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Dinner-time Ruminations on “Diversity in Macroeconomics”

Laura E. Kodres

February 23, 2014

Sheri asked me to spend a few minutes this evening providing my thoughts on the conference and provide some insight into the ways we at the IMF are responding to the crisis and hoping to improve our macroeconomic policy advice.

Let me start by describing the role that the IMF plays in the macroeconomics field as some of you may only be familiar with the adjustment programs we finance. In addition to IMF programs, our main deliverables are surveillance (both bilateral and multilateral) and technical assistance and training.

  • Bilateral surveillance is mainly delivered through Article IV Consultations—these are mandatory once-a-year reviews of a member’s macroeconomic policies, with the purpose of highlighting vulnerabilities that may impede sustained and stable economic growth. The mandate comes from Article IV of our Articles of Agreement—the “constitution” of the IMF, if you will.
  • Also in the bilateral realm are Financial Sector Assessment Programs—these are a close examination of a country’s financial sector, especially its banking system, to develop a view about risks and provide advice.This is where we develop and perform our own stress tests. Twenty-nine countries have now been determined to be systemically important and must undergo an FSAP every 5 years. Twenty-four of the original 25 such systemically-important countries determined 3 years ago have already had an FSAP. FSAPs are voluntary and less frequent for other countries. Most results are publicly available.
  • Multilateral surveillance is primarily visible in our three flagship publications: the World Economic Outlook, the Global Financial Stability Report, and the Fiscal Monitor. Each produced twice a year.
  • Our third main area is technical assistance and training. Technical assistance of TA is provided only when a country makes a specific request. Among other areas of TA, we help central banks with their macro models, and financial supervisors and regulators with their systemic risk measurement techniques. Training courses are provided regionally for the official sector on a range of topics—including on macro-financial and macro-fiscal policies,microprudential andmacroprudential policies, and detecting macroeconomic vulnerabilities. [As an aside this is the part of the Fund where I now work.]

Enough of the synopsis of the IMF’s role. Since the crisis began we are attempting to see where we could have done better both in terms of anticipating the events and in terms of responding to them.

  • We have had our Independent Evaluation Office examine our performance in the run-up to the crisis and now they will also evaluate our response.
  • We have also done a lot of internal work on what lessons to draw from the crisis and how we should improve various aspects of our macroeconomic modeling and financial stability assessments.

As is obvious to those of you attending this conference, traditional macroeconomic models were woefully inadequate in providing guidance about how the macroeconomy might respond to a financial crisis. Not only did we underestimate the virulence of the financial crisis itself, but we also underestimated its effect on the real economy. Macroeconomists did not know what to make of the reactions of households, nonfinancial corporations, and financial firms’ to the events as they unfolded. The official sector’s responses also went well beyond the traditional responses. While some advanced economies, notably Japan, had experimented with unconventional monetary policy (including quantitative easing and forward guidance), this was new territory for many countries and policymakers were basically relying on their “gut” to formulate these new policies and their likely effectiveness.

So, how has the Fund responded, keeping in mind the roles I have just identified? Let me first outline the ways in which we are adjusting that are similar to those being considered by the field as a whole. I will then note how the IMF is changing internally. I will lastly suggest that we (and others) have not gone far enough. Macroeconomic policy support needs an overhaul or it risks becoming irrelevant and possibly damaging.

  • First, we are re-examining our macro models across the institution—looking especially at the areas where our models were inaccurate or misleading. We recognize that many view our institution as the nexus where models and policy advice meet—in fact that is by mandate. Our macroeconomic analysis needs to “lead by example.” Going forward, we need to focus much less on point estimates of an economic forecast, and much more about the risks for an economy (both internally generated and those coming from the outside). Moreover, we need to convince others of this new focus.
  • Second, we are trying to better integrate financial sector issues into our macroeconomic assessments, and into our modeling. Our modeling division inside our Research Department is extending their suit of models to incorporate financial sectors and macroprudential policy analysis. Others in the IMF are also building models, some of which are moving away traditional models. These include economists who are examining interconnectedness and linkages through network modeling. Additionally, we are beefing up internal training of our economists and making it mandatory.
  • Third, we need to be more focused on vulnerabilities and spillovers—the myriad ways in which risks can spread, both locally and globally. We have a new “Spillovers Report” and we now conduct both an Advanced Economy Vulnerabilities Exercise and an Emerging Market Vulnerabilities Exercise, as well as a formal Early Warning Exercise to examine tail risks, with this latter exercise shared with our member countries every six months. The tools used in these exercises are part of our training courses so countries can implement them as well.
  • Even if we were to accomplish improvements in these three areas, we need to ensure that our advice stemming from them is taken seriously by the country officials. This is not so easily accomplished, but at a minimum we need to convey clear, consistent messages to our member countries about the global outlook and the risks as we see them.

