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Macro-financial stability frameworks: experience and challenges

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The 2007–09 Great Financial Crisis underscored the rationale for macro-financial stability frameworks, in both advanced economies (AEs) and emerging market economies (EMEs). Domestically, both AE and EME central banks have increasingly adopted macroprudential tools as a complement to monetary policy to better reconcile price and financial stability over longer horizons. Claudio Borio discusses the use of monetary, macroprudential and exchange rate policies, in both AEs and EMEs.

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This video discusses the evolution and objectives of macroeconomic policy, focusing particularly on macroeconomic stabilization and its relationship with financial stability. It outlines how the post-war economic understanding primarily centered on unemployment and inflation, emphasizing controlling aggregate demand to manage economic fluctuations. However, a shift occurred in the early 2000s, recognizing the need for a macro-financial stability framework that addresses how the financial sector can derail economic stability.

Key points include:

1. **Objectives of Macroeconomic Policy**: The primary aim is to smooth out economic fluctuations and maintain price and financial stability, which is essential for sustainable long-term growth.

2. **The Shift in Economic Cycles**: Traditional business cycle theories, which linked recessions primarily to tight monetary policy due to high inflation, evolved to acknowledge financial cycles—where financial booms and busts started to dictate economic downturns without the trigger of inflation.

3. **Financial Liberalization Impact**: The increasing globalization and liberalization of financial markets have led to major financial expansions that often precede crises, necessitating a broader approach to policy beyond just inflation concerns.

4. **Prudential Policy Evolution**: There has been a transition from a micro-prudential focus—evaluating the health of individual financial institutions in isolation—to a macro-prudential perspective that looks at the financial system as a whole and its interaction with the wider economy.

5. **Emerging Vs. Advanced Economies**: Emerging market economies, historically more prone to financial crises, have utilized macro-prudential tools more extensively than advanced economies, which tended to have a more relaxed attitude towards financial regulation before the recent crises.

6. **External Financial Conditions**: Emerging markets are particularly vulnerable to external financial conditions, leading them to implement various measures like foreign exchange interventions and capital controls to manage currency and capital inflow pressures.

7. **Integration of Policies**: This video emphasizes the need for integrating monetary, fiscal, and macro-prudential policies to address the complexities of modern economies, especially considering the different timelines and authorities involved.

8. **Open Issues**: Several areas of concern remain, such as the interaction between monetary and macro-prudential policies, the treatment of non-bank financial sectors, fiscal influence on financial stability, and the mechanisms for better coordination among various policy authorities.

In summary, the discussion highlights a critical shift in macroeconomic policy thinking that incorporates a deeper understanding of financial stability's role in overall economic health, illustrating a growing need for coordinated and comprehensive policy measures in an interconnected global economy.

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X-TIMESTAMP-MAP:LOCAL=00:00:00.000,MPEGTS=900000

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First of all, the objective of macroeconomic policy at

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least the aspect that we're discussing is macroeconomic

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stabilization and by

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that we mean smoothing out economic fluctuations in

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inactivity avoiding collapses economic

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activity. So as to provide the basis

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for longer term sustainable growth and that

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of course in order to do that, you need

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the price and financial stability you

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need to avoid inflation and you need to avoid

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financial crisis.

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Now much of the post war thinking about

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macroeconomic policy was relatively simple.

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It was about unemployment and inflation the

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idea that the economy would overheat and

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you would try to sort of restrain aggregate demand.

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The economy would be moving too slowly and then

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you would have to push on aggregate demand and that was basically it.

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Now around it early 2000s here

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at the Bas. We started thinking that that was not enough.

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And what was missing there was the the fact

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that there was not sufficient attention.

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To on the way in which the financial side

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of the economy could derail

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the real side of the economy and

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that somehow required a new type of

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framework and that's why we call macro Financial

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stability framework and the keyword here. The

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new term is financial.

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Because that was the aspect that until then was not

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really well incorporated into macro

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stabilization policies, and he

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had to do with some major major fundamental changes

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in the nature of the business cycle.

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Which in turn was related to fundamental changes in

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policy Frameworks, what do I mean by changes in the business cycle?

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And this is really very important.

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Is that until the mid-1980s the typical

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recession that we had was the result of monetary policy

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Titanium because inflation was running out of control and

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therefore the entire interest rates would bring

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the economy down, but there was very little very little in

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terms of changes in the indicators of financial

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expansions and contractions such as strong credit growth or asset

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prices particular property prices.

