monetary policy into the foreground. In fact, since the late 1980s, central banks, their instruments and the problem of choosing goals have become the centre of attention of both theo-rists and practitioners of economic policy.
As emphasized in Section 2.2, central banks gradually began to play a promi-nent role in the institutional structure of the design and implementation of eco-nomic policy. Th eir position, independent of current political pressure, has been practically universally codifi ed and socially and politically accepted. It was com-monly acknowledged that their primary goal is to ensure low and stable infl ation.
Due to the huge scale of capital fl ows and the fl exible exchange rate system, inter-est rates, particularly the open market operation rate, became the key instruments of central banks. Th erefore, due to the long and variable outside lag of monetary policy and expectations as the key channel of transmission of monetary policy impulses, also in this area meant the acceptance of a certain kind of rule. It may be expressed by Taylor’s rule binding the central bank rate with expected infl a-tion and output gap [Taylor 1993, 1999]. In fact there is a family of such reaca-tion rules in which central bank’s interest rate adjusts in response to actual and fore-casted fl uctuations of both infl ation and real sector economic activity. Th ese re-action rules have their roots in Th eil’s fl exible-target approach (see Section 2.2).
According to Orphanides [2007, p. 6] Taylor was inspired by the policy regime evaluation project reported by Bryant, Hooper and Mann [1993]. Th e objective of the project was to identify a simple reaction function in which nominal in-terest rate controlled by a central bank would be consistent simultaneously with price and real sector economic stability. Its main conclusion was a general reac-tion funcreac-tion of the following form (2.16)
i – i* = θπ(π – π*) + θq(q – q*), (2.16) where:
i – short-term nominal interest rate controlled by a central ban, i* –baseline or desired level of nominal interest rates,
π – rate of infl ation,
π* – desired, targeted infl ation rate, q – real output,
q* – potential, trend real output, θπ , θq – reaction function parameters.
Following this general form (2.16) and Taylor, by setting i* and π* to 2 and θπ , θq to 0.5, formulated his monetary policy rule that ex-post, well described ac-tual FED monetary policy reactions in the late 1980s and early 1990s [Orpha-nides 2007, p. 6] followed:
i = 2 + π + 0.5(π – 2) + 0.5(q – q*). (2.17)
Simplicity and empirical soundness made the Taylor rule reaction function popular and triggered work on its extensions. It became not only an important teaching instrument but was also used by central banks as one of their analyti-cal tools. One of these extensions (equation (2.18)) is an open economy dynam-ic version with real eff ective exchange rates, a lagged interest rate, and a more developed real sector impact on the endogenous variable [see: Mohanty & Klau 2004, p. 10; Orphanides 2007, p. 7]:
i (1 θ ri)( *π*)θ ii 1θ π ππ( *)θ q qq( *)
q( s
θΔ ΔqΔ *)q θΔ (ΔsΔ *), (2.18)s where:
r* – equilibrium (natural) rate of interest rate,
(Δq – Δq*) – diff erence between output growth and its potential,
(Δs – Δs*) – diff erence between actual and trend-based real eff ective exchange rate changes,
θi, θΔq, θΔs – reaction function parameters.
Th e Taylor rule describing central bank behavior is linked to the modern sup-ply side function that has been a foundation for contemporary economic policy long-term perspective and its fundamental role in stabilizing infl ation expecta-tions [Mankiw 1997; Blanchard 2011]. Th e standard aggregate supply function can be written in the following form (2.19):
q = q* + α(P – P e), (2.19)
where:
P and P e – actual price and expected price levels respectively, α – parameter.
Equation (2.19) can be expressed in terms of actual price level (2.20):
1( *) P Pe q q
α . (2.20)
Th en by subtracting P–1 from both sides of equation (2.20) and, for the sake of simplifi cation assuming that (P – P–1) = π is infl ation rate, and (P e – P) = π e is expected infl ation rate we have (2.20'):
1( *) π πe q q
α . (2.20')
Following Blanchard [2011, p. 186] and Mankiw [1997, p. 347] it is possible to generalize the aggregate supply equation (2.20') by adding a supply shock term ε,
and substituting the output gap (q – q*) with the deviation of actual unemploy-ment rate u from its equilibrium (natural) rate u_
– (2.21):30 π = π e – β(u – u_
) + ε, (2.21) where:
β – parameter.
In fact equation (2.21), derived from aggregate supply function (2.19) is the ex-pectations augmented Phillips curve. It summarizes the pre-crisis economic policy consensus, where a low and stable infl ation rate became the core of both central bank and fi scal policy concerns. Furthermore it also justifi es longer term priority of infl uencing infl ation expectations and thus relying on autonomous self cor-recting mechanisms of contemporary economies.
In view of the above fi ndings, it can be asserted that the pre-crisis consensus on the optimum economic policy mix ensuring welfare (as its ultimate goal) was based on:
– the postulate for deregulation – freeing market mechanisms in a maximum breadth of sectors,
– central bank providing low and stable infl ation, which was seen as a founda-tion for fi nancial market generafounda-tion of a relatively low real interest rate, – reduction of the output gap (Okun’s gap), with the assumption that the fulfi
ll-ment of the fi rst two conditions considerably increases the probability of the reduction, or even complete elimination of this gap.