Listening to Warsh on Stabilization Policy

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In my long association with the U.S. central bank, I encountered no more thoughtful, conscientious Fed Governor than Kevin Warsh. I have just reread “Rethinking Macro: Reassessing Microfoundations”, his chapter in the collection edited by Martin Baily and John Taylor (2014) on macro policy design in response to the Great Recession. Warsh’s contribution to the star-studded conference is unique, insightful, and important. It should be read by economists seriously interested in stabilization policymaking today.

Warsh worries about distortions rooted both in demand-intervention policies that overreach in their attempt to suppress macro volatility and in the “…complex, novel macroprudential regulatory framework to oversee banks and systemically important financial firms”. He argues that the two policy classes alter micro incentives and constraints throughout the economy, producing systematic changes in agent behavior. In particular, he believes that policymakers should be more alert to the capacity of such disruptions to harm productive and allocative efficiency, thereby reducing the economy’s ability to deliver rising living standards. Macro policy induced changes in incentives and constraints must be identified, calibrated, and factored into stabilization decisionmaking. For example, the aftermath of the Great Recession during which members of Congress openly spoke of punishing large banks has been marked by a rush to pile on product, capital, and liquidity regulations with little apparent regard for efficiency consequences.

The GEM Project. The Project provides a powerful analytic framework for Warsh’s careful critique of the on-going policy response to the 2008-09 extreme instability: “Economists and policymakers have long struggled to draw lines between stability and efficiency (Sargent, 2011). The line-drawing in the post-crisis era appears to be moving to favor macro-policies that elevate stability over efficiency. This is understandable and, by some lights, necessary. But, of no less consequence, I worry that the new stability agenda now in vogue seeks to do far more under the high-sounding auspices of stability than simply mitigating tail risks.”

Warsh plausibly worries that, in the aftermath of the huge welfare losses incurred in 2008-09, the almost exclusive policymaker emphasis on stability implies outcomes greatly biased against efficiency, generating over time costs significantly greater than their stability benefits: “What is this stability about? If it’s about making our financial system more resilient to shocks, then it strikes me as consistent with past motivations, if not practice. Ensuring that the plumbing of the financial system works to promote prosperity is a noble and worthy pursuit. But, in practice, upon surveying the broad suite of new policies, the new stability agenda may be something quite different, something untested, with implications unclear. The new stability agenda appears at least as focused on smoothing macroeconomic aggregates as on mitigating tail risks. It seems keen, in effect if not intent, to remove significant risk from financial markets—even in benign times—as if volatility itself were anathema to prosperity.”

The GEM Project uniquely microfounds the causality from nominal demand disturbances to the empirically familiar combination of involuntary reductions in jobs, output, wage income, and pure profit. It usefully identifies nonstationary demand disturbances (NDD) as a meta-externality, facilitating the identification of the proper policy mix between stability and efficiency effects of regulation. Pigou emphasized that it is the duty of government to prevent, in the interest of improved efficiency, adverse externalities. The Project demonstrates that it is the duty of the central bank, and other stabilization authorities, to prevent, in the interests of efficiency, the class of nonstationary demand disturbances. Effectively combating acute total spending instability, whenever it occurs, promotes efficiency. The Project also demonstrates how the Fed can effectively combat extreme instability. It should today be assembling a powerful demand-management toolkit, while aggressively communicating to investors and lenders globally its enhanced capacity and institutional commitment to halt and reverse future collapses in nominal demand while they are being spontaneously organized, likely as a result of some idiosyncratic financial crisis.

Going too far. The primary focus of the GEM Project on preventing NDD propagation does not imply elimination of all total-spending volatility. Generalized-exchange theory indicates that stabilization efforts should be centrally organized around nominal-demand management and discretionary demand interventions that deter unchecked nonstationary demand disturbances. Adverse NDD produce huge market failure and attendant destruction on employment, output, wage income, profits, wealth, and standards of living. Stabilization authorities must be alert to the metamorphosis of stationary into nonstationary demand disturbances. Typically, automatic stabilizers and standard lean-against-the-wind monetary policy are sufficient to keep nominal disturbances stationary. Keeping the fed funds rate near zero today when unemployment has dropped to 5-1/2 percent is overkill.

The GEM Project also does not rule out policies that are effectively designed to reduce the likelihood of financial crises on the scale of 2008-09 occurring. But that mission does not extend to elimination of risk from the banking system. Close attention must be paid to the efficiency-stability tradeoff always implicit in the design of macroprudential regulatory strategy. Warsh’s eloquent call for such attention contrasts sharply with today’s apparent single focus on risk elimination by most mainstream macroeconomists, as recently manifest in the Baily-Taylor volume.

Kevin Warsh gets a lot right in his chapter in Across the Great Divide: New Perspectives on the Financial Crisis (2014). It should be widely read, not overlooking his wise advice: “Getting the model right appears to be a predominant factor in getting policy right.”

Blog Type: Policy/Topical Chicago

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