Structural Reform Is More Powerful than Fiscal or Monetary Policy

Recall the beginning of the movie, “A Beautiful Mind,” which introduced John Nash’s theory of cooperative games? Nash is in a bar with his classmates and sees an attractive woman. His breakthrough is that if he and his friends all try to meet the one woman, none of them are likely to succeed. If only one makes the attempt, however, the chances of success are much greater. Hence, the theory of cooperative games was born, whereby if they each approach one woman their chances of finding a date are increased.

The G-20 meetings last week ran into the wall of cooperative games theory. Rather than a date, however, the attractive objective was economic growth. Last week, Treasury Secretary Tim Geithner suggested he go after the most attractive prize. Unlike Nash, however, he had little to offer his mates. Hence, the meetings – unsurprisingly – failed.

None of this is to argue that the Federal Reserve’s QE2 strategy represents unmitigated inflationary pressure and currency devaluation. As rhetoric about the program has shown, however, it is perceived as such and one lesson I have learned about policy in recent years is that emotion continues to trump logic among non-economist policymakers – especially in the continuing crisis atmosphere. As Alan Blinder wrote in today’s WSJ, I do not agree that QE2 is the answer, but it is probably not as much of a problem as many people believe.

In fact, the biggest problem is that QE2 is perceived as more powerful than it will most likely be. I have long argued that if money markets are in disequilibrium, simple solutions may not work (and if they do, it may be for the wrong reasons). Without a Fed Funds rate (or other intermediate) target, monetary policy is rudderless. Hence, it is important to help smooth world economic undercurrents to help keep the economic ship away from more rocks. That is exactly what Timothy Geithner failed to do at last week’s G-20 by creating the appearance of hogging the spoils of worldwide economic growth.

All of this being said, I would be remiss to ignore the fiscal policy cries that are creating undue reliance on monetary policy as a means to recovery. While Keynes is not dead, Keynesianism is a through-the-cycle approach to managing economic growth, not just something that is to be pulled out when it is convenient. Nobody likes the fiscal discipline Keynesianism requires on the upside of the economic growth cycle but they sure like the stimulus on the downside. The problem – illustrated by Ireland last week – is mere fiscal constraint: we cannot just keep throwing money at economic problems and expect results beyond inflation and devaluation. Moreover, we cannot afford the sheer amount of fiscal stimulus necessary to restrain significantly the current bout of business cycle persistence.

Last December, I said before the EU Parliament that the appropriate mechanism to encourage real growth is structural improvement. More recently, the IMF issued a report testifying to the same dynamic. As the Economist magazine describes the dynamic, “The economic case for a growth strategy that combines hefty fiscal cuts with timid structural reforms is not obvious, especially when private demand is likely to stay weak. In the long run bold productivity-enhancing reforms will do more to boost the rich world’s growth prospects than short-term fiscal austerity. And better growth prospects will, themselves, make government debt less onerous. In a recent study, economists at the IMF analyzed the respective impact of deficit reduction, global rebalancing and productivity-enhancing structural reforms on the growth prospects of big rich economies and found that by far the strongest positive effect came from structural reforms.” (A better way: The rich world should worry about growth-promoting reforms more than short-term fiscal austerity, Oct 7th 2010)

What kinds of structural reforms could we enact? How about ridding the financial services sector of redundant and outdated regulations? Some parts of Dodd-Frank were just plain nonsense. Last week the Federal bank regulators continued to struggle with how to intermediate credit information without reference to credit rating agencies, even if only to limit their role. Dodd-Frank also enacts interchange regulation precisely at the moment that Australia – the poster child for such reform – is rescinding their policy.

How about the same for the energy sector? Why don’t we have 60 mpg diesel automobiles? Because of outdated regulations from the days of high-sulphur diesel fuel, which no longer exist. We needlessly continue to hobble both shallow- and deep-water offshore drilling in the Gulf and around the country because of the Deepwater Horizon incident because we cannot emotionally square the short-term need to rely on carbon while transitioning to other energy sources.

Telecoms? Rail infrastructure? Even the foreclosure mess suggests the need for structural and legal reforms that meaningfully support 21st century economic growth; addressing the reasons why the industry adopted the foreclosure shortcuts it did rather than just beating them up for the results. Government sets the incentives, productive or perverse.

A better way toward economic growth is easily within our grasp – if we can just be humble enough to admit that the persistence phase of business cycles following financial crises are particularly nasty economic phenomena that demand thinking outside the standard equilibrium models and borrowing from development literature, as well as closely coordinating policy responses and rhetoric to create the unmitigated perception of forward-looking thinking that focuses razor-like on a single objective: restoring real economic growth.

One Response to "Structural Reform Is More Powerful than Fiscal or Monetary Policy"

  1. Guest   November 16, 2010 at 3:49 pm

    agree. but, don’t try to avoid regulations in financial sector. it’s enormous compared with the ‘real’ economy. it is fictitious wealth. it could go away for days. growth could come from the military industrial complex. make the necessary investment there and transform them into the hi-tech companies of the future. so far they produce destruction only. the crappy story for the technological transfer from them to the civil sector keep for yourself.. or the morons who stuff them with billions annually.