Developed, Emerging & New Paradigms

Financial market developments in the past decade have highlighted, I believe, the need for "New Monetary and Fiscal Policy Paradigms" in developed economies with developed capital markets. GDP/unemployment and inflation are the two targets guiding monetary policy at the Fed (and other central banks). I have believed, however, for many years that in developed countries with developed capital markets, asset prices are the key drivers of GDP/unemployment and inflation. Central banks in these countries not only need to analyze and understand the exact transmission mechanisms from asset prices to the real economy and inflation, but also they need to develop measurable targets for asset prices (or, perhaps, a target for an "index of asset prices") to guide and set monetary policy concurrent with the GDP and inflation targets that they already have and use for guiding monetary policy. Without such asset price targeting by central banks in developed countries with developed capital markets, monetary policy in these countries will be "counter-effective", in the sense of creating cycles of vast overshooting (as in the US prior to the current recession) and vast undershooting (as in Japan's "lost decade", as noted in your article) the economy's long-run equilibrium of GDP and inflation.

Waters are even muddier when we turn to the effectiveness of fiscal policy in developed countries with developed capital markets. Here, too, we need to analyze the transmission mechanism from fiscal policy to asset prices in order to understand the impact of fiscal policy on GDP/unemployment and inflation. Lack of clear, measurable impacts of the 2008 and 2009 fiscal stimulus programs in the US are stark cases in point.

In developing/emerging economies with un-/under-developed capital markets, the traditional monetary and fiscal policy paradigms are effective in guiding the economy along its long-run equilibrium growth path. China is a case in point. Chile is another, as are other Asian emerging economies which have implemented fiscal stimulus programs and monetary policy easing.