Member of the Board Seppo Honkapohja:
Money, Macro and Finance Research Group, 42nd Annual Conference,
Limassol 3.9.2010
- Slides (PDF)
Let me first say that I am very happy to participate in the panel in front of this group of economic researchers. I want to thank the organizer for inviting me to the panel.
It is a common view that there are a great many causes for the current economic and financial crisis. These range from (i) very favorable macro-financial conditions before the crisis, (ii) significant financial imbalances that remained concealed for a long time, and (iii) mistakes by the financial markets, institutions and supervisors. See slide 1 for a more detailed list. [Slide 1] There are a large number of good discussions of these causes and no doubt, the analysis of them will become more refined over time. I will not discuss them further, except to note that the multitude of causes is a big challenge for research and the area provides many good research topics.
The impact of financial instability on the real economy has been the key element in the current crisis. This observation has several important consequences. (i) Money and credit must be central in macroeconomics and policy. (ii) The financial system is occasionally the key source of disruptions to the real economy. (iii) Achieving financial stability (FS) is of major importance for the real economy.
In addition, I want to note that concerns about public debts are the third stage in the current financial crisis. This is an unsurprising development as many financial crises in history have had three stages: banking and/or currency crisis, recession in the real economy, and public debt crisis.
My remarks in the panel focus on two topics. First, I address some aspects of the changing views about macroeconomic/price stability (PS) and financial stability (FS). Second, I want consider the sovereign debt crisis by looking at what we know about these crises in the past.
Let me start with the relationship between PS and FS. Slide 2 present a simplified interpretation of the traditional view of this relationship. [Slide 2] A key idea is that achieving FS contributes to achievement of PS, but link is relatively weak. Monetary policy affects the real economy and its transmission works to a large extent via interest rates that in turn affect the situation of financial institutions. In terms of FS the relation is nevertheless weak, provided monetary policy focuses on PS and is successful in achieving macroeconomic stability. Apart from the cost of finance, the links from the financial system to the real economy are weak. Regulatory policy naturally influences the stability of the financial system.
This view suggests a clear assignment between monetary policy and FS policy. Monetary policy should be assigned to achieve macroeconomic/price stability, whereas regulatory policy is the key tool to address FS. The objectives and instruments are different, though there is some natural interaction. Communication is crucial for the two sets of policies and it is important to distinguish between FS and PS policy communication.
This traditional view about the connections between PS and FS has been altered by the events in the financial crisis. Financial instability during the crisis had major consequences for the real economy. Indeed, it resulted in a very rapid decline in real activity in 2008 and early 2009. Slide 3 sketches how the traditional view about the connections between PS and FS has been changed by what happened during the crisis. [Slide 3] There are several phenomena that are important topics for further research for both theoretical and, in particular, empirical work. One issue is the risk-taking channel of monetary policy, according to which low interest rates lead to more risk-taking and leverage by banks. The mechanisms behind financial frictions and constraints that quickly and in an apparently nonlinear fashion emerged in the crisis are another important topic for further work. In this area new research has already been initiated and the area will most likely become an even more important in the future.
Another lesson from the events in past three years is that both monetary and fiscal policies are needed in the clean-up of major failures of finance and the resulting recessions. Policy-makers have cooperated extensively during the current crisis. This effort has been successful in preventing a melt-down of the international financial system that would also have led to a much worse outcome in the real economy than what happened in 2008-2009.
More generally, in my opinion there are several lessons for monetary policy from the crisis. I will not go into details here but here is a list of issues that are under discussion and would benefit from an academic input as well. (i) A very rapid overall credit growth should always be a warning signal. Such growth is likely to be associated with strong asset price increases. (ii) In terms of objectives monetary policy should remain focused on the maintenance of price stability over the medium term. Moreover, monetary policy should not be burdened with other objectives. (iii) Institutional independence of the central bank is essential. The experiences from the current crisis have not altered this underpinning of modern central banking.
Regulatory measures are the other main set of policies. There are two parts to regulatory policies. First, during a financial crisis there will typically be a need to initiate crisis management. A lot has been said and written about this topic. Let me just point out that regulatory management during a financial crisis must take care of the potentially necessary recapitalization of banks, and it may also have carry out restructuring of financial systems. Finally, its objective should the eventual creation of sustainable business conditions for banks and other institutions. Another aspect of regulatory change is the new regulatory and supervisory initiatives inspired by a financial crisis. At the moment we are seeing this kind of response to the current crisis. The plans under discussion include reformed high-quality capital and liquidity standards for banks, and the regulations are likely to have wide coverage of financial institutions. An important innovation coming from the current crisis is the concept of macro-prudential regulation that focuses on systemically important financial institutions. This is a very new area with many open issues and there are surely good and important research issues in this area.