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But the recession that we had starting is

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in in the mid 1980s were quite different because

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we know that inflation was relatively low unstable.

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So it meant that there was no need for monetary policy to tighten

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during expansions. But what we had was Major Financial

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Booms that were turning into busts and

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that's basically what happened during the the great financial

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crisis, but it's something that also happened happened before and

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then one sees why this as I said, this was

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not a coincidence and was the result of the fact that

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we had Financial liberalization across the world both

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domestically and internationally, which meant

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that this financial expansions are contractions had most cope

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to take place. We had Global

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ethical globalization of the really economy that put persistent

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downward pressure on inflation and we

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had monetary policy regimes, but basically we're focused

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on inflation so that as long as inflation was

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not picking up even if you had big Financial

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expansions, they were not looking at credit. They were not looking at

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money and longer which meant that there was no reason to tighten

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which meant that they were not providing a

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constraint on the financial expans.

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And then turn into contractions. So if you like we move

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from inflation induced to financial cycle induce

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recessions, hence the importance of moving in

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moving and having a framework

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that move Beyond monetary policy

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Beyond fiscal policy and which included Prudential

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policy.

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And along with this there was a key change in the

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way in which Prudential policy was

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conceived which was away from what used to

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be called a micropriential perspective to a macro

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potential perspective. If you like the new kid on the

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block now, it's it may sound technical that

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actually it's it's rather. It's rather simple in

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the end. Now my the micro potential perspective which is

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the way in which regulatory regulation supervision was

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structured before the macro

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credential framers were put in place. It's very much

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focused on the considering the strength of

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financial institutions taken

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on a standalone basis in isolation from

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the rest of the financial system. So how much Capital does

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one institution have in relation to the risk that

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incurs. What is the nature of the counterparties to

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which it's Lending?

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Um, the macro potential perspective on the end

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on the other hand considered institution only in relation

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to the system as a whole if focuses on the

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financial the stability of the system Financial system

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as a whole and once you do that, if you

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look at the word as opposed to the trees, if you like it becomes natural

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for you to think of the relationship between the

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state of the financial system and the state of

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the macroeconomy those macroeconomic fluctuations that I was telling

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you about and there you have two questions one is

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to what extent the financial sector as a

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whole can deal with a financial with a

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blow like a recession or a big Capital outflow

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if that happens and also to

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what extent the the financial system itself

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can generate the shock in

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the first place by contributing to the buildup of

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the financial imbalances by building two by providing

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too much credit right by increasing asset

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prices too much during the expans.

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Until you get a natural contraction. So most

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of the macro Prudential tools relate the

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the state of the financial system to the

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state of the economy to the global or if you like aggregate Financial

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developments. So counter-cyclical Capital

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buffers basically say that you should tighten

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buffer is a good times the minimum requirements and

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you should lose them them when problems arise minimum

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loan to value ratios minimum debt

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to income ratios, which are supposed to try and

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constrain the buildup of financial problems typically in

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the in the real estate sector, but not only they

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are two big differences. I think that

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have to do with the experience of the various economies

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and more to the point with the structure

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of those economies. First of

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all, a key difference is that

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emerging market economies have had more financial crisis

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than advanced economies and

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many crises in this late 70s early 80s. They

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had again many crises in the mid-1990s. So

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originally first originally was Latin America,

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then it was also Asia.

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And therefore because they had so many crisis. They

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tended to use this instruments Much More

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Much More Than advanced economies. Even

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before the great financial crisis in advanced

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economies. We did have a few crises in the early

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90s, like for example in the Nordic countries or in

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Japan or in Japan, but other advanced economies

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not least the United States basically felt.

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Well it cannot happen here.

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So there was less of an interest in a in a

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macro in a macro potential type of framework.

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So that's the first difference the emerging market

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economies did much more active use

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of these tools. Even before the great financial crisis.

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The second the second

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difference has to do with the structure of

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the of the economy. And that is that emerging

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market economies are much more

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exposed to external Financial conditions

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to the absent flows of capital flows

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of Global Financial conditions more

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generally.

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And probably the main reason why that is the case

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is because their financial markets are less developed

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and in particular there is less. There

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are fewer instruments to hedge foreign currency

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exposures.

