4-3.1. How Can Countries Commit to Good Macroeconomic Policies?

In this video, we're going to examine some mechanisms

for creating the right incentives for politicians and

policymakers to deliver good desirable macroeconomic policies.

First, let me introduce some rule-based policy restrictions. What does this mean?

Let's take, for example, monetary policy.

There are some economists who suggest that monetary policy should not be conducted

by a central bank that is independent and has discretion over monetary policy.

Rather, the task of creating money should be left to

a machine that increases money supplied by something like 4% per year.

4%, based on this calculation that the economy

grows at about 3% and you need 1%, 2% inflation,

so, altogether, around 4% or maybe 5% growth rate in

money supply would be adequate to keep the economy going.

And in case there's a recession, automatically,

prices go down and money creation in real terms goes

up and that automatically becomes a stimulus.

And in case the economy goes through a boom,

price level goes up fast and that reduces real money supply

and acts as a contractionary monetary policy automatically.

One doesn't need an independent central bank in order to

pursue a desirable monetary policy.

But there's a problem.

There are many uncertain events in which we want

the central bank to act in a major way to increase money supply,

much more than would be the case if we just relied on price level adjustment.

And we've also seen in previous videos that price adjustment by

itself may not take the economy to its long-run equilibrium quickly enough.

It may take many years and a deep recession

before the economy can reach its long-run equilibrium.

The second example from monetary policy that

some developing countries have pursued is use of currency board.

If politicians are suspected of manipulating money supply,

what one can do is to set up a currency board and,

essentially, tie the supply of money inside

the country to the amount of currency that comes from outside.

Here's how the currency board works.

The law sets a fixed exchange rate and the currency board is obliged to

exchange any amount of foreign currency that comes into

the country with domestic currency and vice versa.

Now, suppose that the economy goes through a boom and demand for money goes up.

Automatically, interest rates inside the country are going to rise,

more money is going to flow in,

and money supply is going to go up,

meeting the demand for money and keeping the economy and the interest rates stable.

On the other hand, if the economy goes through

a recession and people don't need that much money,

domestic money's going to be translated into

foreign currency and it's going to leave the country and,

again, it's going to make sure that interest rates remain stable.

So that's the mechanism in which money supply is going to be adjusted.

Now, if the economy needs some stimulation,

fiscal policy could expand and that

creates demand for money and money supply also automatically increases.

Since interest rates remain constant and they're checked by foreign interest rates,

that means that there's not going to be much crowding out effect,

negative effects, on investment and net exports.

So a currency board has some desirable characteristics and especially because it

ties the hands of policymakers in terms of what they can do and what they can't do.

If they're spending too much,

then money is going to leave the country,

interest rates are going to rise inside the country,

and that's going to actually punish the policymakers,

so they need to be careful with their expenditures and their conduct of fiscal policy.

At least that's the theory.

However, in practice, many situations arise

that a currency board cannot deal with the flow of money inside and outside the country.

Sometimes the source of the shock is outside

the country - there's a crisis in the global markets and domestic money

wants to leave or some additional money

comes in and creates too much demand inside the economy,

it causes overheat inside the economy,

and the government may not be able to respond to all these if it commits itself to

a fixed exchange rate and loses control of monetary policy.

In fact, such problems did materialize in the case of

Argentina that had adopted a currency board in the 1990s in order

to deal with high inflations that it had experienced in the 1980s when politicians could

actually print money as much as they could and

the inflation rate had touched 1000% or more.

In 1990, Argentina adopted a currency board,

making one peso exactly equal to one dollar,

and letting the money flow inside and outside the country very easily.

In the late 1990s and early 2000s,

this became a problem because the government had

spent too much and also oil prices were dropping.

Oil was one source of revenue for the government and for the country and, as a result,

there was expectation on the part of everyone around

the world that Argentina may not be able to pay back

its debts so money started leaving the country and

the central bank did not have

enough dollars to give to the owners of the domestic currency,

one for one, in order to enable them to take their money out of the country.