It is worth noting that these basic tasks are common to all economists—review the macroeconomic models we have been using; better integrate the financial sector into them; move toward a more risk and vulnerabilities-focused approach; and convey all this in a more convincing and cohesive way to those in a position to act on the information.

Let me now address how the internal workings of the IMF are changing to accomplish the tasks. In some ways we are a microcosm of the field, so perhaps some of these changes may be worth considering more generally.

  • First, we are trying various ways to foster an internal environment where candor and diverse, and possibly dissenting views, can be aired. Prior to the crisis, some inside the IMF recognized the warning signs of an impending crisis, but did not feel comfortable raising them when their superiors or colleagues were so convinced that “this time was different.” So-called “group think” is a common problem in many public and private organizations—we are trying to find incentives that will help us to lean against this tendency.
  • Second we are trying to break down the silo behavior and mentality across our various departments. For instance, we want to ensure the research department that does most of the modeling and the monetary and capital markets department that deals more exclusively with financeare cooperating. As well, we have teams providing the bilateral guidance to individual countries that need to incorporate the key guidance from the other multilaterally-focused departments and in return convey the country-specific issues that will require the multilateral skills to “connect the dots.” The key here is to make sure the latest and best analysis is wellknown to all economists to improve both our multilateral and bilateral advice.
  • Concrete efforts are:
  • Mandatory mobility of economists across the IMF’s main departments.
  • Policy papers explicitly co-authored by multiple departments.
  • More rigor and candor in our interdepartmental review process by insisting that we flesh out potential policy advice before teams leave for the field.

Although much of our efforts are focused on the prevention and anticipation of future financial crises, we are also trying to ensure that when crises hit, the IMF is ready and able to contribute to solving the issues.

  • The most visible way that we are pursuing this goal is the design of new facilities to make it easier for countries to “pre-qualify” for a loan from the IMF if they are undertaking good policies but get hit unawares from a crisis generated elsewhere. Hence, the Flexible Credit Line (FCL) was designed to meet the increased demand for crisis-prevention and crisis-mitigation lending from countries with very strong policy frameworks and track records in economic performance. To date, three countries, Poland, Mexico and Colombia, have accessed the FCL: due in part to the favorable market reaction, all three countries have so far not drawn FCL resources.

I haven’t mentioned all the ways we are adapting, but you get the general approach. Let me end with a call to do more.

Macroeconomists risk losing their influence if the field does not reinvent itself.I, for one, believe macroeconomic advice can still be valuable, but to be so it will need to adjust and adopt new thinking about how the economy operates. This new thinking, by necessity, will come from a diversity of approaches—and many of which from other disciplines.Macroeconomic model builders need to get out of their comfort zone of using equations and equilibrium concepts. This doesn’t mean that rigor or logic goes by the wayside, but that new “frameworks” for thinking about economic problems should be entertained.

This conference and most of papers being presented are still on the fringes. Many economists are skeptical about the usefulness of, say, neuroscience or psychology, in economics. Throwing away the maxim that everyone is rational and maximizes either profit or personal wealth will be uncomfortable for economists since it can lead to seemingly nonsensical outcomes.Notice, however, even in economic models, multiple equilibria often exist and we throw some of them out if they seem too weird. The key then is to build logical frameworks (OK, call them “models”) of human behavior than can still be tested and verified. This will not easy, but then no really interesting problem is. Let me end with a quote from John Kennedy, “Too often we enjoy the comfort of opinion, without the discomfort of thought.” Fortunately, this conference is already producing an abundance of “discomfort of thought.”