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So that you have two types of problems. The the old type

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of problem is that this country is tended

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to borrow a lot in foreign currency.

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And as a result of that when the

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when you had Capital inflows,

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the exchange rate of those currencies would

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tend to appreciate but basically made

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the balance sheet of those who were borrowing in

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foreign currency look better because the value of

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the liabilities in domestic currency were falling

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which meant that that meant that Capital influence was

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were coming more and more in and you

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had that kind of feedback self-reinforcing process where

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whereby more Capital inflows were

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generating an appreciation of the currency. They were

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loosening Financial conditions in domestic country because the

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borrowers were looking stronger and that was getting more

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and more Capital Flows In

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and that at some point that turned to this

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boom turned into a past. So this is one of the key

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features of the emerging market economies. Now,

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even after those countries start stop borrowing

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in foreign currency, and you had foreigners investing

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in those kind of

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in those countries in domestic currency.

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Then the the currency mismatch was on the

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balance sheet of the investors because they

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were basically having a long position in domestic

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currency, but they were measuring returns in their domestic currency.

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And that also meant that you had the same problem.

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Buying assets exchange rates were going

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up returns in the currency in the US

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dollars or Euros were going up. And so that called for

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more Capital influence and so on. So these two mechanisms generated

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big booms and busts for emerging

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market economies. The asset. The implication

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of that is that the kinds of tools that

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emerging market economies have views have been

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targeted much more to external conditions and

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they're basically two types of tool one is

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foreign foreign currency intervention.

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And the buildup of Foreign Exchange reserves, so

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when the currency tends to appreciate they tend

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to buy foreign currency and so

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as to limit the appreciation they build

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up a chest of foreign currency reserves, and at

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the same time, they reduce the impact that the appreciation

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of their own currencies has

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on domestic Financial conditions. That is losing Financial

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conditions.

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The other possibilities to use capital capital flow

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management measures or Capital controls that

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Target specifically foreign investors. So

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that's like limiting their ability to

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buy Assets in the country portfolios, like

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stocks bonds or in particular also real estate.

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So on the other hand advanced economies,

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but did not have this type of problem Focus

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much more on if you like domestic conditions

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the domestic buildup of financial imbalances big

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credit expansions speaking increases in

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a surprises and therefore they focus more on macro

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potential measures.

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But no no mistake. EMES have

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also looked used a lot macro potential

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measures but relative to advanced economies.

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They have used more foreign exchange intervention

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and capital controls. Particularly in Asia.

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Let me give you just a couple of examples to sort

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of to clarify the idea but one

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from emerging market economies and one which is

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actually from the recent experience. I would say

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an experience which is still going on in advance economies.

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So the one from emerging market economies

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Is imagine a situation which was typical after the

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great financial crisis in which they

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inflation was

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very low. I'm thinking inflation in emerging market economies as

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well. But there were big Capital inflows because

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interest rates in advanced economies were very very low. There

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was also QE there were sort of big Capital influence that

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were putting upward pressure on the exchange rate

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of emerging market economies that was

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clearly and imagine that at the same time not only

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was inflation to lower relative to Target. But

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you also had because interest rates were locals

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in emerging marketing economies, you had to build up of domestic Financial

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imbalances, like strong credit growth or

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asset price increases domestically like in the real estate sector again

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a common situation.

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Then if you one way in

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which you could try and reduce the impact

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of an appreciating currency on

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the domestic economy.

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Because you were getting these inflation because you're currently was

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appreciating would have been to reduce interest rates.

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Okay, if you don't do FX intervention, you're

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reduced interest rate so that you attract fewer Capital flows

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and the exchange rate appreciates by less.

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But if you do that, of course you fuel

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the buildup of

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domestic imbalances because it would fuel the expansion of

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credit if you pull the expansion of a property

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prices.

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Then actually if you do for an exchange

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intervention is quite clever because you kill kind of two birds

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with one stone on the one hand you limit

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the exchange rate apprecio. Well, first of all, you

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build up a war chest for when the capital flows

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out, right? That's always very good.

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In addition you limit the appreciate appreciation of

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the exchange rate. So you limit the disinflationary

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effect domestically and

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you also limit the channel That was mentioning

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earlier, whereby an appreciation of the domestic currency

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attracts more foreign Capital flows because

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and loosens domestic Financial conditions.

