Economic policy implications of current financial instability

Abstract

At the heart of the current financial crisis lies the procyclical behavior that is inherent to the functioning of financial markets. Contrary to the arguments of orthodox economists, such markets do not stabilize on their own nor do they tend to smooth out the behavior of private spending. This problem is compounded by the fact that current prudential regulations are also procyclical. For developing countries, the crisis has been mixed with structural deficiencies in the functioning of the global monetary and financial system, particularly the strong procyclical shocks that these countries face and the need to accumulate large amounts of international reserves to gain even limited space for adopt countercyclical macroeconomic policies. However, this rational decision to “self-insure” against crises may have contributed to the creation of global payments imbalances. This essay argues that these two dimensions of the global crisis – the absence of a countercyclical prudential regulation framework and the massive “self-insurance” of developing countries – can only be resolved with global solutions. The first of these problems requires that all countries adopt a countercyclical framework of prudential regulation and supervision. The second requires that better global instruments be designed to manage the financial crises of developing countries, which in particular allow opening “policy space” for these countries to adopt countercyclical macroeconomic policies.

JEL classification: E61 ; F33 ; F42 ; F65 ; G01 ; G28