Global Crisis Leads I.M.F. Experts to Rethink Long-Held Ideas

WASHINGTON — The International Monetary Fund has long preached the virtues of keeping inflation low and allowing money to flow freely across international boundaries. But two recent research papers by economists at the fund have questioned the soundness of that advice, arguing that slightly higher inflation and restrictions on capital flows can sometimes help buffer countries from financial turmoil.

One paper has received particular attention for suggesting that central banks should set their target inflation rate much higher — at 4 percent, rather than the 2 percent that is the most widely held standard. As aggregate demand fell across the world in 2008, central banks, including the Federal Reserve, lowered short-term interest rates to nearly zero, where they have largely remained.

While the two papers do not represent a formal shift in the fund’s positions, they suggest that the I.M.F. is re-examining some of its long-established orthodoxies as part of its response to the global economic crisis that began in 2007.

The significant drop in the volatility of output and inflation since the mid-1980s — a period known as the Great Moderation — helped lull “macroeconomists and policy makers alike in the belief that we knew how to conduct macroeconomic policy,” the fund’s chief economist, Olivier Blanchard, wrote in one of the papers. “The crisis clearly forces us to question that assessment.”

That paper examines how, in hindsight, higher rates would have helped in the current crisis.

“Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions,” Mr. Blanchard and two other authors wrote in the paper, released Feb. 12.

The other paper, released Friday, said that in the aftermath of the crisis, officials were “reconsidering the view that unfettered capital flows are a fundamentally benign phenomenon.”

“Concerns that foreign investors may be subject to herd behavior, and suffer from excessive optimism, have grown stronger; and even when flows are fundamentally sound, it is recognized that they may contribute to collateral damage, including bubbles and asset booms and busts,” the fund’s deputy director of research, Jonathan D. Ostry, wrote, along with five other authors.

Both papers contained important caveats.

Mr. Blanchard’s said that fiscal policy — like decisions to tax, spend and borrow — had been as important in responding to the crisis as monetary policy, or control of the supply of credit. It argued that governments that had relatively lower debts to begin with had more flexibility to respond to the crisis.

And it asserted that regulatory measures — like requiring higher capital and liquidity ratios, lower loan-to-value ratios for home mortgages, and increased margin requirements for stock purchases — would be more effective than higher inflation targets in curbing excessive risk-taking.

Similarly, Mr. Ostry’s report said capital controls would be effective only if the flows “are likely to be transitory” and the economy is already operating near potential, with reserves at an adequate level and an exchange rate that is not undervalued.

The report also found that “the jury is still out” on whether capital controls had worked in practice. Evidence from countries like Chile and Colombia, it said, suggests that controls have been more effective at curbing exchange-rate pressures and the risk associated with capital inflows than in reducing the net influx of money.

In separate interviews, three former I.M.F. chief economists said the recommendations were significant but raised questions about the feasibility of carrying them out in today’s situation.

Raghuram G. Rajan, of the Booth School of Business at the University of Chicago, said the I.M.F.’s suggestion for allowing higher inflation might not be well received. “With bond markets worried that governments may inflate their way out of their debt obligations, this is probably not a good time for central banks to start debating their inflation targets,” he said.

Mr. Rajan said he was concerned that the nuances regarding capital controls would be overlooked. “The pressure within emerging markets to set up capital controls, with many countries not meeting the careful conditions laid out by the fund’s paper, will increase,” he predicted.

Kenneth S. Rogoff of Harvard noted that he had urged that the Fed and the European Central Bank consider slightly higher inflation targets after the 2001 recession in the United States. But he added, “Having spent the past two decades convincing the public that 2 percent inflation was magical, it might be both difficult and confusing for central banks to suddenly announce they have changed their minds.”

He said Mr. Ostry’s report was only the latest step in the fund’s reassessment of its “dogma on capital controls” that began with the Asian financial crisis in the late 1990s. “Today, it is patently obvious that the U.S. and Europe’s near-zero-policy interest rates are fueling a surge of international capital into Asia and Latin America that will end in tears if not properly managed.”

Simon Johnson, of the Sloan School of Management at M.I.T., said it would be “a very hard sell” to persuade central banks to raise their inflation targets “just because the financial sector is badly run and hard to reform.”
But he praised the emphasis on regulation. “The I.M.F. is trying to redefine what is and what is not responsible financial policy after the crisis,” he said. “They are commendably aware of the need for greater regulation and the ways to synchronize that around the world.”

By SEWELL CHAN

Published: February 21, 2010