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On Keeping Your Powder Dry:
Fiscal Foundations of Financial
and Price Stability
Keynote Speech by Maurice Obstfeld

Banking systems have rapidly grown to a point where, for many countries,bank assets amount to multiples of GDP. As a consequence, governments’capacities to provide stability-enhancing fiscal guarantees against
systemic crises can no longer be taken for granted. As regulation of
dynamic financial markets will inevitably be imperfect, prudent governments need to adjust other facets of macroeconomic policy to mitigate
financial instability. A precautionary approach to fiscal policy, leading tomoderate levels of public debt relative to GDP over the medium term, isessential for the credibility of government promises to support thefinancial system, as well as the broader economy.
Keywords: Fiscal policy; Financial stability; Monetary policy; Financial
crisis; Banking crisis; Bank resolution
JEL Classification: E44, E58, E63, F62, G15, G28

University of California, Berkeley, CEPR, and NBER (E-mail: obstfeld@econ.berkeley.edu).........................................................................................................................................................
This paper was prepared for the 2013 BOJ-IMES Conference, “Financial Crises and the Global
Financial System,” held by the Institute for Monetary and Economic Studies, Bank of Japan(BOJ) in Tokyo on May 29–30, 2013. I thank the Coleman Fung Risk Management ResearchCenter at UC Berkeley for financial support and Sandile Hlatshwayo for excellent research
assistance. The views expressed in this paper are those of the author and do not necessarilyreflect the oﬃcial views of the BOJ.

MONETARY AND ECONOMIC STUDIES/NOVEMBER 2013
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION

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I. Introduction
Six years of global financial crisis have forced economists to rethink the standard policy
prescriptions for macroeconomic stability that dominated their thinking during the prior
two decades. At the risk of considerable oversimplification, one could describe theconsensus view of best-policy practice as follows: monetary policy, if governed byflexible inflation targeting (perhaps of core inflation), will stabilize prices and output
reasonably well in most circumstances. Fiscal policy should smooth tax rates over thebusiness cycle, avoiding debt buildups that might threaten government solvency andrelying primarily on automatic stabilizers to counter fluctuations.
Superficially, these guidelines seemed adequate for the benign environment of
the “Great Moderation.” However, they took virtually no account of financial markets.
The tacit assumption was that these would function more or less eﬃciently, neither
impeding the transmission of monetary policy nor generating disruptive shocks on theirown. At the most, mainstream policy analysis acknowledged that financial markets
might occasionally generate disturbances, while maintaining that these could be oﬀset
at low economic cost through conventional policy instruments, especially monetary
policy.1 (At the same time, of course, best-practice prudential policy, as codified inBasel II, took inadequate account of macroeconomic considerations.)
The global financial crisis of 2007–09 and its aftereﬀects, including the ongoingcrisis in the eurozone, have overturned earlier complacent views. Recent history teaches
us that considerations of financial stability must be central to our thinking about the
optimal frameworks for monetary and especially fiscal policy. This lesson is apparent
in the interwar experience of the Great Depression, but it is also implied by much
more recent episodes of economic crisis and stabilization, both in emerging markets
and in industrial countries. The puzzle is to understand why policymakers in advanced
economies, up until 2007 and even beyond, underestimated the hazards that these experiences revealed. The evidence before them included such episodes as the developingcountry debt crisis of the 1980s, which could easily have wiped out the capital of U.S.
money center banks, as well as Japan’s post-bubble travails.
Our increasingly complex financial systems seem inherently prone to at least someinstability, even in the face of eﬀorts to regulate them. Because regulation of dynamic
markets will inevitably be imperfect (an implication of Goodhart’s law), prudent
governments need to adjust other facets of macroeconomic policy to mitigate financial
instability and its eﬀects. My main point today will be that a precautionary approach tofiscal policy, leading to moderate levels of public debt in relation to GDP, is essential
for the credibility of government promises to support the financial system, as well as
the broader economy. Clearly defined rules that limit fiscal exposure must also informthe endgame of winding down insolvent financial institutions.
......................................................................................
1. For example, the 1992 Maastricht treaty underlying the architecture of the euro built explicit defenses against
monetary and fiscal malpractice, but did not construct complementary defenses against financial instability.
A number of observers, including me (Obstfeld [2013]), have pointed out that this omission is a central factor in
the current euro crisis. Of course, several writers did emphasize the importance of financial factors for monetary
policy before 2007, but their analyses were not taken to heart by the mainstream of the academic economics
profession. Even among contributors to the present conference series, one could cite Goodfriend (2001) andWhite (2001).