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So that's a way in which on top of

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that you can keep interest rates higher than would otherwise beer case

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which allows you to deal with the domestic imbalance. So

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effectively with this does is to add one degree

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of freedom to the set of instruments that you

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have in order to balance the various objectives that

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that you have in a more in a better way. Now that's

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for emerging market economies. Now for advanced economies a

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very simple example is what's happening these days where my tree

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policies having to tighten in order to

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bring inflation down but in a context of very highly debt

14:37.500 --> 14:37.600
levels

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And so if you activate macro

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potential measures in particular, what you

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can do is to lower increase the resilience of

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the financial system.

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Lower the probability of problems in the financial system and therefore

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allow miles through policy to

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tighten even more without being concerned with the possibility

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of generating stress in the in the

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financial system so that it can focus much more on the

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fight against inflation you provide more Headroom

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again, one more instrument one more

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degree of Freedom that you can use in a you

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know, useful way. Let me sort of mentioned for four

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issues which are still open issues. The

15:19.300 --> 15:23.500
first one is the the relative role

15:23.500 --> 15:27.400
of monetary and and macro potential policies

15:26.400 --> 15:29.500
one view which

15:29.500 --> 15:32.100
is quite common in advanced economy is still these days

15:32.100 --> 15:35.400
is the so-called decoupling principle, which is the only

15:35.400 --> 15:40.000
thing Mastery policy does is to focus on inflation. The

15:39.200 --> 15:42.300
only thing that macro potential policies do

15:42.300 --> 15:44.800
is to focus on financial stability.

15:45.600 --> 15:48.300
Now on the other hand, it has been recognized that

15:48.300 --> 15:52.000
monetary policy has a big impact on financial

15:51.800 --> 15:55.300
imbalances because it operates precisely

15:54.300 --> 15:57.600
by influencing the

15:57.600 --> 16:00.200
amount of credit in the economy the value of

16:00.200 --> 16:03.300
assets and and so on so very very low interest rates

16:03.300 --> 16:06.900
were long for example tend to encourage a lot of risk-taking. So

16:06.900 --> 16:09.100
the question is should monitori policy

16:09.100 --> 16:12.300
not just pick up the pieces when problems arise but

16:12.300 --> 16:15.400
also do help macro potential policy and

16:15.400 --> 16:18.200
try to restrain the buildup of financial imbalances, even

16:18.200 --> 16:21.500
if inflation is is doing okay and that

16:21.500 --> 16:24.600
two different views there and the one that historically the

16:24.600 --> 16:27.300
Bas has taken is to think of a more

16:27.300 --> 16:30.200
of a proactive role of monetary policy also to

16:30.200 --> 16:33.100
deal with the buildup of financial imbalances.

16:33.900 --> 16:36.200
Now the second big issue has to

16:36.200 --> 16:39.400
do with the relationship of the difference between Banks and non

16:39.400 --> 16:39.700
Banks.

16:40.200 --> 16:44.100
And in particular following the

16:43.100 --> 16:47.400
great financial crisis and a

16:46.400 --> 16:49.200
lot of efforts have been put in order to

16:49.200 --> 16:51.100
improve the strength of the banks.

16:52.100 --> 16:55.300
But at the same time very little has been done to deal

16:55.300 --> 16:58.600
with the non-bank financial sector in particular the asset

16:58.600 --> 17:01.100
management sector and in the UK, you recently had

17:01.100 --> 17:05.100
a problem with Pension funds that I think resonates with you.

17:04.100 --> 17:07.700
I'm sure and the

17:07.700 --> 17:10.600
the problem there is that we still do

17:10.600 --> 17:13.900
not have a kind of macro macro

17:13.900 --> 17:16.500
potential approach to the asset management sector.

17:16.500 --> 17:19.600
They have been attempts to put it in place but

17:19.600 --> 17:22.700
those have like behind and so there is

17:22.700 --> 17:25.600
an urgency to do to deal with that sector even

17:25.600 --> 17:28.400
that that sector has grown much more than the banking

17:28.400 --> 17:31.400
sector has over the last 10 years or so.

17:32.300 --> 17:35.800
The third issue is how to integrate fiscal policy

17:35.800 --> 17:39.000
within the macro potential framework.

