Martín Redrado: Effects of the crisis and different policy responses -
emerging vs. advanced economies
Speech by Mr Martín Redrado, Governor of the Central Bank of Argentina, at the Money and
Banking Conference 2009, Central Bank of Argentina, Buenos Aires, 1 September 2009.
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Welcome once again to our already traditional space for discussion in the Southern
hemisphere. While the agenda covers the most current economic and financial topics, as
usual, the aim is more ambitious: to see beyond the short term; to look through the economic
cycle into the medium term, anticipating the challenges that we have in face.
The international crisis triggered economic policy responses that were both suited and
aggressive. And we have learnt from this framework. In central banking, it has become
evident that we need a more comprehensive view including financial stability as a key goal
for every monetary authority in the planet.
Moreover, in contrast with what happened with previous episodes, now emerging countries,
have the chance to participate in the decision-making of how to design the new international
financial architecture. For example, we take part sistematically in international bodies such
as the G-20 with a view of making an intelectual contribution in the world economy.
Our knowledge and experience in managing turbulences is valuable and also show that
"there is life after a crisis".
Another example is the participation of emerging economies - and of Argentina as a full
member since June - in the newly created financial stability board (FSB) and Basel
Committee on Banking Supervision.
The FSB is beginning to play a key role in the new system. The inclusion of emerging
countries - with more experience in adjusting regulatory frameworks to avert crises or
mitigate their impact - will provide a new perspective to the board. We will have higher
quality standards and, thus, a greater probability of adequately applying them at the national
level.
Through our direct participation in the Standing Committee for Vulnerabilities Assessment,
we are working towards opening private sector access to credit, policy sustainability and
strategies for exiting the crisis. Also, we take part in the Basel Committee on Banking
Supervision, where we have proposed concrete steps towards liquidity management and the
regulatory treatment of currency mismatches.
Further evidence of increased integration is the currency swap agreements with our
colleagues from the central banks of China and Brazil. An agreement on contingent liquidity
lines in foreign currencies for nearly 12 billion dollars also reflects the confidence of our
peers in our monetary and financial system as well as in the policies the Central Bank of
Agentina is implementing.
The strength many emerging countries - particularly in South America - have shown in
overcoming the crisis will allow us to strenghten our position in the global economy.
The impact of the crisis has been stronger in those emerging economies with external
imbalances, higher financial fragility and fixed exchange rate regimes. But, through its
"second round" effects, the spread of the crisis has compromised short term economic
growth of most developing economies, even those with relatively robust positions.
As to most economies in our region, this episode has found them in a better position than in
previous occasions, with higher growth rates, an improved fiscal position and a relatively
sound external front, supported by a previous foreign reserve accumulation process through
sterilized operations. It is clear that, in a very favorable international context, cyclical factors
had an influence on these developments. However, the better performance the region
achieved was mainly due to the gradual assimilation of the lessons learned from a past
characterized by recurring macroeconomic instability episodes.
The magnitude of an unprecedented crisis has forced us to face some difficult policy
dilemmas. In fact, for the first time in a long period, it has given policymakers, a clear
opportunity to make a difference with the past. The world was headed to the abyss at a very
high speed. A new great depression.
But, now we can say that such free fall was left behind and that policymakers around the
world, have been up to the occasion, being able to avoid the abyss and instead overcome a
period that will probably be inscribed in history as a great recession.
Of course, this does not mean there is room for complacency.
On the contrary, great challenges that need full attention still remain ahead of us; not only for
policymakers but also for the entire profession.
In South America we got around the challenges trying to preserve most of the basic
equilibriums achieved in the external and fiscal fronts. We suddenly moved from a context
characterized by an abundance of financing to a much more adverse scenario. Most
governments have adopted a set of expansionary measures aimed at mitigating
contractionary trends. The chance of adopting these measures in an adverse context has
been a relatively unusual phenomenon in the region, traditionally characterized by highly
procyclical policies.
And this is the behavior we have adopted in Agentina. We have built a monetary and
financial framework that gives priority to avoiding "the next crisis", a concept that is present in
every citizen's mind. We have designed the mechanisms to confine the shock and prevent it
from affecting the rest of the economy. For the first time in decades, the central bank has
been an anchor of stability for our entire economy.
