MANAGING RISK
The evolving paradigm
© OECD
Pier Carlo Padoan Chief Economist and Deputy Secretary-General of the OECD
The history of economic policymaking has been marked by a succession of “paradigms” defining the goals of economic policy and the instruments used to attain them. OECD Chief Economist Pier Carlo Padoan looks at where we go from here. A prominent paradigm shift took place in the early 1990s, when structural policy issues progressively gained prominence while macroeconomic policies became more rules-based. The “Great Moderation” of stable growth and prices since the
Mechanisms need to be found to allow different policy settings to co-exist across the globe in a way that promotes economic stability and growth mid 1990s was seen as evidence of the paradigm’s success. However, favourable headline statistics masked growing underlying imbalances and, when these erupted with the financial crisis of 2008-09, established certainties broke down (again) and new approaches to policymaking came to the fore. What produced these imbalances? Since the mid 1990s the world economy has become increasingly integrated, owing to the removal of trade barriers, the liberalisation of capital flows, the spread of new technologies and the fall of the Iron Curtain. The case of China, now the second largest economy in the world, deserves separate mention. Since its accession to the World Trade Organisation in 2001, China has been running large current account
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OECD Yearbook 2012 © OECD 2012
surpluses, as have several other economies, including the oil exporting economies. The global “saving glut” allowed the US and other external deficit countries to finance their current account deficits at favourable terms and to keep bond yields low—especially since globalisation meant a massive increase in the global supply of lowskilled labour that kept core measures of inflation low. This allowed monetary policy to be supportive which, along with misguided “financial innovation”, contributed to excessive risk taking and leveraging. The dotcom bust in 2000-01 should have been taken as a warning that systemic risk was unduly increasing. However, the potential for systemic financial risks was not effectively monitored. And policy decisions failed to incorporate the implications of the rapid pro-cyclical growth in financial leverage and risk taking, the concentration of risk, and the increasing potential for shocks to cross borders and markets. This explains how problems in a small corner of US financial markets (subprime mortgages accounted for only 3% of US financial assets) could infect the entire global banking system and set off an explosive spiral of falling asset prices and bank losses. The financial crisis thus exposed a number of serious flaws in the predominant paradigm. First, while monetary policy won the battle against inflation, it did so with support from globalisation, damping inflationary pressures amid buoyant economic conditions. This arguably led to excessive accommodative policy. Second, fiscal policy rules failed to provide incentives for building up buffers in good times or to factor in the implications of rising private sector imbalances for sustaining public finances, thus producing sovereign debt crises. Third, financial market supervision paid too little attention to systemic risks arising from leverage and the potential implications of rapidly increasing financial globalisation for the transmission of shocks across borders. And finally, while structural policies were undertaken in many countries, there was little international co-ordination of policy choices, contributing to a persistence of cross-country imbalances in savings and investment.