17:38.500 --> 17:41.300
Now, there is a consensus, of course

17:41.300 --> 17:45.200
that fiscal policies critical for macroeconomic stability,

17:44.200 --> 17:47.100
but far less has been

17:47.100 --> 17:50.900
done in order to tackle specifically the relationship

17:50.900 --> 17:53.500
between fiscal policy and

17:53.500 --> 17:54.800
financial stability.

17:55.600 --> 17:58.800
And this relationship goes both ways on the

17:58.800 --> 18:02.100
one hand you have the the question of

18:01.100 --> 18:04.600
how the buildup of this financial boom some

18:04.600 --> 18:07.600
bests create problems for fiscal policy

18:07.600 --> 18:10.300
and there are two ways in which it does. So

18:10.300 --> 18:13.500
in during the expansion phase when

18:13.500 --> 18:16.500
things are really going well when you've got the strong increases

18:16.500 --> 18:19.300
in credit as a price the strong Capital flows from

18:19.300 --> 18:22.600
abroad then the fiscal position looks much much

18:22.600 --> 18:24.400
Sounder than it really is.

18:25.200 --> 18:28.700
And when the capital flows out or when the the big

18:28.700 --> 18:31.700
Financial boom turns into a past you realize actually that

18:31.700 --> 18:35.000
The Sovereign has big financial problems not

18:34.400 --> 18:37.200
please because if there is a crisis it will

18:37.200 --> 18:40.300
also have to intervene in order to try and

18:40.300 --> 18:43.900
be the backstop to the financial system. So that's

18:43.900 --> 18:46.300
one the second issue is precisely because

18:46.300 --> 18:49.400
of that if you don't take into account the possibility of

18:49.400 --> 18:52.500
financial crisis, when you measure the strength of

18:52.500 --> 18:56.100
the physical position the room for fiscal space,

18:55.100 --> 18:59.200
if you like, then you can easily overestimate

18:58.200 --> 19:02.400
it and find yourself that when the

19:01.400 --> 19:04.800
problems arise you won't have enough fiscal room

19:04.800 --> 19:05.500
for maneuver.

19:06.100 --> 19:09.800
So that's one side. The other side goes from the fiscal policy

19:09.800 --> 19:12.200
to the financial system and we know that

19:12.200 --> 19:15.800
fiscal problems can generate Financial instability.

19:15.800 --> 19:18.200
This is in particular. There is the so called

19:18.200 --> 19:21.200
fiscal Bank Doom Loop

19:21.200 --> 19:24.200
because banks are exposed to The Sovereign but it's not just

19:24.200 --> 19:27.500
Banks. It's also then Banks and again in the UK saw something

19:27.500 --> 19:31.100
recently. What happened when when the

19:30.100 --> 19:33.600
fiscal positions seem to be out of control and

19:33.600 --> 19:36.300
the tensions that this created in financial markets and

19:36.300 --> 19:39.600
the final and the final Point has to do with how far

19:39.600 --> 19:42.600
you can actually integrate these various

19:42.600 --> 19:45.400
policies that I mentioned before and how far you should

19:45.400 --> 19:48.300
go in the direction of integrating them

19:48.300 --> 19:51.600
and there are a number of conceptual and practical

19:51.600 --> 19:54.200
issues that need to be addressed and that will have to

19:54.200 --> 19:57.500
be addressed including the fact that these policies are

19:57.500 --> 20:01.000
implemented with different Horizons. The the

20:00.500 --> 20:03.500
instruments are adjusted at different

20:03.500 --> 20:05.700
frequencies and the authorities that are

20:06.100 --> 20:09.100
possible for these various policies are need not be the same.

20:09.100 --> 20:12.500
We've got fiscal authorities. You've got the central banks. Sometimes

20:12.500 --> 20:15.200
you have Prudential authorities that are not the central

20:15.200 --> 20:19.000
bank. And therefore you have to find a ways of somehow coordinating

20:18.300 --> 20:22.100
or at least making sure that these policies are consistent.

20:21.100 --> 20:24.300
So these are for areas in which

20:24.300 --> 20:27.600
more work I think will need to be done both conceptually,

20:27.600 --> 20:29.100
but also in practice

00:06 - First of all, the objective of macroeconomic policy at least the aspect that we're discussing is macroeconomic stabilization and by that we mean smoothing out economic fluctuations in inactivity avoiding collapses economic activity. So as to provide the basis

00:24 - for longer term sustainable growth and that of course in order to do that, you need the price and financial stability you need to avoid inflation and you need to avoid financial crisis. Now much of the post war thinking about macroeconomic policy was relatively simple. It was about unemployment and inflation the idea that the economy would overheat and you would try to sort of restrain aggregate demand.

