ignazio visco : rebalancing trade and capital flows remarks by mr ignazio visco, deputy director general of the bank of italy, at the global economic symposium 2010, istanbul, 29 september 2010. * 1. * * the role of macroeconomic policies in the global crisis policy responses to the global crisis have helped stabilize confidence and limit the threats of financial instability, but at the cost of a huge accumulation of public debt. this could potentially lead to a higher cost of borrowing if markets were to become concerned about its sustainability, and of a protracted period of very low policy interest rates and abundant liquidity, which may end up fuelling new asset price bubbles, thus building up the conditions for the next crisis. in order to reduce the risk that again in the future a combination of distortions may lead to large and destructive financial crises, it is essential to address both macroeconomic and financial policy failures. important changes in financial market regulation and banking supervision are already being introduced. in the macroeconomic area, an effort is being conducted to strengthen the coordination of economic policies in the context of the g - 20. beyond exiting from exceptional expansionary policies, the global economy will face the challenge of adapting to an extended period of higher private saving in the advanced economies, where the process of deleveraging is still at its early stages. a shift to a more sustainable global pattern of demand is needed, with important policy implications to facilitate this adjustment over the medium term. policy frameworks should adjust to allow for stronger growth in private demand in economies with substantial external surpluses that have accumulated large reserve positions over the past several years. in other words, the composition of global demand will need to shift in order to deliver strong, sustained and balanced global growth, as in the g - 20 intendments. supply - side policies and structural reforms will be important to support potential growth – which may have been damaged by the crisis. one may wonder what would have happened to the global economy had this policy framework been implemented in due time. such a counterfactual scenario has been studied by catte et al. ( 2010 ) who show that, if a substantial and globally coordinated demand rebalancing had been undertaken in the early 2000s, internal and external imbalances would not have accumulated to the extent that they did ( catte, p., p. cova, p. pagano, and i. visco ( 2010 ), “ the role of macroeconomic policies in

the global crisis ”, banca d ’ italia occasional papers, no. 69, july ). in particular, the scenario considered contemplates tighter monetary and supervision policies in the united states and an increase in domestic demand in major surplus economies. the latter would have been the result of wealth effects obtained through productivity enhancements in the nontradable sector in advanced surplus economies and of policies aimed at directly rebalancing growth towards domestic demand – such as measures that reduce households ’ precautionary savings and reforms of corporate governance which decrease retained earnings, coupled with exchange rate appreciation – in emerging economies. even though it is difficult to say whether in that scenario the financial crisis might have been avoided, its propagation would likely have been less destructive, as both the us financial system and the global economy would have been less vulnerable to it. specifically, us housing prices would not have expanded at the same pace as they did and the pattern of current accounts would have been better balanced. overall, the results of such a counterfactual scenario highlight the complementarity of policy actions in deficit and in surplus countries with respect to the correction of both internal and global imbalances. notwithstanding announcements about the importance of coordination and cooperation in the design and development of crisis strategies, in practice, countries have proceeded to adopt policies that appear to be national in character. strengthening multilateral coordination to mitigate global distortions remains a priority. the issue of cooperation extends beyond the design and implementation of stabilization policies and appears particularly relevant in managing exchange rate flexibility. 2. exchange rate flexibility and financial flows for countries in surplus, the rebalancing toward domestic demand should normally be accompanied by an exchange rate appreciation to help re - direct production toward nontradables and part of the additional absorption toward imports. the consequent terms - oftrade gains would help stimulate domestic consumption. in principle, an effective exchange rate appreciation can be achieved in different ways depending on the exchange rate regime. greater exchange rate flexibility could, for example, take the form of exchange rate fluctuation within a moving ( e. g. gradually appreciating ) target band, defined with reference to either the dollar or a currency basket. it is possible to imagine a wide range of variants of this regime depending on the width of the band, the speed of appreciation, the composition of the basket and whether the margins of the band are “ hard ” or “ soft ”, as well as depending on the degree of pre - commitment