Macro stabilization policies for long-run growth: Lessons for developing Asia
The global financial crisis of 2008-2009 has reignited the debate on the role of macroeconomic policies. The role of macroeconomic stabilization policies can be contentious, especially as the policy room is increasingly limited in most advanced economies.
I had a pleasure of participating in an event organized by the Indian Institute of Foreign Trade as one of the Satellite events under the auspice of the Delhi Economics Conclave last week. The theme of the event was “Macroeconomic Stabilization Policy in an Era of Low Growth.”
The global financial crisis of 2008-2009 has reignited the debate on the role of macroeconomic policies. The role of macroeconomic stabilization policies can be contentious, especially as the policy room is increasingly limited in most advanced economies. While the situation is improving modestly in recent months, global recovery remains vulnerable. The euro crisis remains unresolved and the United States faces a potential fiscal cliff, presenting the biggest downside risk to the global outlook. Although Asian economies are a little better off, they also reeled from the impact of the protracted slowdown in advanced economies. Growth in Asia’s two giants— People's Republic of China (PRC) and India—has slowed quite significantly this year.
Will macroeconomic stabilization policies help in this environment? In traditional macro theory, long-term GDP growth should be independent of any short-term macroeconomic stabilization policies. Similarly, the conventional view held that money is neutral. In the long run, monetary policy affects prices, not real output. Although high inflation and price uncertainty is generally considered as harmful to growth, the effect of monetary policy on growth according to this view is only temporary. This draws largely on the neoclassical growth models where the ultimate determinant of long-term growth is technology—an exogenous variable.
The development of endogenous growth models challenged this view, however. The endogenous growth models view per capita GDP growth as an endogenous equilibrium outcome of the decisions by rational optimizing agents, whether firms or individuals, or the government and hence internalize the determinants of growth (Romer, 1986; Rebelo, 1991), such as accumulation of physical or human capital, evolution of technology through research and development, or even the role of macroeconomic policy.
Plenty of evidence suggests that macroeconomic stability is crucial for long-term growth. No country has achieved sustained high growth in a persistently high inflation environment. The sharp volatility in output associated with financial crises and external shocks (for example, an oil price shock) had a rather enduring negative impact on growth. Post-crisis evaluations often show that the crisis has a significant impact on potential growth starting. Many Asian economies have experienced a sharp drop in their growth potential since the Asian financial crisis of 1997-1998. Preliminary assessments suggest that growth potential of the US and European economies are being hurt in the aftermath of the global financial crisis of 2008-2009.
There is little disagreement that macro stabilization policy should respond to short-term shocks and mitigate output volatility to minimize social welfare losses around the business cycle. However, this view is too passive, given the importance of providing stable macro environment for the long-term growth potential of the economy.
If we believe that our future is a collective outcome of our decisions today, providing an environment conducive for today’s right decisions is crucial to achieving tomorrow’s growth. In this endogenous growth framework, monetary policy and broadly macro stabilization policy play an important role in economic decisions for investment in physical and human capital, R&D, and technology and productivity growth. That is, macro stabilization policy would be as important as any other factors including capital investment, education, and technology.
Lessons from the crisis are clear. In an increasingly more complex economic environment with globalized finance, policymakers around the world need to think and act flexible at all times. The ultimate goal of macroeconomic stabilization policies remains to be the output and price stability. Traditionally such stabilization policies refer to monetary and fiscal policies. However, with the economies increasingly open, globalized, and financially integrated, the scope of these policies need to expand much broader, while financial regulations, exchange rate policies and the internationally policy coordination can also play an important role in maintaining output and price stability.
For example, monetary policy needs to consider its implications for macro-financial stability, beyond price stability. The crisis painfully illustrated the limitation of financial regulations alone in preventing a buildup of systemic risks. Monetary policy can have implications for asset price booms, credit growth, and increases in leverage, and hence the authority should be mindful of these. Fiscal policy can be also effectively used to mitigate the crisis impact, but this requires sufficient fiscal space at hand. The country needs to exercise fiscal prudence during normal times to build fiscal space. Otherwise, fiscal expansion in the crisis can further undermine market confidence and aggravate the financial instability.
Asia is no longer a small player in the world in every aspect. The crisis underscored the impact of collective responses at the regional level through both monetary easing and fiscal expansion can be significant in arresting the panic and containing the spread of a crisis. Multilateral policy consultation and cooperation on financial regulations, exchange rates, and macroeconomic surveillance can enhance both domestic and regional macroeconomic and financial stability.
The crisis offers a rare opportunity for many economies to undertake wide-ranging structural reforms to improve productivity and economic efficiency. In Asia, the prolonged weakness in the global economy suggests that its economies need to adopt policies to prop up their own demand to sustain the growth momentum, while deepening structural reforms to promote inclusive and balanced growth. Appropriate macroeconomic policy responses should therefore support and facilitate the reform process within a more comprehensive policy framework towards these medium-term goals.