Dubrovnik Economic Conference 2005 Financial Stability During Convergence Is Fiscal Policy the

1. Dubrovnik Economic Conference 2005 Financial Stability During Convergence Is Fiscal Policy the Right Regulator? Max Watson

2. Some Key Questions Convergence setting has led to calls for larger and smaller deficits than, eg, SGP: …larger = support for growth (investment) etc, or …smaller = risks of credit booms, access, ERM II, etc • Should policy lean against the wind in booms? • Should it build in safety margins for shocks? • Can it substitute for role of other policies? Context: (1) convergence risks, (2) policy assignments/ regimes, (3) channels of fiscal influence, (4) trade-offs

3. Convergence & Stability Question is: stability risks during real and financial convergence (not liberalization): • External current account financing constraints • Heavy burden on risk premia, which can be cyclical • Tendency to foreign currency borrowing • Financial systems undiversified, contagion risks • Screening issues during rapid credit catch-up • Supervision evolving, cross-border coordination • Risks versus equilibrium trends? (Stability Reports)

4. Policy Assignments How should macro and financial policies contribute to financial stability? In long run, their goals congruent with financial stability But in short run, financial stability is a “policy orphan” Should we abandon Tinbergen “1 instrument/1 goal”? • As far as possible, steer expectations transparently • Use three degrees of freedom: policy co-ordination, secondary features of policy, and time-consistency • Policies to contain fx exposure are an example

5. The Monetary Context Monetary regimes: an inflation anchor but also influence risk features of system… • Exchange rate targeting (incl. ERM II): highlights policy mix, credibility; strong balance sheet risks • Inflation targeting: interest rates can address credit booms (if inflationary); stress goes to financial markets; some balance sheet risks; mix tensions • Euro and hard pegs: stress to real sector markets, external risk = slow adjustment (fiscal challenge) • Diminishing urgency/changing costs in fiscal policy

6. Supervisory & Other Policies These can help limit instability and also the output cost of financial shocks: • Not misuse supervision for macroeconomic ends • Use stress-tests to internalize systemic risks • Co-operation with foreign supervisors: local risks • Real sector frameworks also limit output cost of financial instability (labour market; insolvency) • Governance issues also very important – including because banks shift financial risks to clients

7. Fiscal Sustainability Is the bedrock of stability, but there are degrees of freedom in support for growth: • Basic requirement is adequate primary balance • But in most cases demographics a major issue • EU-8 typically addressing it through micro reforms …more growth-oriented than high primary balance but need accompanying by labour market reforms • Also: contingent liabilities (real, financial shocks) …can be a major reason for rise in debt ratios

8. Fiscal Stabilization Is the challenge greater in convergence, given scope for real shocks, credit booms? • In terms of scope for automatic stabilizers no, but need to consider real transformations underway • The main challenge in credit/asset price booms is analysing potential growth, sustainable revenues • Time consistency: use good times to consolidate and avoid getting boxed-in (Spain v. Portugal) • Micro dimensions (deductibility, debt management) • Co-ordination: evaluate risks in monetary context

9. Safety Margins & Institutions Some factors imply case for prudent safety margins (beyond Treaty requirements): • External current account constraints • Approach to euro (market attacks, entry rate) • Case for debt headroom in case of volatility • Uncertainty about growth, taxes in credit booms …Discretionary adjustments are hard to judge and work with a lag; cannot tighten indefinitely …Safety margins, but costly. Strengthen institutions

10. Fiscal Policy and Growth Structural features of fiscal policy play important role in fostering growth: • Priority spending on infrastructure, education, R&D, costs of pension reforms – widen deficits • Subsidy cuts, targeted transfers, broader tax bases • Not equate growth mechanically with wider deficits • Still, can be both complementarities and trade-offs • Specify risks against which low deficits “insure” • Also, consider contribution of other policies

11. Complementarities & Trade-offs Factors need to be weighed on case-by-case basis for complementarities and trade-offs: • In central Europe, cases with greater debt & deficit challenges also have more restructuring scope • This pattern may also apply in candidate countries • In Baltics (CBAs) debt and deficits much lower; a key issue is automatic stabilizers during booms • Challenges evolve as countries approach euro • For low debt CBA countries, once under euro, care needed in timing of any fiscal easing

12. Main Conclusions Fiscal policy not for fine-tuning: strategic framework to help pre-empt instability: Mix, consolidation in good times, micro aspects = key • Primary balance, but address ageing through micro • In credit booms: structural balance? Box-in risks? • Monetary regimes: urgency of mix, credibility • Safety margins are wise but also: institutions, micro • Restructuring existing programs to support growth • Benign case-by-case trade-offs? (Use CPs, PEPs)

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