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On Keeping Your Powder Dry: Fiscal Foundations of Financial and Price Stability

Absent adequate fiscal space, financial instability will worsen and may lead to priceinstability or sovereign default, which themselves will further impair the functioningof financial markets, at great cost to the broader economy. Japan’s current push toescape from decades of slow growth and deflation illustrates how dangerous it can be
to tolerate large public debt buildups. An individual country’s high debt is dangerous
not only to itself but also globally, as its own instability is likely to infect countries withwhich it has financial and trade links, along with those countries’ trade partners.

II. Growth and Stability of Banking Systems
Deregulation, globalization, and technological innovation (including financial innovation) have supported a massive growth in global banking activities since the adventof floating exchange rates in 1973, and especially over the last two decades. It is by
now a commonplace that cross-border gross assets and liabilities have reached highlevels relative to national products—massive levels for countries that also serve as
global financial hubs. Overall assets and liabilities of banking systems and shadowbanking systems have expanded in parallel with international asset trade. This is no
surprise, because a globalized financial market allows even banks headquartered insmall countries to grow very big relative to GDP.
For a selection of OECD members, Figure 1 reports illustrative measures of bankassets relative to the GDPs of the banks’ headquarter countries. (These data give only
a very partial picture of the growth of financial intermediation, and therefore should
be viewed as illustrative; in particular, the U.S. data take no account of a very large
shadow banking system.) Accompanying the trend of increasing overall size of banking
Figure 1 Ratios of Bank Assets to GDP

7

Percent
Belgium
Canada6

France5GermanyJapan

4

Netherlands
3South Korea
Spain

2

Switzerland
1
United Kingdom
0

United States
1990

92

94

96

98

2000

02

04

06

08

Source: OECD banking statistics.

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systems has been a trend of increasing concentration in banking—fewer banks withmuch larger balance sheets. Even in some of the larger European countries, there
are individual banks with balance sheets comparable to, or exceeding, home-country
GDP. The spectacular growth of banking, coupled with its increasing concentration
and wider scope, has critical implications for all dimensions of macroeconomic
stabilization policy.
Has a constellation of fewer banks with much larger balance sheets led to greater
financial stability? Some literature exists on the relationship between bank size andprofitability, but it does not suggest that size promotes higher social returns (oncethe costs of various government guarantees are incorporated; see Haldane [2012]).
Clearly, the changing banking environment has been associated over time with morecrises, initially concentrated in the emerging markets, but now mostly in the advanced
economies, including much of the euro area.
Figure 2, based on the banking crisis chronology of Laeven and Valencia (2012),
illustrates the frequency of ongoing systemic or near-systemic banking crises since1970. The figure does not establish causality—it may be that banking crises would
have been even more frequent had banks been smaller, more limited in the scope of
their activities, and more competitive. If that were the case, however, perhaps the low
frequency of banking problems in the postwar period prior to the early 1970s would be
the puzzle.
Recent banking crises have inflicted heavy costs on economies. To start with, thereis the direct (gross) cost to governments of reorganizing and recapitalizing failed banks,
protecting depositors and other bank creditors, and the like. In the Asian crisis of
1997–98 and earlier crises in Latin America, such fiscal costs amounted to large fractions of GDP for some emerging market economies (EMEs), and a few richer countries

Figure 2 Annual Frequency of Ongoing Banking Crises (1970–2011)

35
5
30
0
25
5

Emerging/developing

Advanced

20
0
15
5
10
0
5
0
1970 72

74

76

78

80

82

84

86

88

90

92

94

96

98 2000 02

04

06

08

Source: Author’s calculations using Laeven and Valencia (2012) banking crisis dates.