00:55 - The economy would be moving too slowly and then you would have to push on aggregate demand and that was basically it. Now around it early 2000s here at the Bas. We started thinking that that was not enough. And what was missing there was the the fact that there was not sufficient attention. To on the way in which the financial side of the economy could derail the real side of the economy and that somehow required a new type of

01:28 - framework and that's why we call macro Financial stability framework and the keyword here. The new term is financial. Because that was the aspect that until then was not really well incorporated into macro stabilization policies, and he had to do with some major major fundamental changes in the nature of the business cycle. Which in turn was related to fundamental changes in policy Frameworks, what do I mean by changes in the business cycle?

01:57 - And this is really very important. Is that until the mid-1980s the typical recession that we had was the result of monetary policy Titanium because inflation was running out of control and therefore the entire interest rates would bring the economy down, but there was very little very little in terms of changes in the indicators of financial expansions and contractions such as strong credit growth or asset prices particular property prices. But the recession that we had starting is

02:26 - in in the mid 1980s were quite different because we know that inflation was relatively low unstable. So it meant that there was no need for monetary policy to tighten during expansions. But what we had was Major Financial Booms that were turning into busts and that's basically what happened during the the great financial crisis, but it's something that also happened happened before and then one sees why this as I said, this was not a coincidence and was the result of the fact that we had Financial liberalization across the world both

02:57 - domestically and internationally, which meant that this financial expansions are contractions had most cope to take place. We had Global ethical globalization of the really economy that put persistent downward pressure on inflation and we had monetary policy regimes, but basically we're focused on inflation so that as long as inflation was not picking up even if you had big Financial expansions, they were not looking at credit. They were not looking at money and longer which meant that there was no reason to tighten

03:27 - which meant that they were not providing a constraint on the financial expans. And then turn into contractions. So if you like we move from inflation induced to financial cycle induce recessions, hence the importance of moving in moving and having a framework that move Beyond monetary policy Beyond fiscal policy and which included Prudential policy. And along with this there was a key change in the

03:56 - way in which Prudential policy was conceived which was away from what used to be called a micropriential perspective to a macro potential perspective. If you like the new kid on the block now, it's it may sound technical that actually it's it's rather. It's rather simple in the end. Now my the micro potential perspective which is the way in which regulatory regulation supervision was structured before the macro credential framers were put in place. It's very much

04:26 - focused on the considering the strength of financial institutions taken on a standalone basis in isolation from the rest of the financial system. So how much Capital does one institution have in relation to the risk that incurs. What is the nature of the counterparties to which it's Lending? the macro potential perspective on the end on the other hand considered institution only in relation to the system as a whole if focuses on the

04:55 - financial the stability of the system Financial system as a whole and once you do that, if you look at the word as opposed to the trees, if you like it becomes natural for you to think of the relationship between the state of the financial system and the state of the macroeconomy those macroeconomic fluctuations that I was telling you about and there you have two questions one is to what extent the financial sector as a whole can deal with a financial with a blow like a recession or a big Capital outflow

05:25 - if that happens and also to what extent the the financial system itself can generate the shock in the first place by contributing to the buildup of the financial imbalances by building two by providing too much credit right by increasing asset prices too much during the expans. Until you get a natural contraction. So most of the macro Prudential tools relate the the state of the financial system to the

05:56 - state of the economy to the global or if you like aggregate Financial developments. So counter-cyclical Capital buffers basically say that you should tighten buffer is a good times the minimum requirements and you should lose them them when problems arise minimum loan to value ratios minimum debt to income ratios, which are supposed to try and constrain the buildup of financial problems typically in the in the real estate sector, but not only they are two big differences. I think that

06:26 - have to do with the experience of the various economies and more to the point with the structure of those economies. First of all, a key difference is that emerging market economies have had more financial crisis than advanced economies and many crises in this late 70s early 80s. They had again many crises in the mid-1990s. So originally first originally was Latin America, then it was also Asia.

