Sunday, October 4, 2015

Why The IMF Abandoned The Washington Consensus And More

Ostensibly, this article provides a tribute to Olivier Blanchard who recently retired from the IMF after many years as its chief economist.  However, since Blanchard led the IMF through some dark times during the financial crisis, the research that he led at the IMF caused him to change his mind about economic theory and its practical applications in the real world.  The changes that occurred in Blanchard's thinking, and at the IMF during his tenure, provide a unique glimpse into changes that have taken place in macroeconomics over the last few decades.

The IMF plays an important role in funding economic development and in assisting nations that get into fiscal difficulty.  For many years it operated under what was known as the "Washington Consensus".  Their clients were expected to support the free flow of capital into their markets.  They were also required to reduce inflation and government spending.  Blanchard found out that these policies did more harm than they did good.  The Washington Consensus no longer guides IMF policy decisions.  Paul Krugman praised Blanchard for changing his mind about "expansionary austerity" when IMF research showed that the imposition of fiscal austerity, particularly when interest rates are at the zero lower bound, is contractionary.  He believes that too many economists adhere to their belief system in the face of disconfirming data.

This article also does a nice job of describing the ebbs and flows of macroeconomic theory after the rise of rational expectation theory at the universities of Chicago and Minnesota.  One of the implications of rational expectation theory is that government efforts to steer the economy are bound to be ineffective.  Rational agents are presumed to calculate the effect of government policies, and they will respond by making decisions which counter the intended effect.  We have learned that rational agents are not as rational as the theory assumes, and that economic decisions are affected by emotion as well as they are by reason.  The financial crisis provides a classic example of herd behavior in financial markets. It also showed Blanchard, and the IMF, that credit markets play an  important role in the economy.  They were assumed to be external to the real economy by economists associated with rational expectation theory and real business cycle theory with which follows from it.

The battles that have occurred within economics have a more powerful effect on the real world than one might expect.  They are more than academic.  Most of the world's central banks and international agencies such as the IMF and World Bank are strongly influenced by prevailing theory.  

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