28 MONETARY AND ECONOMIC STUDIES/NOVEMBER 201310

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On Keeping Your Powder Dry: Fiscal Foundations of Financial and Price Stability

have spent comparable sums since 2007. Table 1 reports selected estimates of directfiscal costs in support of crisis-stricken banking systems. (Estimates do not include
asset guarantees.) These costs have been upward of one-third of a year’s GDP in someEME episodes, and, more recently, in Ireland (41 percent) and Iceland (44 percent).
Apart from Iceland, Ireland, and Greece, however, the advanced-economy fiscal
costs mostly reside in the single digits. But direct fiscal costs are only part of the story.
Banking crises generally bring lengthy recessions, implying a great deal of forgone
output and substantial increases in public debt in support of the general economy(Reinhart and Rogoﬀ [2009]). Given political realities, high public debt is likely toconstrain the exercise of expansionary fiscal policy, leaving the central bank to bear
the burden of stabilization through a low—even zero—policy interest rate. In turn,protracted expansionary monetary responses may subsidize banks but have negative
economic side eﬀects that emerge only gradually and that are hard to quantify evenafter the fact.2

III. Fiscal and Monetary Implications of Financial Stabilization
Once one recognizes financial stability as a first-order concern, one necessarily
recognizes a rich set of interactions with fiscal and monetary considerations. These
interactions have been very apparent in earlier EME crises, including in Latin Americaand Asia, where extreme fiscal costs of supporting the financial sector (Table 1) havebeen associated with high inflation and with crises in sovereign debt and currency
markets. Honohan’s (2005) comprehensive discussion of the links among financial,fiscal, and monetary policy, based mostly on EME experience, now appears quite
relevant to a broader set of economies. Much earlier, Dı́az-Alejandro (1985) oﬀered
a remarkably prescient analysis of Chile’s financial collapse in the early 1980s, thethemes of which resonate strongly in subsequent crises, including those that began in
2007. We must now acknowledge a range of financial stability safeguards as integral
parts of the overall macro policy framework. The design and implementation offinancial stability policy is much more than a sideshow to the main attraction ofmonetary cum fiscal policy.3
Countries erect ex ante barriers against domestic financial instability, but alsointervene ex post with monetary and fiscal instruments once a crisis has nonethelessbroken out. Market expectations about ex post responses will influence behavior in
financial markets, and thereby the financial stability outcomes that trigger ex postinterventions through monetary and fiscal means. Thus, the design of ex ante defenses
cannot be separated from the likely policy response to a crisis. Regulations cannot
be so strict as to stifle financial markets in the performance of legitimate functionsof resource allocation over time and states of nature. Yet they must take account of the......................................................................................
2. For a recent discussion of potential negative eﬀects of long-term monetary easing, see International Monetary
Fund (2013, chapter 3). More generally, Laeven and Valencia (2012) argue that stabilization policies in advanced
countries tend to delay financial-sector restructuring, lengthening the aftermaths of financial crisis. Japan, towhich I return below, is a case in point.
3. The Asian crisis provided some especially vivid examples of financial-sector considerations that influenced
policy responses, including fiscal and monetary policies implemented under IMF programs. See Fischer (2001).

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Table 1 Direct Fiscal Outlays in Some Banking Crises
Ratio to GDP, percent
Argentina (1980–82)
Belgium (2008–11)
Chile (1981–85)
China (1998)
Germany (2008–11)
Greece (2008–11)
Iceland (2008–11)
Indonesia (1997–2001)
Ireland (2008–11)
Japan (1997–2001)
Latvia (2008–11)
Mexico (1994–96)
Netherlands (2008–11)
South Korea (1997–98)
Spain (2008–11)
Thailand (1997–2000)
Turkey (2000–01)
United Kingdom (2007–11)
United States (2007–11)

55
6
43
18
2
27
44
57
41
14
6
19
13
31
4
44
32
9
5

Source: Laeven and Valencia (2012).