And besides, because people have lost confidence in that country,

interest rates inside the country were rising very sharply,

people were not willing to keep

the domestic currency anymore and those high interest rates meant

that investment had gone down and the country

was facing negative growth rate and very high unemployment rates.

Eventually, in 2002, when the government could not meet the demand for foreign currency,

devalued the currency and made

the peso worth one-third of a dollar in order to deal with this problem.

But the process of change was quite messy and, in early 2002,

Argentina changed six presidents before it reached some stability.

The lesson of all of this is that committing to simple rules is

very risky because the world is complex and things

might happen that are unforeseen and the rules may not be able to deal with them.

One needs some discretion to deal with unforeseen situations and that's

why these rules eventually break down.

Now let me give you some examples from fiscal policy.

One of the most hotly debated fiscal policy rule to

constrain politicians is balanced budget laws.

This is promoted by some politicians and economists.

They argue that, under balanced budget laws,

politicians are limited to the revenues that the government for what they can spend,

as a result, that crisis could be avoided.

This sounds good. Sounds like a good way of limiting politician's discretion.

However, here's the problem that comes up with this kind of rule.

Suppose the economy is in recession.

Tax revenues drop and private sector is laying off

workers and the economy needs some sort of stimulus.

But that's exactly when the government does the opposite.

Because the tax revenues are declining,

the government has to cut back its expenditure,

creating less demand for goods and services,

laying off workers, and exacerbating the situation in the economy,

making fiscal policy pro-cyclical,

which is very undesirable.

That's why this kind of rule does not work very well even if, for a while,

it may be adopted and politicians may abide by it,

but eventually, it's going to break down.

Some economists have proposed an alternative version of

balanced budget laws known as the golden rule and some states,

in fact, do have these rules.

Here's the difference between the golden rule and the simple balanced budget laws.

Under the golden rule,

the idea is that, if the government wants to invest,

it should be able to borrow,

but for current expenditure,

it should not be borrowing,

which makes sense and it's much better than simple balanced budget laws

because it gives politicians and policymakers more flexibility.

However, once this kind of policy is adopted, the problem arises.

Politicians actually can rename,

rebrand a lot of current expenditure as capital expenditure and,

as a result, spend the way they want.

There's, in fact, some evidence from states in the United States that have adopted

the golden rule that they reclassify their expenditures

as capital expenditure in order to avoid

the restrictions imposed by balanced budget laws on their current expenditure.

For example, some government staff may be assigned to

some capital expenditure projects and get paid over there while, in fact,

their main job is in the bureaucracy and should be part of current expenditure.

So what's the alternative to fixed rules?

The're ways of dealing with the manipulation of policymaking by

politicians by delegating the tasks of policymaking to professionals,

giving them some independence in their jobs,

and then setting up a system of checks and balances on what they do.

Here's some examples.

In monetary policy,

the most prominent example of delegation is independent central bank.

Under an independent central bank arrangement,

the governor or board of governors are appointed for

a fixed term and they cannot be removed during that term except for cause.

Then the key issue becomes who gets selected to run the independent central bank and,

for checks and balances,

one can use professional critique of what the central bank does and

public scrutiny of the board of governors and their decision making.

And when the governor of central bank or the governors of the central bank are selected,

one should set up the process in a way that people in those positions

follow professional values and care about their professional reputations and,

as a result, they will deliver policies that are publicly

good rather than privately good.

In some cases, once the task of making monetary policy is delegated to professionals,

then inflation targets are set and the performance

of the central bank is measured against reaching that target.

Whether there is too much inflation or too little inflation,

then the central bank governor is given the incentive to reach that target,

but the tools and mechanisms used for that purpose are

left to the discretion of the central bank governor or board of governors.

In the context of fiscal policy,

in order to achieve coordination in fiscal policy,

make sure that there's not too much expenditure

and the tragedy of commons does not occur, usually,

the power to set the maximum expenditure or expenditure limits,

debt limits, is given to one person in the government.

