John Taylor, Mary and Robert Raymond Professor of Economics at Stanford University; George P. Shultz Senior Fellow in Economics at Stanford’s Hoover Institution, former Undersecretary of the Treasury for International Affairs; former member of the President’s Council of Economic Advisors; and former Director, Stanford Institute for Economic Policy Research.
Has the experience of the crisis changed your view of the central bank policy tool kit?
Undersecretary Taylor: My reading of what has happened in the years leading up to and following the crisis, and including the crisis itself, is that we deviated from some of the policies that worked well for a couple of decades or more – during the so-called Great Moderation – and that has led to problems.
So, it’s not really that there’s a new tool kit needed but rather that we need to reinforce the lessons of the way the tools were used in the past when policy worked well. I would add that it’s not just the experience in the U.S. and the developed countries, but also in emerging market and other countries in the world that leads to this conclusion.
Some of the frequently-mentioned items in the tool kit are macro-prudential tools. I think those are being called on, at least to some extent, because of the unusual nature of recent monetary policy. For example, the low interest rates which spread to small open economies and emerging market countries meant that those countries had to find another way to do policy because their rates were affected by that. They had little choice but to do some kind of macro-prudential policy. If we re-normalize policy there would be much less need for that.
The use of the macro-prudential tools also has distracted policy makers from the basic kind of policies. By macro-prudential, I mean policies that move with the cycle – move with the economy in some way – other than just getting the levels right. I have no problem with getting the levels of capital requirements up or getting the loan-to-value ratio lower if needed. But using the policies counter cyclically is counterproductive. You could see it, for example, in Switzerland where constraints on monetary policy meant they had to use macro-prudential tools to contain the housing boom.
Where should we be looking now for financial stability risks given this experience?
Undersecretary Taylor: The concerns now are, to a great degree, the unusual nature of monetary policy and how to get back to more conventional policies or how to renormalize. We have never been here before: the zero interest rate for so long and the gigantic balance sheets. So, there’s a risk in undoing it – this has always been a concern to me. I believe that concerns about this risk have been a drag on the economy already.
There’s also the question of how do we get out of this big implied currency battle; quantitative easing (QE) seems to have impact on the currencies. Japan Prime Minister Abe ran on the strong yen issue. He won and appointed Mr. Kuroda as the Governor of the Bank of Japan, which undertook QE, weakening the yen. Then European Central Bank President Draghi makes an announcement in Jackson Hole a year or so later that something has to be done, so they plan for QE and then the euro depreciates. Getting out of this mode is important, and it is somewhat risky where we are now.
Another risk is that “too big to fail” is still there. We have had more consolidation in the financial sector. There’s a concern that the Dodd Frank resolution process will not work. This process hasn’t been tested, and it seems to me that it’s not something that could easily work out to contain another crisis. The fact that living will plans have been rejected by the FDIC and the Fed is indicative of that. I’m not sure what’s going to happen with the next living will submissions.
What do we need to do to preserve the benefits of global finance?
Undersecretary Taylor: I think there are two things that need to happen. One is to restore the systematic, understood, predictable policies that worked in the 1980s and 1990s and until recently (the exact years depend on what country you're looking at). That’s a period where there weren't a lot of concerns about spillovers. Of course, the emerging markets were affected by the move from the high inflation to the low inflation in the early 1980s. But for the most part, that was a good period of global finance. And it was getting better as emerging markets began to move toward inflation targeting. I think that's probably the most important thing.
I think there are still issues on the IMF's role. I’ve been arguing they should return to their Exceptional Access Framework that was put in place in 2002-03. They deviated from it in the case of Greece. That framework really contained or limited the use of very large loans to cases where the debt was sustainable. In the case of Greece, they broke the rules: they lent to Greece in 2010 in an unsustainable situation and that’s led to some of the problems we are having now. So those two things—returning to rules-based policy at central banks and reforming the Exceptional Access Framework at the IMF— are important for global finance and stability.
Let me make a few more comments about the IMF’s Exceptional Access Framework which was adopted in 2003: The aim was to improve global economic stability by ending, or at least reducing the likelihood of, the financial crises that had been raging in emerging markets. International monetary and financial policy needed more predictability, more accountability, and more systematic official sector behavior.
The exceptional access framework set forth criteria that had to be met before the IMF could lend exceptionally large amounts to countries. The criteria included evidence of exceptional pressure on the country’s capital account, good prospects that the IMF loans would be temporary, and a strong implementable economic program. Most important was the criterion saying that the IMF could not make new loans to countries with unsustainable debts.
The expectation was that limiting loans in this way would reduce bailouts of private sector creditors, contain moral hazard, lower uncertainty, reduce the recipient country’s debt burden, encourage more responsible fiscal and monetary policy, reduce spillovers, improve accountability, and thereby create more economic stability. And, in fact, the 2003 framework was accompanied by many such changes. Compared with the 1980s and 1990s there were few crises emanating from emerging markets in the years that followed, and the emerging market countries as a whole weathered the global financial crisis remarkably well.
Unfortunately, the exceptional access framework was abandoned in 2010 when the Greek sovereign-debt crisis emerged and the IMF staff could not establish that the Greek debt was sustainable with high probability. Rather than follow the “no loans to a country with unsustainable debt” rule, the IMF simply changed the rule. It wrote in an exemption saying that new loans could be made in unsustainable or uncertain situations after all so long as there was a "high risk of international systemic spillover." The IMF then claimed, with very little evidence, that spillover risk was high and approved an exceptionally large loan to Greece. The loan was made without any debt restructuring.
As is well known, events in Greece that followed this 2010 decision have not been pleasant. The Greek economy continued to deteriorate under the burden of the large debt. By February 2012 it was clear to all that a restructuring was essential and Greek debt was written down by 60%. By now most of the private sector creditors have gotten out with the IMF and European governments left holding much of the Greek public debt.
So, it is time to reform and strengthen the exceptional access framework. A starting place would be simply to repeal the exemption for systemic risk that has caused much of the problem and may have had the unintended consequence of increasing systemic risk.
Would you like to make any further comments?
Undersecretary Taylor: I don't disagree with the view expressed by others that the dollar swaps provided by the Fed were helpful to emerging market countries. In fact, the Fed’s actions during the panic had a lot of good aspects. The swaps were one. Some people complained that they didn't get the swaps from the Fed. I think India didn't get them, they asked for them. So it’s not clear in the future who gets them and who doesn’t. But I think the option for getting dollar lender-of-last-resort support in other countries was a good part of the rescue effort during the panic. More generally I say that monetary policy was bad before and bad after the crisis in the fall of 2008, but during the heat of the crisis they did the right thing.
Blog authors' note: On December 16, 2015, as part of a deal to advance an important, but long-delayed, reform of the IMF, Congressional and Administration negotiators agreed to include in an upcoming budget bill the elimination of the "systemic exemption" to the IMF's "exceptional access framework." Hat tip to John Taylor (see here) for alerting us.