In particular, our risk management strategy based on four pillars (convergence of supply and
demand in the monetary market, a managed floating exchange rate regime, a countercyclical
policy with liquidity buffers both in domestic and foreign currency, and adequate banking
regulation and supervision) allows us to overcome every episode of stress, minimizing its
impact on the real economy. Our strategy also prevents inconsistencies that could
undermine its sustainability over time.
We have recently gone through periods of considerable stress in the domestic market, and
our policies have responded as expected. We successfully overcome four episodes in the
past two years (July-October 2007, April-June 2008, September-November 2008 and March
2009), proving beyond any doubt the soundness of the approach adopted by the central
bank.
During each episode, we acted firmly in an attempt to normalize the demand for money and
stabilize the foreign exchange market. Then, with simple tools - easy to understand by the
market - we ensured the supply of liquidity to guarantee systemic stability.
In this framework, the managed floating exchange rate regime has proven useful for the
current stage of development, considering our history of macroeconomic volatility. But, it has
also proven to be useful in other countries. The literature is clear: even for central banks
using inflation targeting regimes, the exchange rate is a significant variable in their reaction
function.
In the specific case of emerging countries that are very prone to financial and fiscal crises
(such as Agentina), where dollarization/currency substitution levels are high, we have
designed a monetary regime that is sufficiently robust to weather the challenges that we face
in the transition phase towards a long term equilibrium.
Thus, we have avoided "corner solutions", implementing a flexible and robust monetary and
financial regime based on a managed floating exchange rate regime and the strict control of
relevant monetary aggregates.
This regime has allowed us to achieve stability and, at the same time, build a sound financial
system (with no currency mismatches or excessive public sector exposure), which has
gradually regained its function as savings intermediary.
Given the history of our economy, the monetary and financial policy options are part of an
extensive review of the relevance for central banks of the various policy objectives.
Particularly, what role to assign and how to weigh up monetary stability, GDP stability and
financial stability. For instance, both in developed and emerging countries, monetary regimes
focused on a single instrument, such as the interest rate, have become more flexible. Many
central banks have had to revisit their usual regulation, operation and intervention
mechanisms.
In this sense, it is essential to analyze how this crisis affects the economy and policies. As a
matter of fact, there was partly a "surprise effect" due to which early warning mechanisms
failed. Therefore, there is a social debt in terms of the capacity to prevent and warn about
potential risks.
Furthermore, the dramatic reversal of the previous prosperity has led to a significant
reassessment of risk premia. Even the "awareness" of the meaning of risk in itself has
changed. Previous confidence in the possibility to accurately quantify and estimate risk has
been lost and later proved to be naïve. In addition, academics have come to revalue Frank
Knight's definition of uncertainty, according to which the relevant variable's probability
distribution may be unknown to economic agents. All in all, the crisis has caused greater
"humility" in all of us.
Undoubtedly, the interaction of several phenomena, in econometric terms, was what
mattered most. The synergy of different factors combined was not taken into account. For
this reason, a vibrant and healthy discussion is taking place about the most appropriate
theoretical models and paradigms.
Another important debate focuses on fiscal policy. This issue has gained so much relevance
that in the most recent Jackson Hole Symposium there was a whole section dealing with it.
Professor Auerbach from the University of California and Professor Gale from Brookings
thoroughly compiled a series of empirical and theoretical studies related to the impact of
countercyclical fiscal policies, arriving at a single clear conclusion: the controversy on the
multipliers will remain open.
This year we have seen a paper by Cogan, Cwik, Taylor and Wieland, from Stanford
University, and another by Christiano, Eichenbaum and Rebelo, from Northwestern
University, both based on the same "workhorse", the Smets and Wouters' stochastic dynamic
general equilibrium model, showing opposite results: the former argue the multiplier is below
one, whereas for the latter, it is above one.
Why such differences? Because of the assumption that consumers and monetary policy will
behave in a certain way. And again, an interesting contribution of Auerbach and Gale's paper
was to emphasize the greater effectiveness achieved when coordinating fiscal and monetary
policies.
What can we say about economic policy?
