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Thursday, 18 December 2014

Coordinating macroprudential and macroeconomic policies: Issues facing Europe in the decade ahead

Democritus writes:

Financial stability is a critical new policy objective for the European Union, especially the euro area, requiring a careful rethink of policy assignments and institutional arrangements. This proposition was put forward by Russell Kincaid (Senior Member, St Antony’s College) and Valerie Herzberg (Member, Cabinet of Vice President Kataninen, EC) and debated at Chatham House on November 5, 2014.

Their presentations summarized two separate, but complementary, PEFM discussion drafts (see that were both coauthored with Max Watson.

Structural macroprudential measures (e.g., capital/liquidity buffers, SIFI surcharges) were viewed as new instruments to be assigned unambiguously to the objective of financial stability. Meanwhile time-varying macroprudential tools (e.g., counter cyclical capital buffers/risk weights, loan-to-value/debt-to-income limits) at the national level would seek to avoid boom/bust cycles as witnessed in Ireland and Spain for example. Such time-varying macroprudential policy by tailoring the ‘one-size-fits-all’ common monetary policy of the euro area to fit national conditions would thus also tackle the Walters critique—the inability of the common monetary policy to tackle country-specific shocks. This objective/policy tasking would accord with the well-established principles for policy assignments laid down by Tinbergen and Mundell and the prevailing frameworks for monetary and fiscal policies.

The new Single Supervisory Mechanism and other relevant EU legislation (e.g., CRD-IV/CRR), allows national competent authorities to implement macroprudential actions, after advance ECB notification, to address national conditions. However, national macroprudential policies need to be coordinated with area-wide policies in order to avoid adverse spillovers to the rest of the EU. At the same time, national macroprudential policies need to be supported by complementary actions by other EU authorities to avoid ‘regulatory’ leakages that would undermine the effectiveness of national action. These leakages stem from limits to the regulatory perimeter, which can stop at the national border, exclude foreign branches or not extend to domestic non-bank financial institutions—the ‘shadow-banking’ system.

The Single Supervisor plus the European Systemic Risk Board provide the EU institutional arrangements to coordinate macroprudential instruments amongst EU national authorities and with the common monetary policy conducted by the ECB. Nonetheless, several participants questioned whether these complex coordination arrangements and untested macroprudential tools would be up to this task. In addition, some wondered these arrangements might in the end operate asymmetrically as was the case with the excessive deficit procedure; in which case, macroprudential measures would be more beneficial for large countries.

Concerns about the limited effectiveness of macroprudential tools caused some participants to stress the importance of national fiscal policy as a tool to help correct national macroeconomic imbalances. However, it was noted that this approach requires a more active use of fiscal policy than envisaged by EU procedures. For example, policy recommendations by the European Commission under the macroeconomic imbalance procedures did not focus on using fiscal policy other than to ensure SGP compliance, but instead relied upon structural measures. More generally, it was mooted that the fiscal stance in the euro area needed to provide more help to monetary policy, which was constrained by the zero lower bound for interest rates, and struggling with deflationary pressures. Others however argued that fiscal space was lacking because the levels of government debt and deficits were too high; this also explained the emphasis on structural measures, which in any case were necessary to lift long-term growth rates.

As macroprudential policies may also be less effective after a financial crisis than before one, some observers emphasized the contributions to be made by banking union—a major structural reform. The recently completed comprehensive assessment—asset quality review plus stress test—was viewed as helping to repair the banks’ balance sheets and to promote confidence in the banking system. In this connection, many commented that it would be important to stop bank deleveraging and encourage prudent lending, especially to small-and medium sized enterprises.

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