There are three huge tasks: averting financial system collapse; reducing the depth and duration of recessions; and putting in place longer-term structures for innovation and risk management. In all three we need pragmatic heterodoxy. The dangers lie in too much orthodoxy and populist heterodoxy. By populism I mean a political strategy that emphasises short-run benefits to middle and poorer groups, often with an explicitly anti-elite orientation. Benefits to middle and poorer groups are a good thing. The problem arises when short-run gains undermine longer-term development and genuine equity.
On the task of avoiding financial collapse, there has been a triumph of pragmatic heterodoxy in the best policy responses. The UKs package, that includes government recapitalisation of banks, various guarantees on interbank lending and deposits, and conditions on continued lending to key sectors, is a well-designed response to market failures and the immense short-run uncertainties that have been killing confidence. It would have seemed heretical before the deluge. The US has adopted core elements, but an overhang of orthodoxy has made it more timid in seeking conditions from re-capitalised banks. The mix is hardly populist. Indeed, putting taxpayer money at risk has heightened populist demands for action elsewhere.
On the task of managing the recession, a striking consensus has emerged in favor of short-run fiscal stimulus and monetary loosening. This is a return to Keynesian orthodoxy on fiscal management! And for central banks committed to inflation targeting the monetary choice was undoubtedly made easier by falling commodity prices and reduced inflationary pressures from the recession. There is potential alignment with populist demands, but the details matter. The optimal fiscal stimulus should involve elements that are quick-acting, high in non-tradable spending, and temporary. Increases in unemployment benefits, increases in existing transfers to poorer groups and higher maintenance spending all fit the bill. Populist pressures may favour generalised tax cuts or pet projects of politicians; these would typically be a much poorer fit. In the financial sector there is a good case for supporting lending to housing and small and medium businesses, either through requirements on publicly recapitalised banks or time-bound guarantees.
Short-run macroeconomic stimulus carries risks. If a high fiscal deficit is integral to the loss of confidence, fiscal cuts may be needed even as the economy is going into a recession. But here too pragmatic judgment rather than orthodox reflex is needed. Even the fiscally orthodox IMF shifted during the 1997/98 East Asian crisis from demanding fiscal cuts to fiscal expansion as the situation unfolded!
The case for protection for households falling into poverty is strong, and aligned with macroeconomic requirements. Also valuable are measures that encourage lenders and houseowners to renegotiate contracts rather than foreclose. More worrying are populist demands for greater trade or industrial protectionalready on the agenda in the US and France. The case for temporary protection is that recessions do a bad job of sorting good and bad activities, with irreversible losses of organisational and industrial capabilities. But the politics of protection typically favours the influential over what is best for society. It is better to take measures to keep credit flowing. And for countries suffering currency falls, the upside is greater protection for tradeable activities.
The third task is the hardest: what kind of regulatory and institutional system will best balance societal protection against the need for innovation The core malaise behind the crisis was too much of the wrong kind of financial innovation, combined with an extraordinary spreading of risks through the financial system. Industrialised countries are clearly moving to greater regulation of the financial system, with lower profits, tighter review of new products and undoubtedly lower financial innovation. Some shift in balance makes sense. Also needed is reform of managerial salary systems to reward longer-term success and punish failure, though I would prefer these to come from shareholder demands rather than government regulation. The real challenge lies in institutional designs to encourage the right kind of innovation in the real economy, rewarding risk-taking without imposing external costs on society. This requires venture capital for new starts, public support for exploration and adaptation, and greater financial lending for small businesses. The hard task is to design structures that achieve these ends without excessive waste.
This is a time for pragmatic, specific policy design, focusing on solutions to real market failures, fostering innovation, whilst protecting society. This implies avoiding both ideological orthodoxy and unsustainable populist designs.
The author is at the Harvard Kennedy School, the Institute of Social and Economic Change and the Centre for Policy Research