Macroeconomic governance since the financial crash

Acknowledging the redundancy of silo governance will be a vital first step in creating the new macroeconomic institutional arrangements we need

Andrew BakerThe most distinguishing feature of the macroeconomic governance frameworks that emerged throughout the world in the 1990s was the creation of a number of narrowly focused institutional silos (fiscal, monetary and financial regulation). In the aftermath of the financial crash of 2008, the boundaries, this silo form of governance represent, have come under increasing pressure.  Together with growing criticisms that many of the formal targets for macroeconomic policy have not provided a reliable guide for policy for close to a decade, the sustainability of current macroeconomic governance arrangements are increasingly questionable.

Macroeconomic governance in institutional silos was the product of number of distinct impulses. In monetary policy, policy debate focused on how best to overcome persistent and sticky inflationary expectations as a hangover from the 1970s.  Pre-committing to an inflation target based on some measure of consumer and retail prices, communicated authorities’ good intentions and was seen to effectively dampen inflationary expectations.  At the same time, using monetary policy to hit a specified inflation target was thought to be most effective when central banks could set monetary policy free from political interference.  Thus the central bank monetary policy silo was born.

In fiscal policy, following a number of flagship examples in the late 1980s, notions of expansionary fiscal consolidation became popular.  In this formulation reducing fiscal deficits, usually at a time of economic growth, created the space for monetary easing, thus making investment and credit cheaper, and producing market-led expansions.  Authorities could therefore signal their good intentions and contribute to stable market-led growth by making a deficit/GDP ratio a primary guide for fiscal policy, and move to lock in a commitment to medium term fiscal discipline.

The third leg of silo governance, involved creating specialist regulatory agencies to supervise financial institutions (for example the Financial Services Authority in the UK), ensuring their risk management models followed good practice.  Sophisticated financial institutions with sophisticated risk management practices would then make good investment decisions, with financial stability resulting from such sound practice.

These silo policy solutions became the very definition of good macroeconomic governance. For politicians, it is easy to understand why they were attractive .  They produced neat, compartmentalised policy making, that absolved them of responsibility for difficult distributional decisions, allowing macroeconomic governance to run on autopilot.  At the same time neat delegation contracts created simple but clear lines of accountability, specifying who was responsible for what.

Finally, all of the above made intellectual sense in the terms of the dominant strain of macroeconomic modelling – Dynamic Stochastic General Equilibrium (DSGE) modelling – where the financial cycle and instability were not included.  In a DSGE model the macroeconomic role of government becomes about stabilising the expectations of rational dynamic private agents by delivering low inflation and fiscal discipline.

It is true that the financial crash shook the third leg of the silo governance stool.  Financial stability is now recognised as an important strand of macroeconomic governance, with some responsibilities being relocated to central banks through macroprudential policies (the Financial Policy Committee in the UK case).  Yet silo governance and its mentalities persist.

However, silo governance is coming under significant pressure from numerous sources. First it is now widely recognised that DSGE modelling was not all it was cracked up to be.  The search for alternatives is very much under way.  Different models, using different assumptions, under different sets of conditions will likely point to a different set of necessary roles and suitable targets for macroeconomic policy.  Neat compartmentalization may no longer be possible, or optimum.

Second, silo governance was a product of its time and was a form of institutional design to reflect a very specific set of conditions. Inflation targets are not much use if inflation is no longer the pressing global macroeconomic problem of the age.  Likewise, a deficit reduction focus in fiscal policy makes little macroeconomic sense in a liquidity trap with interest rates stuck at record lows, constraining expansionary monetary policy space, while government borrowing costs are at record lows and economists talk of secular stagnation.  In such circumstances, the autopilot system of silo governance is no longer capable of steering the ship.

Third, growing political frustration with and criticism of central banks (see recent public utterances on Mark Carney in the UK) from all parts of the political spectrum are a direct function of the growing dysfunctionality of silo governance.  Seemingly frozen low interest rates in a context of very low inflation, combined with quantitative easing are fuelling claims that central banks are no longer fulfilling their mandates by following unorthodox policies, while also playing distributional politics.  Allegations of creeping politicisation mushroom, due to the lack of direction and outright confusion produced by inadequate silo governance mandates.

Fourth, the real game changer and biggest challenge to silo governance, comes from the recognition that financial stability is a macro, rather than a microeconomic issue, most appropriately handled by central banks.  This comes with unintended consequences.  In the UK, senior Bank of England staff are being drawn into a range of issues from climate change to Brexit, as part of new financial stability responsibilities, further fuelling the politicisation narrative.

Moreover, the evolving experimental practice of enacting financial stability is producing an even more fundamental challenge to silo governance. Recognising that the highly pro-cyclical repo market, where financial institutions can issue shadow money (or claims to repay on demand) was and remains a key source and amplifier of systemic instability, as in 2008, central banks including the Bank of England and European Central Bank have revealed they stand ready to place a floor under the price of collateral required to operate in that market.  That collateral is primarily sovereign debt, with central banks making purchases in the name of systemic stabilisation.  In one fell swoop the boundaries between monetary, fiscal and financial stability policy blur and the institutional fictions of silo governance are revealed.  Such practices are indicative of the cross-cutting nature of macroeconomic management in a global economy displaying disequilibrium properties.  They also create a need to co-ordinate relations between finance ministries and central banks to allow co-operative management of various categories of debt and their increasingly complex inter-relationships for some defined purpose.  Silo governance essentially denies the possibility or desirability of such an enterprise, but it is already happening implicitly and informally.

Silo governance is consequently revealed as resting on institutional fictions of declining relevance in the contemporary context, given messy complex current realities. The lens of silo governance does however illuminate the need for wholesale institutional re-design of macroeconomic governance.  Unfortunately, many political and intellectual elites remain oblivious, or in denial.  Acknowledging the redundancy of silo governance, would however be a vital first step in edging us closer to the kind of new macroeconomic thinking and governance arrangements the current context requires.