06:58 - And therefore because they had so many crisis. They tended to use this instruments Much More Much More Than advanced economies. Even before the great financial crisis in advanced economies. We did have a few crises in the early 90s, like for example in the Nordic countries or in Japan or in Japan, but other advanced economies not least the United States basically felt. Well it cannot happen here. So there was less of an interest in a in a

07:28 - macro in a macro potential type of framework. So that's the first difference the emerging market economies did much more active use of these tools. Even before the great financial crisis. The second the second difference has to do with the structure of the of the economy. And that is that emerging market economies are much more exposed to external Financial conditions to the absent flows of capital flows

07:59 - of Global Financial conditions more generally. And probably the main reason why that is the case is because their financial markets are less developed and in particular there is less. There are fewer instruments to hedge foreign currency exposures. So that you have two types of problems. The the old type of problem is that this country is tended to borrow a lot in foreign currency.

08:26 - And as a result of that when the when you had Capital inflows, the exchange rate of those currencies would tend to appreciate but basically made the balance sheet of those who were borrowing in foreign currency look better because the value of the liabilities in domestic currency were falling which meant that that meant that Capital influence was were coming more and more in and you had that kind of feedback self-reinforcing process where

08:56 - whereby more Capital inflows were generating an appreciation of the currency. They were loosening Financial conditions in domestic country because the borrowers were looking stronger and that was getting more and more Capital Flows In and that at some point that turned to this boom turned into a past. So this is one of the key features of the emerging market economies. Now, even after those countries start stop borrowing in foreign currency, and you had foreigners investing

09:25 - in those kind of in those countries in domestic currency. Then the the currency mismatch was on the balance sheet of the investors because they were basically having a long position in domestic currency, but they were measuring returns in their domestic currency. And that also meant that you had the same problem. Buying assets exchange rates were going up returns in the currency in the US dollars or Euros were going up. And so that called for

09:55 - more Capital influence and so on. So these two mechanisms generated big booms and busts for emerging market economies. The asset. The implication of that is that the kinds of tools that emerging market economies have views have been targeted much more to external conditions and they're basically two types of tool one is foreign foreign currency intervention. And the buildup of Foreign Exchange reserves, so when the currency tends to appreciate they tend

10:26 - to buy foreign currency and so as to limit the appreciation they build up a chest of foreign currency reserves, and at the same time, they reduce the impact that the appreciation of their own currencies has on domestic Financial conditions. That is losing Financial conditions. The other possibilities to use capital capital flow management measures or Capital controls that Target specifically foreign investors. So

10:54 - that's like limiting their ability to buy Assets in the country portfolios, like stocks bonds or in particular also real estate. So on the other hand advanced economies, but did not have this type of problem Focus much more on if you like domestic conditions the domestic buildup of financial imbalances big credit expansions speaking increases in a surprises and therefore they focus more on macro potential measures.

11:24 - But no no mistake. EMES have also looked used a lot macro potential measures but relative to advanced economies. They have used more foreign exchange intervention and capital controls. Particularly in Asia. Let me give you just a couple of examples to sort of to clarify the idea but one from emerging market economies and one which is actually from the recent experience. I would say an experience which is still going on in advance economies.

11:54 - So the one from emerging market economies Is imagine a situation which was typical after the great financial crisis in which they inflation was very low. I'm thinking inflation in emerging market economies as well. But there were big Capital inflows because interest rates in advanced economies were very very low. There was also QE there were sort of big Capital influence that were putting upward pressure on the exchange rate of emerging market economies that was

12:25 - clearly and imagine that at the same time not only was inflation to lower relative to Target. But you also had because interest rates were locals in emerging marketing economies, you had to build up of domestic Financial imbalances, like strong credit growth or asset price increases domestically like in the real estate sector again a common situation. Then if you one way in which you could try and reduce the impact of an appreciating currency on

12:54 - the domestic economy. Because you were getting these inflation because you're currently was appreciating would have been to reduce interest rates. Okay, if you don't do FX intervention, you're reduced interest rate so that you attract fewer Capital flows and the exchange rate appreciates by less. But if you do that, of course you fuel the buildup of domestic imbalances because it would fuel the expansion of credit if you pull the expansion of a property

13:24 - prices. Then actually if you do for an exchange intervention is quite clever because you kill kind of two birds with one stone on the one hand you limit the exchange rate apprecio. Well, first of all, you build up a war chest for when the capital flows out, right? That's always very good. In addition you limit the appreciate appreciation of the exchange rate. So you limit the disinflationary effect domestically and

13:51 - you also limit the channel That was mentioning earlier, whereby an appreciation of the domestic currency attracts more foreign Capital flows because and loosens domestic Financial conditions. So that's a way in which on top of that you can keep interest rates higher than would otherwise beer case which allows you to deal with the domestic imbalance. So effectively with this does is to add one degree of freedom to the set of instruments that you have in order to balance the various objectives that

14:22 - that you have in a more in a better way. Now that's for emerging market economies. Now for advanced economies a very simple example is what's happening these days where my tree policies having to tighten in order to bring inflation down but in a context of very highly debt levels And so if you activate macro potential measures in particular, what you can do is to lower increase the resilience of the financial system.

