Fiscal Foundations of Price and Financial Stability

On Keeping Your Powder Dry: Fiscal Foundations of Financial and Price Stability*

Maurice Obstfeld

University of California, Berkeley, CEPR, and NBER

June 14, 2013

Abstract

Banking systems have rapidly grown to a point where for many countries bank assets amount to

multiples of GDP. As a consequence, government’s capacity to provide stability-enhancing fiscal

guarantees against systemic crises can no longer be taken for granted. As regulation of dynamic

financial markets will inevitably be imperfect, prudent governments need to adjust other facets of

macroeconomic policy in order to mitigate financial instability. A precautionary approach to

fiscal policy, leading to moderate levels of public debt relative to GDP over the medium term, is

essential for the credibility of government promises to support the financial system, as well as

the broader economy.

*Keynote speech prepared for the annual research conference of the Institute for Monetary and

Economic Studies, Bank of Japan, Tokyo, May 29-30, 2013. I thank the Coleman Fung Risk

Management Research Center at UC Berkeley for financial support and Sandile Hlatshwayo for

excellent research assistance.

1. Introduction

Six years of global financial crisis have forced economists to re-think the standard policy

prescriptions for macroeconomic stability that dominated their thinking during the prior two

decades. At the risk of considerable oversimplification, one could describe the consensus view

of best-policy practice as follows: Monetary policy, if governed by flexible inflation targeting

(perhaps of core inflation), will stabilize prices and output reasonably well in most circumstances.

Fiscal policy should smooth tax rates over the business cycle, avoiding debt buildups that might

threaten government solvency and relying primarily on automatic stabilizers to counter

fluctuations.

Superficially, these guidelines seemed adequate for the benign environment of the “Great

Moderation.” However, they took virtually no account of financial markets. The tacit assumption

was that these would function more or less efficiently, neither impeding the transmission of

monetary policy nor generating disruptive shocks on their own. At the most, mainstream policy

analysis acknowledged that financial markets might occasionally generate disturbances, while

maintaining that these could be offset at low economic cost through conventional policy

instruments, especially monetary policy.

(At the same time, of course, best-practice prudential

policy, as codified in Basel II, took inadequate account of macroeconomic considerations.)

The global financial crisis of 2007-09 and its after-effects, including the ongoing crisis in

the euro zone, have overturned earlier complacent views. Recent history teaches us that

considerations of financial stability must be central to our thinking about the optimal frameworks

For example, the 1992 Maastricht treaty underlying the architecture of the euro built explicit defenses against

monetary and fiscal malpractice, but did not construct complementary defenses against financial instability. A

number of observers, including myself (Obstfeld 2013), have pointed out that this omission is a central factor in the

current euro crisis. Of course, several writers did emphasize the importance of financial factors for monetary policy

before 2007, but their analyses were not taken to heart by the mainstream of the academic economics profession.

Even among contributors to the present conference series, one could cite Goodfriend (2001) and White (2001).

for monetary and especially fiscal policy. This lesson is apparent in the interwar experience of

the Great Depression, but it is also implied by much more recent episodes of economic crisis and

stabilization, both in emerging markets and in industrial countries. The puzzle is to understand

why policymakers in advanced economies, up until 2007 and even beyond, underestimated the

hazards that those experiences revealed. The evidence before them included such episodes as the

developing-country debt crisis of the 1980s, which could easily have wiped out the capital of

United States money center banks, as well as Japan’s post-bubble travails.

Our increasingly complex financial systems seem inherently prone to at least some

instability, even in the face of efforts to regulate them. Because regulation of dynamic markets

will inevitably be imperfect (an implication of Goodhart’s Law), prudent governments need to

adjust other facets of macroeconomic policy to mitigate financial instability and its effects. My

main point today will be that a precautionary approach to fiscal policy, leading to moderate

levels of public debt in relation to GDP, is essential for the credibility of government promises to

support the financial system, as well as the broader economy. Clearly defined rules that limit

fiscal exposure must also inform the endgame of winding down insolvent financial institutions.

Absent adequate fiscal space, financial instability will be worse and may lead to price

instability or sovereign default, which themselves will further impair the functioning of financial

markets, at great cost to the broader economy. Japan’s current push to escape from decades of

slow growth and deflation illustrates how dangerous it can be to tolerate large public debt

buildups. An individual country’s high debt is dangerous not only to itself, but also globally, as

its own instability is likely to infect countries with which it has financial and trade linkages,

along with those countries’ trade partners.