We could call that person powerful finance minister,

it could be a prime minister,

it could be the president,

but one person who has broader interest in setting

the policies that are good for the country rather

than bringing everybody in - all the interest groups,

all the representatives getting involved in the process of setting the limits.

Of course, how public resources are spent on various projects,

what the government actually does with the money that it wants to spend,

that could be debated and that could be set in the parliament or within the cabinet,

whatever the process of the decision making in fiscal policy is.

But the limits on how much the government should be running

a deficit or how much debt it could have at each point

in time needs to be checked in order to make sure that fiscal policy

is sustainable and desirable and follows the path of optimal policy.

In these situations, giving more power to the finance minister or to the prime minister

to enable them to veto proposals by various ministers,

veto proposals in the parliament,

to change the budget in favor of some interest group,

that could help a lot to set the policy closer to optimal policy.

But even better than that is to form

something which is mirror image of independent central bank,

and that's an independent national debt board.

Whatever a powerful finance minister may be able to achieve,

he or she is still a politician and may have incentives to deviate from optimal policies.

But having a national debt board,

along the lines of an independent central bank,

could solve this problem to a large extent.

Professionals could be appointed to the national debt board,

given some independence to choose the limits on deficit and debt every year,

based on what they observe in the economy,

whether the economy needs more expenditure, needs more debt,

or needs to cut back on the debt to get in

a better position to be able to deal with future shocks, for example.

Those things are professional matters and better be

determined by independent policymakers.

Of course, again, there should be checks and balances on them,

but that would be much better than just leaving it to the politicians.

So let me conclude this discussion.

What should good policy making look like?

First of all, from what we've discussed in previous videos, no fine-tuning.

Small deviations from production capacity do not

require any major changes in fiscal or monetary policy.

The economy has the ability to adjust to small shocks.

It's really the larger shocks that need to be dealt with,

so active macroeconomic policies should be reserved for dealing

with big shocks when the economy cannot adjust by itself in the short run or,

as we've seen before,

if it goes through a recession and inflation goes down, becomes a deflation.

We know that that could cause the recession to be prolonged, and therefore,

there may be a need for avoiding liquidity trap and,

in that situation, some policy,

especially fiscal policy, could be helpful.

Similarly, when there's some overheating in the economy,

active policy may be needed to bring stability to the economy.

In terms of achieving optimal policies,

as we've seen, it's very useful to use delegation rather than rules.

Of course, one needs accountability and checks and

balances for professionals who become policymakers

and run institutions such as independent central banks or national debt board.

Another final thought is that,

as we've seen in previous videos,

it's very important to reach coordination between monetary and fiscal policies.

Monetary policy should come first in dealing with any shock, but sometimes,

as in the case of liquidity trap,

we need fiscal policy to come in and the two need to be working together.

If, for example, the central bank tries to reduce inflation and,

at the same time, the government is increasing expenditure,

cutting taxes in order to stimulate the economy,

this could become very counterproductive.

And then there are mechanisms one can design that automatically

stabilize the economy and do not require active monetary or fiscal policies.

A very good example of this is progressive income taxes.

When the economy goes through a boom,

tax rates go up and automatically reduce demand

and reduce expenditure and cool down the economy.

On the other hand, if there is a recession,

tax rates drop sharply and that automatically

stimulates expenditure or helps expenditure go up and,

therefore, it helps stabilize the economy.

Another example is unemployment benefits and unemployment insurance.

If the economy goes through a recession,

some people lose their jobs and if they don't have income,

their expenditure goes down.

As a result, other firms will not be selling as much;

they may have to lay off their workers.

If you have unemployment insurance,

expenditure of those who get laid off doesn't go down that much and,

as a result, deep recessions could be avoided.

Let me end by saying that,

ultimately, good policies are made when the society appreciates good policies,

rewards policymakers who follow good policies, desirable policies,

and understanding of macroeconomics,

and economics in general,

helps a lot in improving policymaking by

politicians and giving them the right incentives.

Country Level Economics: Policies, Institutions, and Macroeconomic Performance

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