Let me now move to the second part of my remarks that are directed the sovereign debt crisis. We know from basic economics that successful resolution of a fiscal crisis has two crucial parts. Turning primary public balance, i.e. balance between expenditure and revenues excluding interest payments, gradually positive is one key step. The other basic step is resumption of economic growth, so that the growth rate of real GDP is preferably higher than the average level of real interest on public debt that a country is paying.
The current fiscal situation is challenging in many countries. This is shown, for example, by the computations by the IMF done in early part of 2010 in Slide 4. [Slide 4] Major corrections in the fiscal balances need to be carried out. There is a large literature estimating the effects of different types of fiscal consolidations. The basic messages from this literature are the following.
A fiscal consolidation usually has short run costs in terms of reduced growth and a temporary worsening the public debt-to-GDP ratio. One message is that a consolidation should be relative large and persistent, i.e. last for several years. Initial conditions also matter – best chances for success are when the fiscal deficit is large and the public debt position is unsustainable in the long run. There are also differences in effects between expenditure cuts and tax increases. I will not go into the details. In principle, one should adopt measures that have small fiscal multipliers as this minimizes the negative short-run effects.
In the long run, the effects of a fiscal consolidation are often positive as growth speeds up. To achieve this, a consolidation should primarily focus on expenditure cuts rather tax increases. The reason is that tax increases are often distortionary and tend to reduce economic growth. However, in reducing government expenditures one should avoid cuts in productive public spending, as such cuts can have negative effects on growth. Initial conditions of the economy also matter. Best success seems to be in a “difficult” initial situation, i.e. when the government sector is relatively large and the initial public debt-to-GDP ratio is relatively high.
There are even situations with non-Keynesian short-run effects, in which the fiscal multipliers are negative and thus expenditure cuts are expansionary even in the short run. These possible Non-Keynesian effects operate through expectations about improvements in the future fiscal situation and also faster economic growth. The basic idea is that Non-Keynesian effects can arise when a country is in an unsustainable situation (expectations of a “mess” in the future) and the consolidation succeeds in changing these expectations.
Let me next look at some examples of public debt dynamics after a financial crisis. [Slides 5-9]. A key feature of a fiscal consolidation is that the actual process of debt reduction takes many years. The crises of Finland and Sweden, which erupted in 1991, involved major increases in public debt and it then took over ten years to reduce the debt-to-GDP ratios by 20-30 percent. Mexico 1994 is another example with smaller build-up of debt but it took five years to reduce the debt ratio to the pre-crisis level. Sometimes, there is only stabilization of the public debt to GDP ratio as a result of the crisis. Korea in the 1990s and Spain in the 1970s are two examples.
Current discussions about public debt problems in many Western market economies illustrate a fundamental difficulty in public debt crises. Realistic time horizons for fiscal action by a government and market perceptions of the speed of public decision making are very different. Carrying out a fiscal consolidation is inherently a very slow process as indicated by the examples just discussed. Even drawing up plans for the fiscal actions takes non-trivial amount of time.
These uncertainties trouble the markets, lead to rumors and occasional herds that move the market sentiments. To minimize these uncertainties it is important to try to anchor expectations about future fiscal developments. Clear multi-year fiscal programs to improve credibility and significant size of the consolidation can help here. Likewise, front-loading may well be a good thing. Focusing on items with small fiscal multipliers should also provide some relief. Credibility of the consolidation will depend on its execution. The plans should not be overly ambitious, so that they can be carried through the political decision-making process. Goals should be set somewhat conservatively in order to minimize the probability of disappointments in the early years.
Development of better fiscal institutions is vital for improving credibility and, in the longer run, reputation. The experiences of Finland and Sweden during the 1990’s crises provide examples of the role of improvement of fiscal institutions. Both countries made reforms that gave better centralized control for policy-making about fiscal decisions, in particular the budget process. One useful innovation was the adoption of multi-year expenditure ceilings and other practices that helped to achieve the fiscal consolidations.
Improvement of fiscal institutions is currently a major objective in the EU and euro-system fiscal institutions. Enforcement of the Stability and Growth Pact has clearly been inadequate before the current crisis. Major steps are now being taken to strengthen the European fiscal institutions. These include the European Financial Stability Mechanism (ESFM) and European Financial Stability Facility (EFSF), stronger surveillance of budgetary policies and the Van Rompoy task force on economic governance in the EU. In UK, the new government has established an Office for Budgetary Responsibility that will monitor the fiscal situation in the UK in the coming years.