2. Growth and Stability of Banking Systems

Deregulation, globalization, and technological innovation (including financial innovation) have

supported a massive growth in global banking activities since the advent of floating exchange

rates in 1973, and especially over the last two decades. It is by now a commonplace that cross-

border gross assets and liabilities have reached high levels relative to national products – massive

levels for countries that also serve as global financial hubs. Overall assets and liabilities of

banking systems and shadow banking systems have expanded in parallel with international asset

trade. This is no surprise, because a globalized financial market allows even banks headquartered

in small countries to grow very big relative to GDP.

For a selection of OECD members, Figure 1 reports illustrative measures of bank assets

relative to the GDPs of the banks’ headquarter countries. (These data give only a very partial

picture of the growth of financial intermediation, and therefore should be viewed as illustrative.

In particular, the U.S. data take no account of a very large shadow banking system.)

Accompanying the trend of increasing overall size of banking systems has been a trend of

increasing concentration in banking – fewer banks with much larger balance sheets. Even in

some of the larger European countries, there are individual banks with balance sheets

comparable to, or exceeding, home-country GDP. The spectacular growth of banking, coupled

with its increasing concentration and wider scope, has critical implications for all dimensions of

macroeconomic stabilization policy.

Has a constellation of fewer banks with much larger balance sheets led to greater

financial stability? There is some literature on the relationship between bank size and

profitability, but it does not suggest that size promotes higher social returns (once the costs of

various government guarantees are incorporated; see Haldane 2012). Clearly, the changing

banking environment has been associated over time with more crises, initially concentrated in the

emerging markets, but now mostly in the advanced economies, including much of the euro area.

Figure 2, based on the banking crisis chronology of Laeven and Valencia (2012),

illustrates the frequency of ongoing systemic or near-systemic banking crises since 1970. The

figure does not establish causality – it may be that banking crises would have been even more

frequent had banks been smaller, more limited in the scope of their activities, and more

competitive. If that were the case, however, perhaps the low frequency of banking problems in

the postwar period prior to the early 1970s would be the puzzle.

Recent banking crises have inflicted heavy costs on economies. To start, there is the

direct (gross) cost to governments of reorganizing and recapitalizing failed banks, protecting

depositors and other bank creditors, and the like. In the Asian crisis of 1997-98 and earlier crises

in Latin America, such fiscal costs amounted to large fractions of GDP for some emerging

market economies (EMEs), and a few richer countries have spent comparable sums after 2007.

Table 1 reports selected estimates of direct fiscal costs in support of crisis-stricken banking

systems. (Estimates do not include asset guarantees.) These costs have been upward of one-third

of a year’s GDP in some EME episodes, and, more recently, in Ireland (41 percent) and Iceland

(44 percent).

Apart from Iceland, Ireland, and Greece, however, the advanced-economy fiscal costs

mostly reside in the single digits. But direct fiscal costs are only part of the story. Banking crises

generally bring lengthy recessions, implying a great deal of forgone output and substantial

Table 1 Direct Fiscal Outlays in Some Banking Crises (percent of GDP)

Argentina (1980-82)

Belgium (2008-11)

Chile (1981-85)

China (1998)

Germany (2008-11)

Greece (2008-11)

Iceland (2008-11)

Indonesia (1997-2001)

Ireland (2008-11)

Japan (1997-2001)

Korea (1997-98)

Latvia (2008-11)

Mexico (1994-96)

Netherlands (2008-11)

Spain (2008-11)

Thailand (1997-2000)

Turkey (2000-01)

United Kingdom (2007-11)

United States (2007-11)

Source: Laeven and Valencia (2012)

increases in public debt in support of the general economy (Reinhart and Rogoff 2009). Given

political realities, high public debt is likely to constrain the exercise of expansionary fiscal policy

leaving the central bank to bear the burden of stabilization through a low, even zero, policy

interest rate. In turn, protracted expansionary monetary responses may subsidize banks but have

negative economic side effects that emerge only gradually and that are hard to quantify even

after the fact.

