International coordination of macroprudential and monetary policy.

Author:Heath, Daniel
  1. INTRODUCTION II. INTERACTION OF MACROPRUDENTIAL REGULATION AND MONETARY POLICY A. Monetary Policy and Financial Stability. B. Macroprudential Policy's Role and Limitations C. Interaction of Monetary and Macroprudential Policies 1. Interaction. 2. Advantages of Interaction. 3. Interaction in Action. 4. Complex and Infinite Variations III. THE IMPORTANCE OF INTERNATIONAL COORDINATION A. Insufficient International Coordination. B. Cross-Border Financial Frictions C. Institutional and Framework Approaches 1. Structural Agreements 2. Principles 3. Discretion for ad hoc Bilateral/regional Policy Coordination 4. Global Expert Watch Assistance IV. THE CHALLENGE TO INTERNATIONAL INSTITUTIONS A. Look to the IMF B. IMF Record C. New IMF Potential V. MINILATERALISM AND EFFECTIVE FINANCIAL DIPLOMACY VI. CONCLUSION I. INTRODUCTION

    Macroprudential regulation of the finance sector now holds a secure position in legal and economic policy. An impressive, layered structure with dozens of multilateral committees built on individual national entities of regulators and economic authorities sponsors and consumes research and negotiations. (1) This is of course one responsible reaction to the recent Global Financial Crisis (Crisis), along with unprecedented monetary and fiscal interventions and macroprudential regulations to stabilize the financial system. Optimism about a new era of financial stability grows from confidence about new measures and a determination that such a crisis "will never happen again." (2) There is even a hopeful assurance--next time it will be different--captured in the title of a popular history of financial crises. (3)

    That same claim was made in 2000 following the Asian crisis. (4) It is worth reflecting that lawyers and economists have been here before the latest Crisis, and that the previous dedication to macroprudential policy by many in law and economics did not save the sector "this time." In fairness, knowledge of macroprudential policy's workings was rudimentary fifteen years ago. While our understanding may be greater now, in fact many financial analysts and economists are aware of how little we know about systemic risks and macroprudential tools. In that regard "this time" is indeed different. While much important work is being done on the interactions and effects under endlessly varying conditions, we do not definitively know what measures will work, and how. Studies on the few countries with analytically useful history of using macroprudential regulatory tools present ambiguous evidence, though recent theoretical and empirical work shows the benefits of macroprudential policy. (5) There may well be a non-linear track to the promised land of financial stability.

    Macroprudential thinking and its consequences for global growth and stability is so important that its theorists and practitioners must welcome insights from any and all disciplines. This is especially true of policy subjects with responsibilities and institutional investments in financial stability. After all, a broad concern or interrelationships is inherent in the term macroprudential. Such policies include, inter alia, microprudential, fiscal and structural, competition, supervisory, crisis management, resolution, and hitherto less-explored areas of macroeconomics.

    This Article considers the role of monetary policy in macroprudential regulation. It reviews current thinking to demonstrate how monetary policy affects financial stability and, importantly, how it can enhance or diminish macroprudential policy tools. Growing research warns that the coordination of monetary and macroprudential policies is critical to countercyclical management, and an expanding literature explores the institutional arrangements to coordinate these policies within countries. (6) Establishing the national policy frameworks for coordination is the vital first level, but should be only an interim objective.

    A further goal, international arrangements for macroprudential policies coordination, is much less studied at present. There is, of course, a large body of analysis and venerable international architecture for cooperation and even coordination of economic policies. However, the macroprudential mission, at this point, need only strive for the proximate goal of multilateral coordination of policy variables affecting financial stability, though itself a significant challenge. The Crisis certainly made the general public, like never before, well aware of the international character of finance and of contagion and spillover effects of national monetary policy on financial stability. A popular example is the idea of China's current account surplus leading to excessive risk-taking on Wall Street. (7) More specifically, several emerging market economies have been deploying countercyclical macroprudential instruments and reserve requirements to manage swings in capital flows that threaten financial and macroeconomic stability. (8)

    Despite the growing evidence of its need, coordination of monetary and macroprudential policy at the multilateral level for the purpose of strengthening macroprudential regulatory efforts is not well explored. The paucity of research may be due in part to the priority focus on policy coordination within countries. Neglect might also be attributed to the perennially low priority placed on multilateralism by national authorities facing low growth and high unemployment in their electorates. (9)

    The inattention might also reflect the lack of new ideas about what to do to improve the situation. The International Monetary Fund (IMF), the likely coordinator of monetary and macroprudential policies, practices a financial diplomacy model based on analysis and consensus building through expert advice. Yet the IMF knows, or reveals, surprisingly little about how effective its efforts have been and what else it might try to improve multilateral monetary coordination.

    The conventional financial diplomacy model of the IMF has many virtues, and many proposals have been made to strengthen its effectiveness. Efforts to enhance financial diplomacy are critical to the success of macroprudential policy because it is best coordinated multilaterally with macroeconomic policy. Monetary policy coordination may be more difficult because often it is less rules-based and mechanistic than macroprudential regulation. Monetary policy moves the macroprudential enterprise in a more discretionary direction. (10) At the same time, economists search for economic rules and patterns with which to guide the vise of tools. Minilateralist approaches offer a promising way forward.

    Part II of this Article reviews the potential for financial stability and the limitations, first of monetary policy, second of macroprudential policy, and third of the two policies when interacting. It shows how the aims coincide, but that the capabilities and means can complement or frustrate achieving the objective under specific conditions. Overall there is loss of regulatory efficiency when the role of monetary measures is neglected. Part III describes the need for international coordination of monetary policy with macroprudential policy. The growing work on coordinating these policies on the national level suggests institutional approaches with which to promote an international framework. In Part IV, the challenge to international institutions appears through a preliminary examination of the IMF's experience with multilateral coordination of policy. Its model of financial diplomacy, based in persuading with expert economic advice, offers little quantitative evidence of success and little direction for radically changing its approach. Nonetheless, Part V reviews the several proposals since the Crisis, including the IMF's, to strengthen the expert advice model. While these tend to embody characteristics of minilateralism, a bolder minilateralist design would likely improve financial diplomacy in the service of the financial stability goals of macroprudential policy.


    Macroprudential policy, like many subjects in law and economics, does not function in isolation but interacts with other policies that bear on systemic risk. It is integrated especially with monetary policy instruments and theory because monetary policy operates through the fundamental financial channel of interest rates and aggregate credit supply. Moreover, the financial sector often falls under the regulatory eye of the monetary authority, the central bank. This Part demonstrates how monetary policy is important in itself for financial stability, and as a partner with macroprudential policy, and properly belongs as part of international financial regulatory policy.

    1. Monetary Policy and Financial Stability

      Monetary policy aims to achieve price stability and stable economic growth by determining the conditions that affect the supply and demand for credit. In recent decades this primary function appeared sufficiently successful to forestall much inquiry into the working of monetary tools on financial stability. (11) Most monetary economists agreed that flexible inflation targeting was sufficient for conducting monetary policy, that it would achieve financial stability, and that the framework of monetary policy could deal with international spillovers. The Crisis revealed financial instability--growing imbalances--beneath the placid macroeconomic surface of stable growth and low inflation. Regulators turned to macroprudential instruments and economists are reconsidering the ways and conditions under which the side effects of monetary policies can greatly affect financial stability.

      While not regarded as a direct instrument for financial stability in recent decades, monetary policy uses macroeconomic management tools for price stability--inflation targeting and short-term interest rates--that gives it a potential for financial stability. (12) Indeed, changes...

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