The Day After Tomorrow: Macro-Financial Policy Catches Up With Reality

The 2008-09 crisis opened the door to a different kind of thinking in international macroeconomics -- and closed it on some of the previous orthodoxy. Let's take a look at some of the most obvious cases.

First, some now see a bit of inflation (perhaps as high as 5 percent per year) as desirable for countries that pursue inflation targets, because it would allow more space to reduce nominal interest rates when an economy falls in recession. In fact, what to target (e.g., consumer, producer, asset, housing, or other prices) is the question.

Second, regulatory parameters and practices in the financial sector have proved to be more critical for real growth than we previously thought, whether through systemic risk, over-lending, costly bailouts, or other channels. Floating exchange rate regimes are falling out of favor, since "managed" ones proved to be better at controlling inflation and reducing sudden, unnecessary fluctuations. Controls on the movement of capital across boundaries have become an acceptable tool (they used to be heretical), almost the price to pay for policy success.

Third, multilateral surveillance is in the cards, initially through the G-20, since the actions of hard-hit, over indebted rich countries cause volatility in many emerging markets. But fiscal policy advice is bifurcated -- between a short-term need for sustained stimulus and a medium-term need for consolidation, and between massive deficits in the developed world and the accumulation of surpluses in sovereign funds in the developing one.

From all this, a new paradigm is likely to rise. The profession is in flux, as we argue in The Day After Tomorrow: A Handbook on the Future of Economic Policy in the Developing World, World Bank Publications, Washington D.C. And nowhere is that flux clearer than in finance. There is broad agreement that inadequate prudential regulation of finance was the main cause (albeit not the only cause) of the global crisis. There is much less agreement on what to do about it. In particular, massive systemic risk was allowed to accumulate on the balance sheets of unregulated institutions and off the balance sheets of regulated ones. Their failure could, and did, bring down the whole system. This has sparked a flurry of reform proposals.

Some of the proposals are focused on the relationship across financial agents -- on how one agent's fate is correlated with others. The core idea is "to tax" (literally or through various forms of capital requirements) institutions that can jeopardize the system, not just because they are "too big" but because they are also "too interconnected." The assumption is that regulation will now reach all agents and the "regulatory perimeter" will expand. In practice, regulators may not have enough information to impose that "tax." So, various proxies for an institution's contribution to systemic risk have been put forward: sheer size of its balance sheet, degree of leverage, maturity mismatches, and so on. All of them are yet to be tested by experience.

Other financial reform proposals emphasize time -- that is, how financial risk changes over the economic cycle. When the economy booms, there is less perceived risk, asset prices rise, and it is easier to borrow. When the economy turns, the opposite happens, perhaps more abruptly. What kind of "macro-prudential" regulations can automatically moderate lending in the upswing and ease it during downturns? Two candidates stand out: pro-cyclical capital requirements and pro-cyclical bank provisioning. Only the latter has actually been deployed (in Spain, and more recently, in Colombia and Peru). But the jury is still out on its impact.

Whether reforms are geared toward interconnectedness or timing, there is another potential reason to render their result uncertain at best: lack of international coordination. If countries (developed and developing) adopt different regulatory standards, money, risk and bubbles, they will shift to jurisdictions that are less strict or less capable of enforcement. That is thus far the fate of "Basle III", the recently prescribed prudential guidelines sponsored by richer countries.

With regulatory wisdom under construction, is there anything macroeconomics can do in the meantime to help financial stability? Possibly. Monetary policy could target asset prices, not just inflation or output gaps, although it may end up with inconsistent objectives, or serving none very well. Fiscal policy can help too, especially if it can inject resources in the economy automatically and rapidly during recessions, and if it can avoid giving tax incentives to borrowing (to mortgages, for example). Lastly, external financing decisions will also have a bearing on the stability of domestic financial markets -- the risk of sudden exchange rate fluctuations will be lower when foreign debts are smaller and reserves are larger.

The bottom line is that the search for financial stability, through regulatory or macroeconomic policy, is just beginning. This is putting developing countries in a bind. Should they wait for new global standards to emerge, or should they tailor their own regulatory strategies? Stay tuned.

This blog was originally posted on the World Bank Insititute Growth and Crisis website.

Otaviano Canuto is the World Bank's Vice President for Poverty Reduction and Economic Management, and Marcelo Giugale is the Sector Director of Poverty Reduction and Economic Management for the Latin America and the Caribbean Region. They are both the coeditors of The Day After Tomorrow: A Handbook on the Future of Economic Policy in the Developing World. To access the publication, please visit:

The book can also be read online and purchased (World Bank Publications; ISBN 978-08213-8498-5; $35) here, through bookstores, and through the World Bank's network of international distributors.