3. Fiscal and Monetary Implications of Financial Stabilization

Once one recognizes financial stability as a first-order concern, one necessarily recognizes a rich

set of interactions with fiscal and monetary considerations. These interactions have been very

apparent in earlier EME crises, including in Latin America and Asia, where extreme fiscal costs

of supporting the financial sector (Table 1) have been associated with high inflation and with

crises in sovereign debt and currency markets. Honohan’s (2005) comprehensive discussion of

the links among financial, fiscal, and monetary policy, based mostly on EME experience, now

appears quite relevant to a broader set of economies. Much earlier, Díaz-Alejandro (1985)

offered a remarkably prescient analysis of Chile’s financial collapse of the early 1980s, the

themes of which resonate strongly in subsequent crises including those that began in 2007. We

must now acknowledge a range of financial stability safeguards as integral parts of the overall

macro policy framework. The design and implementation of financial stability policy is much

more than a sideshow to the main attraction of monetary cum fiscal policy.

Countries erect ex ante barriers against domestic financial instability, but also intervene

ex post with monetary and fiscal instruments once a crisis has nonetheless broken out. Market

expectations about ex post responses will influence behavior in financial markets, and thereby

For a recent discussion of potential negative effects of long-term monetary easing, see International Monetary

Fund (2013, chapter 3). More generally, Laeven and Valencia (2012) argue that stabilization policies in advanced

countries tend to delay financial-sector restructuring, lengthening the aftermaths of financial crisis. Japan, to which I

return below, is a case in point.

The Asian crisis provided some especially vivid examples of financial-sector considerations influencing policy

responses, including fiscal and monetary policies implemented under IMF programs. See Fischer (2001).

the financial stability outcomes that trigger ex post interventions through monetary and fiscal

means. Thus, the design of ex ante defenses cannot be separated from the likely policy response

to a crisis. Regulations cannot be so strict as to stifle financial markets in performing legitimate

functions of resource allocation over time and states of nature. Yet, they must take account of the

economic costs – public and private – of a breakdown, as well as the expectations of financial

actors about how the government will act in a crisis.

A key consideration is the dynamic consistency of the promised rules of the game

concerning liquidity support, its limits, and the consequences of a determination by the

authorities that the line between illiquidity and insolvency has been crossed. Will ex post

reactions of authorities coincide with the announced ex ante rules? A particular danger is that of

collective moral hazard, as analyzed by Schneider and Tornell (2004) and Farhi and Tirole

(2012). Unless ex ante constraints on financial actors are strong, the widespread understanding

that the government ultimately will not let the economy collapse may lead to “bad equilibria”

with very adverse and systemic low probability tail outcomes. In short, frenzies of competitive

risk taking can arise, as arguably was the case in recent housing bubble episodes in the United

States and elsewhere. In a memorable passage, Díaz-Alejandro (1985, p. 18) put it this way:

It may be that private financial agents, domestic and foreign, lenders, borrowers and

intermediaries, whether or not related to generals, know that the domestic political and

judicial systems are not compatible with laissez-faire commitments which a misguided

Minister of Finance or Central Bank President may occasionally utter in a moment of

dogmatic exaltation. When a crisis hits, agents will reason, bankruptcy courts will break

down; when almost everyone (who counts) is bankrupt, nobody is!

Such episodes make the macro-prudential perspective essential, because collective exuberance

can inflate profits, capital, and collateral values, masking underlying threats. (In addition, the

For a wide-ranging overview of regulatory issues in light of the global crisis, see Brunnermeier et al. (2009).

government’s budgetary position will also appear deceptively strong, as in Ireland and Spain

before 2008.) Many of the recent financial reform initiatives taken and proposed in the advanced

economies represent attempts to erect credible structures that will both limit financial instability

ex ante while minimizing the monetary and fiscal costs of the interventions that, of necessity,

will still appear necessary at times.

As noted above, prudential restrictions so severe that crises become zero probability

events are unlikely to allow the financial markets efficiently to allocate capital and its risks so as

to promote economic growth. Moreover, regulators will forever play a game of catch-up with

financial innovation and regulatory arbitrage. Thus, while regulation may limit the number of

crises and perhaps even guard against the direst systemic events, certain government guarantees

will remain necessary to reduce the risk of self-fulfilling panics and to support expectations of a

stable overall economic environment on the part of firms and consumers. Such guarantees

include insurance for small retail depositors, as well as official assurances that financial

institutions, banks and even some non-banks, can be supported in the continuous performance of

essential economic functions during times of crisis. Regulation’s role in part is to limit the moral

hazard that these guarantees would otherwise promote; in particular, there is in my view a strong

case for limits on the size and/or interconnectedness of institutions when these become “too big

to fail.”

Post-crisis rules for reorganizing insolvent institutions also can play a role in limiting

moral hazard.