economic costs—public and private—of a breakdown, as well as the expectations offinancial actors about how the government will act in a crisis.4
A key consideration is the dynamic consistency of the promised rules of the game
concerning liquidity support, its limits, and the consequences of a determination by
the authorities that the line between illiquidity and insolvency has been crossed. Will
ex post reactions of authorities coincide with the announced ex ante rules? A particulardanger is that of collective moral hazard, as analyzed by Schneider and Tornell (2004)
and Farhi and Tirole (2012). Unless ex ante constraints on financial actors are strong,
the widespread understanding that the government ultimately will not let the economy
collapse may lead to “bad equilibria” with very adverse and systemic low probability
tail outcomes. In short, frenzies of competitive risk taking can arise, as arguably was
the case in recent housing bubble episodes in the United States and elsewhere.
In a memorable passage, Dı́az-Alejandro (1985, p. 18) put it this way:
It may be that private financial agents, domestic and foreign, lenders, borrowers
and intermediaries, whether or not related to generals, know that the domestic
political and judicial systems are not compatible with laissez-faire commitments
which a misguided Minister of Finance or Central Bank President may occasionally utter in a moment of dogmatic exaltation. When a crisis hits, agents willreason, bankruptcy courts will break down; when almost everyone (who counts)
is bankrupt, nobody is!
......................................................................................
4. For a wide-ranging overview of regulatory issues in light of the global crisis, see Brunnermeier et al. (2009).

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On Keeping Your Powder Dry: Fiscal Foundations of Financial and Price Stability

Such episodes make the macroprudential perspective essential, because collective
exuberance can inflate profits, capital, and collateral values, masking underlying threats.
(In addition, the government’s budgetary position will also appear deceptively strong,
as in Ireland and Spain before 2008.) Many of the recent financial reform initiatives
taken and proposed in the advanced economies represent attempts to erect credible
structures that will both limit financial instability ex ante while minimizing the monetary and fiscal costs of the interventions that, of necessity, will still appear necessary
at times.
As noted above, prudential restrictions so severe that crises become zero probability events are unlikely to allow the financial markets eﬃciently to allocate capital andits risks to promote economic growth. Moreover, regulators will forever playa game of catch-up with financial innovation and regulatory arbitrage. Thus, whileregulation may limit the number of crises and perhaps even guard against the direst
systemic events, certain government guarantees will remain necessary to reduce therisk of self-fulfilling panics and to support expectations of a stable overall economic
environment on the part of firms and consumers. Such guarantees include insurance forsmall retail depositors, as well as oﬃcial assurances that financial institutions, banks
and even some nonbanks, can be supported in the continuous performance of essential
economic functions during times of crisis. Regulation’s role in part is to limit the moral
hazard that these guarantees would otherwise promote; in particular, there is in myview a strong case for limits on the size and/or interconnectedness of institutions whenthese become “too big to fail.”5 Post-crisis rules for reorganizing insolvent institutions
also can play a role in limiting moral hazard.
Recent crises demonstrate that the central bank’s classic lender-of-last-resort
function remains an essential component of the ex post policy toolkit (although in
the United States as well as in Europe the standards of “acceptable” collateral for
central bank liquidity support have been stretched to new limits). Certain liquidity
support operations could also be provided by national Treasuries if the fiscal situation issound; Treasuries generally backstop national deposit insurance schemes. A potential
cost of activist central bank liquidity support is a blurring of the line between monetary and fiscal policies, with potential political consequences for the central bank’s
independence to pursue price stability.6 The fiscal implications of liquidity support
become especially stark when the borderline of insolvency approaches (although eventhis determination can be subjective, leading to excessive cost to taxpayers and theeconomy). At this point, conventional wisdom has it that the problem becomes fiscal
in its entirety, and falls at the door of the ministry of finance.
There is a growing oﬃcial consensus that when financial institutions become
insolvent, small depositors should be protected but fiscal costs should be borne by bankequity holders, by junior creditors, and, if necessary, by unsecured senior creditors,
in that order. Last to be hit would be large, uninsured deposits. There is a case to
be made for debt instruments that automatically convert into equity in well-specified......................................................................................
5. Stein (2013) makes a persuasive case for regulation not only of banks but also of nonbank financial
intermediaries that could be forced into asset fire-sales by creditor runs.
6. See Goodfriend (2011) for an insightful discussion. In general, concern about a troubled banking system could
deter a central bank from raising interest rates promptly in the face of an inflation threat.

