Medium- to Longer- Term Issues

A. Turning Crisis Into Opportunity

Crisis is a time to think ahead about what to do when good times return. While macroeconomic policies must remain supportive until recovery is firm, it is also important to develop exit strategies for unwinding central bank balance sheets and raising interest rates as well as for withdrawing unprecedented fiscal stimulus. Over the medium- to longer-term, it is important not only to take measures to help prevent the occurrence of another crisis by strengthening the system of prudential supervision, but also to build institutions that will help make policies more effective when responding to a negative shock. The overwhelming lesson of the recent crisis experience is that countries must secure adequate monetary and fiscal policy space during good times by maintaining sufficiently high interest rates and by keeping public debt to GDP ratios sufficiently low.

B. Monetary Policy

Going forward, what type of monetary policy regime should be pursued by Asia's central banks? Experience in Asia suggests that inflation targeting is not the only way to achieve price stability (Filardo and Genberg 2009). Much less consensus exists on the extent to which central banks should take account of asset prices in the conduct of monetary policy. It would probably be a mistake to target a particular level of asset prices. In the context of inflation targeting, central banks simply cannot stabilize two prices (the consumer and asset prices) with a single instrument; even if it were possible, it would not be prudent to adjust policy interest rates in response to frequent changes in asset prices. It should be possible, however, to pursue mediumterm price stability while taking some account of a sustained one-way movement in asset prices.

C. Fiscal Policy

As to fiscal policy, debt-financed spending could increase the cost of borrowing for an emerging market economy and hence reduce investment and growth over the medium-term. Although the long-term impact is theoretically ambiguous, standard models suggest that higher debt has negative effect on investment and growth. Fiscal policy therefore is not a permanent solution. Increasing government purchases may raise GDP in the short run; but a short-term fiscal stimulus could not jump start an economy adversely affected by other factors, nor could it cause a sustained recovery (Taylor 2009). To stimulate domestic demand, rebalancing toward private demand is eventually necessary, but the political economy of fiscal policy may make exit difficult by turning what is intended as a short-term measure into a permanent one. Institution building is the key. Countries should consider putting into place good automatic stabilizers, fiscal rules to minimize the procyclicality of fiscal policy, and ensure long-term fiscal sustainability procurement procedures for public works that minimize the scope for corruption among other things.

D. Regional Cooperation

Regional cooperation must be part of the longer-term solution. Agreeing on a region-wide free trade agreement would help reduce Asia's vulnerability to adverse demand shocks from outside the region by creating a larger Asian market for final goods. A closer framework of macroeconomic coordination would make the use of countercyclical fiscal policy more effective when an extraordinary event calls for fiscal activism again (Kawai and Zhai 2009). In view of the helpfulness of the US Federal Reserve Board swap arrangements in stabilizing the markets for shortterm dollar liquidity, there is no reason why the region cannot pool part of its enormous foreign exchange reserves to provide liquidity to each other; this would also allow the region's economies to terminate the unproductive policy of reserve accumulation. Such a framework would also allow the region's economies to cooperate more on exchange rate policy. The type of beggar-thy-neighbor response seen in some countries during the recent crisis would then be a thing of the past, with greater exchange rate cooperation spreading the burden of adjustment more evenly across the region.

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