Recent crises demonstrate that the central bank’s classic lender of last resort function

remains an essential component of the ex post policy toolkit (although in the U.S. as well as in

Stein (2013) makes a persuasive case for regulation not only of banks, but also of non-bank financial

intermediaries that could be forced into asset fire sales by creditor runs.

Europe the standards of “acceptable” collateral for central bank liquidity support have been

stretched to new limits). Certain liquidity support operations could also be provided by national

Treasuries if the fiscal situation is sound; Treasuries generally backstop national deposit

insurance schemes. A potential cost of activist central bank liquidity support is a blurring of the

line between monetary and fiscal policies, with potential political consequences for the central

bank’s independence to pursue price stability.

The fiscal implications of liquidity support

become especially stark when the borderline of insolvency approaches (although even this

determination can be subjective, leading to excessive cost to taxpayers and the economy). At this

point, conventional wisdom has it that the problem becomes fiscal in its entirety, and falls at the

door of the ministry of finance.

There is a growing official consensus that when financial institutions become insolvent,

small depositors should be protected but fiscal costs should be borne by bank equity holders, by

junior creditors, and, if necessary, by unsecured senior creditors, in that order. Last to be hit

would be large, uninsured deposits. There is a strong case for debt instruments that automatically

convert into equity in well-specified circumstances. In contrast, unsecured senior creditors and

others were widely bailed out during recent advanced-country crises, as had occurred earlier in

some emerging market episodes, promoting future moral hazard and leading to severe economic

hardship in countries such as Ireland. In a joint statement last year, the Federal Deposit Insurance

Corporation and the Bank of England advocated a resolution doctrine for large cross-border

institutions in which haircuts on uninsured bank creditors play a key role.

Similar ideas underlie

the European Commission’s proposals for a Single Resolution Mechanism in the euro area (as

See Goodfriend (2011) for an insightful discussion. In general, concern for a troubled banking system could deter a

central bank from raising interest rates promptly in the face of an inflation threat.

See: “Resolving Globally Active, Systemically Important, Financial Institutions,”

http://www.fdic.gov/about/srac/2012/gsifi.pdf

well as the inclusion of collective action clauses in euro area sovereign debt issues starting last

January 1).

While a “bail-in” approach limits ex post taxpayer costs while deterring moral hazard, it

also has the potential to increase instability in financial markets as unsecured bond creditors sell

en masse to avoid losses. Thus, central bank lender-of-last-resort support for liquidity problems

and perhaps even Treasury support become even more essential. Of course, the risk-taking

behavior of banks and other financial intermediaries depends on the credibility of the threat that

they can be closed and reorganized: as emphasized by Claessens, Herring and Schoenmaker

(2010), the resolution endgame affects short-run behavior. If creditor bail-in is a component of

that endgame, then its exercise must be credible and not subject to fears of financial contagion.

(Recall the contagion concerns that postponed a Greek sovereign default for so long, as well as

the prolonged efforts by authorities to avoid triggering credit default swaps on Greek debt.) It

falls on supervisors to render ex post creditor haircuts safe (and therefore credible) through ex

ante rules and interventions.

If fiscal resolution practices cannot be structured so as to limit taxpayer exposure and

moral hazard, and if a crisis inflicts significant collateral damage on the economy, leading to

bigger fiscal deficits, the government’s credibility as a guarantor of the financial system can

come into doubt. In a context such as the euro zone, where independent monetary policy is not

available, sovereign debt will go to a discount, adding a negative balance-sheet shock to the

harm already done by non-credible government guarantees, and as economic activity falls further,

the government’s fiscal space – and the price of its sovereign obligations – can plummet. Safe

assets disappear from the financial system. This “doom loop” linking banks and sovereigns is

now well appreciated thanks to the euro crisis.

In a context where the government can (in principle) print money to repay its debts, a

possible outcome, seen in the past in many EMEs, is a resort to inflation to address the joint debt

overhangs of the private and public sectors. These scenarios put us in the realm of the fiscal

theory of the price level, as analyzed by Sims (1997) and Woodford (2001), because they tend to

occur when the political capacity to resolve distributional disputes by nonmonetary means is

lacking. I noted above the conventional view that while the central bank should address the

illiquidity of banks, the fiscal authority must address insolvency. When the fiscal authority itself

is overstretched, however, the central bank may again be brought into play, this time to resolve

budgetary inconsistencies through inflation. If price stability is to be preserved, sound fiscal

management is a prerequisite for financial stability. Furthermore, financial stability is hardly

compatible with highly variable inflation.