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circumstances. In contrast, unsecured senior creditors and others were widely bailed
out during recent advanced-country crises, as had occurred earlier in some emerging
market episodes, promoting future moral hazard and leading to severe economic hardship in countries such as Ireland. In a joint statement last year, the Federal Deposit
Insurance Corporation and the Bank of England advocated a resolution doctrine forlarge cross-border institutions in which haircuts on uninsured bank creditors play a
key role.7 Similar ideas underlie the European Commission’s proposals for a Single
Resolution Mechanism in the euro area (as well as the inclusion of collective action
clauses in euro area sovereign debt issues starting last January 1).
While a “bail-in” approach limits ex post taxpayer costs while deterring moral
hazard, it also has the potential to increase instability in financial markets as unsecured
bond creditors sell en masse to avoid losses. Thus, central bank lender-of-last-resort
support for liquidity problems and perhaps even Treasury support become even moreessential. Of course, the risk-taking behavior of banks and other financial intermediaries depends on the credibility of the threat that they can be closed and reorganized:
as emphasized by Claessens, Herring, and Schoenmaker (2010), the resolution endgame
aﬀects short-run behavior. If creditor bail-in is a component of that endgame, then its
exercise must be credible and not subject to fears of financial contagion. (Recall thecontagion concerns that postponed a Greek sovereign default for so long, as well as theprolonged eﬀorts by authorities to avoid triggering credit default swaps on Greek debt.)
It falls on supervisors to render ex post creditor haircuts safe (and therefore credible)
through ex ante rules and interventions.
If fiscal resolution practices cannot be structured to limit taxpayer exposure andmoral hazard, and if a crisis inflicts significant collateral damage on the economy,
leading to larger fiscal deficits, the government’s credibility as a guarantor of the financial system can come into doubt. In a context such as the euro zone, where independent
monetary policy is not available, sovereign debt will go to a discount, adding a negativebalance-sheet shock to the harm already done by non-credible government guarantees,
and as economic activity falls further the government’s fiscal space—and the price of its
sovereign obligations—can plummet. Safe assets disappear from the financial system.
This “doom loop” linking banks and sovereigns is now well appreciated thanks tothe euro crisis.8
In a context where the government can (in principle) print money to repay its debts,
a possible outcome, seen in the past in many EMEs, is a resort to inflation to address
the joint debt overhangs of the private and public sectors. These scenarios put us in therealm of the fiscal theory of the price level, as analyzed by Sims (1997) and Woodford(2001), because they tend to occur when the political capacity to resolve distributional
disputes by nonmonetary means is lacking. I noted earlier the conventional view thatwhile the central bank should address the illiquidity of banks, the fiscal authority
must address insolvency. When the fiscal authority itself is overstretched, however, thecentral bank may again be brought into play, this time to resolve budgetary inconsistencies through inflation. If price stability is to be preserved, sound fiscal management is......................................................................................
7. See Federal Deposit Insurance Corporation and Bank of England (2012).
8. For an insightful model and evidence, see Acharya, Drechsler, and Schnabl (2011).

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On Keeping Your Powder Dry: Fiscal Foundations of Financial and Price Stability

a prerequisite for financial stability. Furthermore, financial stability is hardly compatible
with highly variable inflation.
Public debt itself does not seem to be a strong predictor of subsequent financial
crises, unlike increases in private credit, which do have considerable predictive ability.
Among other studies, Gourinchas and Obstfeld (2012) reach this conclusion forpost-1970 data on a broad sample of emerging and advanced economies, whereas
Jordà, Schularick, and Taylor (2013) reach the same conclusion using a long historical data sample (1870–2010) for a group of 17 advanced economies. However, it isstill possible that countries entering financial crises with large initial public debts facedeeper and longer-lasting contractions, and this is exactly what Jordà, Schularick, andTaylor (2013) find on the basis of a nonlinear empirical model.9
For advanced countries, the historical record also suggests that financial crises leadto deflation, especially when public debt is initially high. Jordà, Schularick, and Taylor(2013) conjecture that this is due to a resort to fiscal austerity once debt levels become
too large. The pattern certainly would diﬀer if the same exercise were performed for
EMEs. There, crises and large public debts have typically ended in “the time-honored
route of washing out old financial mistakes via inflation (which is not allowed to bereflected in interest rates)” (Dı́az-Alejandro [1985, p. 17]). When the political system isbrittle, this is the easiest way of reconciling competing distributional claims, as arguedby Rajan and Tokatlidis (2005). This fate could be in store currently for some advanced
countries, whose politics seem to have become more brittle in the face of recent crises.
In any case, it is clear that the combination of financial crisis and high public debt hasoften undermined price stability in the past.