14:49 - Lower the probability of problems in the financial system and therefore allow miles through policy to tighten even more without being concerned with the possibility of generating stress in the in the financial system so that it can focus much more on the fight against inflation you provide more Headroom again, one more instrument one more degree of Freedom that you can use in a you know, useful way. Let me sort of mentioned for four issues which are still open issues. The

15:19 - first one is the the relative role of monetary and and macro potential policies one view which is quite common in advanced economy is still these days is the so-called decoupling principle, which is the only thing Mastery policy does is to focus on inflation. The only thing that macro potential policies do is to focus on financial stability. Now on the other hand, it has been recognized that monetary policy has a big impact on financial

15:51 - imbalances because it operates precisely by influencing the amount of credit in the economy the value of assets and and so on so very very low interest rates were long for example tend to encourage a lot of risk-taking. So the question is should monitori policy not just pick up the pieces when problems arise but also do help macro potential policy and try to restrain the buildup of financial imbalances, even if inflation is is doing okay and that

16:21 - two different views there and the one that historically the Bas has taken is to think of a more of a proactive role of monetary policy also to deal with the buildup of financial imbalances. Now the second big issue has to do with the relationship of the difference between Banks and non Banks. And in particular following the great financial crisis and a lot of efforts have been put in order to

16:49 - improve the strength of the banks. But at the same time very little has been done to deal with the non-bank financial sector in particular the asset management sector and in the UK, you recently had a problem with Pension funds that I think resonates with you. I'm sure and the the problem there is that we still do not have a kind of macro macro potential approach to the asset management sector. They have been attempts to put it in place but

17:19 - those have like behind and so there is an urgency to do to deal with that sector even that that sector has grown much more than the banking sector has over the last 10 years or so. The third issue is how to integrate fiscal policy within the macro potential framework. Now, there is a consensus, of course that fiscal policies critical for macroeconomic stability, but far less has been done in order to tackle specifically the relationship

17:50 - between fiscal policy and financial stability. And this relationship goes both ways on the one hand you have the the question of how the buildup of this financial boom some bests create problems for fiscal policy and there are two ways in which it does. So in during the expansion phase when things are really going well when you've got the strong increases in credit as a price the strong Capital flows from

18:19 - abroad then the fiscal position looks much much Sounder than it really is. And when the capital flows out or when the the big Financial boom turns into a past you realize actually that The Sovereign has big financial problems not please because if there is a crisis it will also have to intervene in order to try and be the backstop to the financial system. So that's one the second issue is precisely because of that if you don't take into account the possibility of

18:49 - financial crisis, when you measure the strength of the physical position the room for fiscal space, if you like, then you can easily overestimate it and find yourself that when the problems arise you won't have enough fiscal room for maneuver. So that's one side. The other side goes from the fiscal policy to the financial system and we know that fiscal problems can generate Financial instability. This is in particular. There is the so called

19:18 - fiscal Bank Doom Loop because banks are exposed to The Sovereign but it's not just Banks. It's also then Banks and again in the UK saw something recently. What happened when when the fiscal positions seem to be out of control and the tensions that this created in financial markets and the final and the final Point has to do with how far you can actually integrate these various policies that I mentioned before and how far you should go in the direction of integrating them

19:48 - and there are a number of conceptual and practical issues that need to be addressed and that will have to be addressed including the fact that these policies are implemented with different Horizons. The the instruments are adjusted at different frequencies and the authorities that are possible for these various policies are need not be the same. We've got fiscal authorities. You've got the central banks. Sometimes you have Prudential authorities that are not the central bank. And therefore you have to find a ways of somehow coordinating

20:18 - or at least making sure that these policies are consistent. So these are for areas in which more work I think will need to be done both conceptually, but also in practice

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