Public debt itself does not seem to be a strong predictor of subsequent financial crises,

unlike increases in private credit, which do have considerable predictive ability. Among other

studies, Gourinchas and Obstfeld (2012) reach this conclusion for post-1970 data on a broad

sample of emerging and advanced economies, whereas Jordà, Schularick, and Taylor (2013)

reach the same conclusion using a long historical data sample (1870-2010) for a group of 17

advanced economies. However, it is still possible that countries entering financial crises with

For an insightful model and evidence, see Acharya, Drechsler, and Schnabl (2011).

large initial public debts face deeper and longer lasting contractions, and this is exactly what

Jordà, Schularick, and Taylor (2013) find on the basis of a nonlinear empirical model.

For advanced countries, the historical record also suggests that financial crises lead to

deflation, especially when public debt is initially high. Jordà, Schularick, and Taylor (2013)

conjecture that this is due to resort to fiscal austerity once debt levels become too large. The

pattern certainly would differ were the same exercise performed for EMEs. There, crises and big

public debts have typically ended in “the time-honored route of washing out old financial

mistakes via inflation (which is not allowed to be reflected in interest rates)” (Díaz-Alejandro

1985, p. 17). When the political system is brittle, this is the easiest way of reconciling

competing distributional claims, as argued by Rajan and Tokatlidis (2005). This fate could be in

store currently for some advanced countries, whose politics seem to have become more brittle in

the face of recent crises. In any case, it is clear that the combination of financial crisis and high

public debt has often undermined price stability in the past.

4. Implications

Far from being immune to serious financial instability before 2007, industrial countries also

suffered from systemic financial crises as well as notable near misses. This makes it puzzling

that alongside the conventional arguments against high levels of public debt, the need to

maintain fiscal space in order to guard against systemic financial instability did not receive more

prominence until recently. The most extreme recent problem cases involve small countries with

In general, fiscal contraction is likely to be an especially appropriate response to big credit booms: the policy

dampens demand, but simultaneously enhances the stock of precautionary fiscal resources available in case of a

crash.

banking systems several times bigger than GDP, countries that clearly could not credibly

backstop their financial systems without compromising government solvency or price stability.

But across the industrial world, public debts remained high in the run up to the global crisis as

banks and domestic credit expanded willy-nilly. The fiscal costs of bank support, augmented

with the much greater fiscal costs of crisis-induced recessions, have now led to advanced-country

debt levels that leave little room for further mishaps (see Figure 3, where Japan has a heavy

weight in the advanced country group). In contrast, EMEs (apart from Central and Eastern

Europe) avoided credit booms before the global crisis, maintained fiscal space, recovered quickly,

and recently have enjoyed falling government debt ratios on average. Whether the EMEs’

defenses will prove as effective next time they are tested remains to be seen.

Japan provides a leading example of advanced-country financial instability prior to 2007

– and the global crisis has not helped its plight. Its problems, which once seemed exceptional to

economists, now appear to be more widely shared. According to the IMF, Japan’s gross public

debt stood at 230 percent of GDP in 2011 (its net public debt was 127 percent), and it is forecast

to rise even higher and remain high for the near future. These conditions are the culmination of

many years in which insolvent entities including banks received financial support, low short-

term interest rates encouraged banks to buy government bonds rather than find new business

customers, fiscal policy was ineffective, and deflation expectations became entrenched. Japanese

authorities now propose to promote positive inflation expectations. However, to do so at current

public debt levels, while avoiding financial instability and government financing problems as

nominal interest rates inevitably rise, will require a delicate balancing act. Despite the evident

risks, there is now no alternative to a radical policy shift; further postponement will only lower

the chances of success.

Even justified warnings on the perils of debt do not imply that draconian austerity is

always and everywhere the correct remedy, and certainly not in already depressed economies

with weakened financial systems. The European Union has been trying that approach, with

largely negative results. Once the horse has left the barn, austerity will not get it back.

Empirically, outside of default, growth in GDP has been the prime method of successfully

reducing high public debt ratios, and so growth-promoting structural reforms, as now are

proposed by Japan’s government, are essential. The realities of politics do not allow

governments simultaneously to impose the pain of both austerity and reform. If a choice is

necessary, political capital invested in reform is far more likely to yield a positive payoff.

Success will be more durable if politicians at the same time can build institutional structures that

return public debts to moderate levels over the long term.

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