IV. Implications
Far from being immune to serious financial instability before 2007, industrial countries
also suﬀered from systemic financial crises as well as notable near-misses. This makes
it puzzling that alongside the conventional arguments against high levels of public debt,
the need to maintain fiscal space to guard against systemic financial instability did
not receive more prominence until recently. The most extreme recent problem cases
involve small countries with banking systems several times larger than GDP, countries
that clearly could not credibly backstop their financial systems without compromising
government solvency or price stability. But across the industrial world, public debts
remained high in the runup to the global crisis as banks and domestic credit expanded
willy-nilly. The fiscal costs of bank support, augmented with the much greater fiscal
costs of crisis-induced recessions, have now led to advanced-country debt levels thatleave little room for further mishaps (see Figure 3, where Japan has a heavy weightin the advanced-country group). In contrast, EMEs (apart from Central and Eastern
Europe) avoided credit booms before the global crisis, maintained fiscal space,recovered quickly, and recently have enjoyed falling government debt ratios on average.
......................................................................................
9. In general, fiscal contraction is likely to be an especially appropriate response to large credit booms: the policy
dampens demand, but simultaneously enhances the stock of precautionary fiscal resources available in case ofa crash.

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Whether the EMEs’ defenses will prove as eﬀective next time they are tested remains
to be seen.
Japan provides a leading example of advanced-country financial instability prior to
2007—and the global crisis has not helped its plight. Its problems, which once seemed
exceptional to economists, now appear to be more widely shared. According to the IMF,
Japan’s gross public debt stood at 230 percent of GDP in 2011 (its net public debt was
127 percent), and it is forecast to rise even higher and remain high for the near future.
These conditions are the culmination of many years in which insolvent entities including banks received financial support, low short-term interest rates encouraged banks
to buy government bonds rather than find new business customers, fiscal policy was
ineﬀective, and deflation expectations became entrenched. Japanese authorities now
propose to promote positive inflation expectations. However, to do so at current public
debt levels, while avoiding financial instability and government financing problems asnominal interest rates inevitably rise, will require a delicate balancing act. Despite theevident risks, there is now no alternative to a radical policy shift; further postponement
will only lower the chances of success.
Even justified warnings on the perils of debt do not imply that draconian austerity
is always and everywhere the correct remedy, and certainly not in already-depressed
economies with weakened financial systems. The European Union has been trying thatapproach, with largely negative results. Once the horse has left the barn, austerity will
not get it back. Empirically, outside of default, growth in GDP has been the prime
method of successfully reducing high public debt ratios, and so growth-promoting
Figure 3 Gross General Government Debt: Advanced vs. Emerging Economies

140

Ratio to GDP, percent

120

Major advanced economies
Emerging market and developing economies

100

80

60

40

20

0
2000

01

02

03

04

05

06

07

Note: The advanced-country group consists of the G-7.
Source: IMF, WEO database, April 2013.

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On Keeping Your Powder Dry: Fiscal Foundations of Financial and Price Stability

structural reforms, as now proposed by Japan’s government, are essential. The realitiesof politics do not allow governments simultaneously to impose the pain of both austerity
and reform. If a choice is necessary, political capital invested in reform is far more
likely to yield a positive payoﬀ. Success will be more durable if politicians at the sametime can build institutional structures that return public debts to moderate levels overthe long term.

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38 MONETARY AND ECONOMIC STUDIES/NOVEMBER 2013