I think, in this respect, there seem to be better outcomes. Quite a number of lessons were
learned at various levels:
1. Regarding the importance of financial stability as an objective.
2. Regarding the position of the countercyclical (fiscal and monetary) policy.
3. Regarding the need to create protection buffers, both in terms of liquidity and
solvency.
4. Regarding the relevance of coordination of economic policy.
Moreover, the value of immediate action, without relying too much on automatic stabilizers,
has proven to be essential. Besides, it was necessary to be forceful (and even overact) in
order to overcome economic agents' negative expectations.
For an appropriate international policy coordination, to avoid the temptation to act selfishly
was key. Instead of confining economies and failing to cooperate, we globally avoid
"beggarthy-neighbour" protectionisms, through action at G-20 and other fora.
But there is yet another lesson as regards to timing: policies implemented should never be
prematurely abandoned. Several authors pointed out how the reversal of the United States'
expansionary fiscal policy in the mid 1930s was a setback for recovery. Moreover, it delayed
the efforts to bring the economy back on the long-term path, which only happened in 1942.
Of course, being careful so as not to frustrate the recovery does not mean we should run
unnecessary risks in the opposite direction. The monitoring of potential (non-linear) reversals
especially in inflationary expectations must be ongoing.
Economics is a dynamic discipline. Two years ago, many of our colleagues were worried
about inflationary pressures derived from the booming commodity, real estate and stock
markets. The adjustment process started in the real estate market which, together with the
subprime meltdown, caused fears to take the opposite direction: a deflationary environment
would most likely be created.
Massive interventions around the world, through fiscal and monetary tools largely reduced
the risk of deflation. However, even today, when activity is showing signs of improvement, in
some markets the fiscal and monetary policy exit strategy may tip the scales either way.
While an early exit could affect the recovery, a late exit could fuel inflation, which would bring
uncertainty in terms of employment and economic activity.
It would be senseless to consider only two extreme scenarios: going back to the 1930s or the
1970s. Both episodes have provided economic theory and practice with important lessons.
Therefore, this is the time to maximize efforts to put the world's economy on the track to
sustained and credible growth. The best strategy is to match three closely related aspects:
the gradual decrease in public incentives, the normalization of credit markets, and the
improvement of regulation and supervision. Due to the financial sector's unique features -
especially its multiple negative externalities and systemic aspects - governments should
reduce their incentive policies as the financial system fully recovers its traditional
intermediary role. At the same time, we should implement new prudential regulations and
supervision mechanisms to ensure this role is played in a healthier framework.
Although since March, international financial markets have shown significant improvement,
after the stress peaks in October 2008 and February 2009, the need for caution still prevails.
Expected volatility for the US equity (VIX index) was reduced by half in the past five months,
although it still doubles pre-crisis levels. Something similar occurs with interbank market,
corporate debt, and CDS spreads of US banks.
Given that institutions operate transnationally, there is a need to implement new regulations
to level the playing field. Simultaneously, new regulations should be careful not to stifle credit
recovery.
If institutions were forced to comply with new regulations at once - for example, in terms of
capital - when unable to increase their capital through stock injections or retained earnings,
they would have no choice but to liquidate their assets and cut down on loans, which would
have an opposite effect on credit expansion.
After all, all great crises have led to the reformulation of the international financial
architecture. The world is facing a new stage where our region has to take a leading role.
Many of the world financial crises in the past few decades started and expanded in and
among emerging economies. These traumatic experiences taught us a lesson. Our
economies started adopting sound policies which have allowed us to withstand the contagion
effect of the crisis.
The challenge is to ensure this framework persists after the crisis is over, so that our
countries may be inserted in the global economy in a less asymmetric and more effective
way. By less asymmetric I mean the need and possibility to reduce the "cost" of being
insured against financial crises. In my opinion, this is the path to a more stable, balanced
system which is less prone to inconsistencies that jeopardize the sustained development of
our nations.
In short, we must deepen those policies that enable us to face changes in the external
context and, in turn, to develop our economic institutions so as to better channel benign
scenarios and improve the power of our policy instruments, with the aim of being fully
responsible for the achievement of the objectives set and, thus, aim higher and higher.
This is the path for monetary and financial policy to provide the stability and predictability
needed for the development of our people. Thank you.