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Implementing countercyclical macroeconomic policy

Macroeconomic policy is a necessary tool in crisis containment and resolution. Countercyclical macroeconomic policy can dampen an overly exuberant upswing and cushion a precipitous downturn. Countercyclical macroeconomic policy consists of anticyclical monetary and fiscal policy, as well as macroprudential regulation.

Since the 1980s, rather than focusing on economic activity, monetary policy has generally focused on inflation (Blanchard et al. 2010). Monetary policy made use of the short-term interest rate that the central bank could directly control. Whereas it may be an important countercyclical measure, the focus has not been on dampening the business cycle per se. One issue of caution in using monetary policy is that using it to prick a bubble can be dangerous and difficult. Normally there is disagreement among policy makers as to whether a bubble indeed exists and is harmful to the economy. In addition, a sudden tightening of monetary policy can have larger effects on the economy than anticipated. An increase in interest rates may not only prick the bubble, but also lead the economy into a downturn. Monetary policy would be better used in conjunction with macroprudential regulation that would dampen, rather than amplify, the business cycle. This type of regulation places emphasis on controlling leverage ratios, loan-to-value ratios, and other capital buffers (Demirguq-Kunt and Serven 2009).

Soros (2012) makes the case that monetary tools are insufficient to control asset bubbles. He writes that credit controls such as margin requirements and minimum capital requirements must be implemented to prevent loss of capital. This would provide the financial system with more control at the microeconomic level to ensure capital is present in the areas that most require it in the case of a financial downturn.

Countercyclical fiscal policy is also important but has become less of a focus than monetary policy. The effects of fiscal policy became a matter of debate given Ricardian equivalence arguments and lags in implementation (Blanchard et al. 2010). However, use of countercyclical fiscal policy, including changes in both taxation and spending according to the phase of the business cycle, can be helpful in the recognition that there are social effects of economic activity, and can be used to maintain income and employment. Countercyclical fiscal policy does not exclude decreasing government expenditures and increasing revenues as a percentage of GDP during a boom, and should be used to counter the formation of a bubble. As Alesina et al. (2008) point out, fiscal policy is procylical in many developing countries (to prevent governments from appropriating rents during upswings) and generally countercyclical in OECD countries. Appropriate countercyclical fiscal policy should ideally focus on creating fiscal space during booms by reducing debt-to-GDP ratios, so that net government expenditures can be increased during downturns.

Macroprudential regulation, mentioned above, is a useful accompaniment to both monetary and fiscal policy. It also addresses problems that cannot be targeted by fiscal or monetary policy. Rather than focusing on regulation of individual institutions alone, macroeconomic financial regulation focuses on systemic risk and can enhance countercyclical monetary and fiscal policy by ensuring financial markets are properly cushioned with limited exposure to risk. Deviations of asset prices from fundamentals, excessive risk taking, and excessive leverage can be restricted by macroprudential regulation (Blanchard et al. 2010). Macroprudential regulation is supposed to be managed by the new US Financial Stability Oversight Council and the European Systemic Risk Board and European System of Financial Supervisors.

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