Implications for Monetary, Fiscal, and Exchange Rate Policies

The crisis also underscores the advantages of policy space. Stronger budget balances and lower debt ratios gave emerging markets more room for countercyclical fiscal policies. Discretionary fiscal stimulus of 2.9% of GDP in the PRC, 2.0% in Russia and 1.5% in Mexico (all averages for 200910) has helped to buffer the effects of falling export demand, an experience that stands in sharp contrast to earlier crises.¹⁷ There has also been room for automatic stabilizers; budget deficits associated mainly with more slowly growing tax revenues amount to some 3% of GDP in 2009 in G20 emerging markets. Again it would not have been possible to allow for this stabilizing impact had fiscal positions not been strong on the eve of the crisis. Finally it has been possible to expand social programs this time to help shelter society's most vulnerable members from the blow of the crisis as a result of the relatively strong stance of fiscal policy going in. All this is a reminder of the value of keeping one's powder dry.

Economists still like to debate the merits of IMF advice to jack up interest rates in 1997–8, but given how the interaction of foreign currency obligations with sharp currency depreciation could cause an outright financial meltdown it is hard to see what else the countries concerned could have done.¹⁸ In 20089, in contrast, lower inflation, greater central bank credibility, and less foreign currency debt facilitated the more active use of monetary policy.

Essentially all G20 emerging markets in Asia and Latin America had room to cut policy rates. The PRC, India, Korea, and Turkey all cut theirs by more than two percentage points in the six months from August 2008. The reduction in policy rates was even more dramatic, if starting from higher levels, in Colombia and Brazil. Some might argue that the different response this time reflected differences in the nature of the crisis or better economic advice. But given how emerging markets with less policy credibility and more foreign debts (Pakistan, Jamaica, much of Eastern Europe) were forced to raise rates, it seems clear that the stronger position entering the crisis is the main explanation for the different response.

This more flexible use of monetary policy has been facilitated by the shift from exchange rate targeting to inflation targeting in Latin America and, to a lesser extent, East Asia. During the period when external demand was strong, countries were in a position to allow their currencies to strengthen to prevent overheating. They could then allow their exchange rates to adjust downward when the crisis struck and external demand slackened.¹⁹ Currency depreciation when the economic backdrop deteriorates is not entirely welcome—it is a symptom of the fact that all is not well—but it helped to maintain export competitiveness at a time when exports were needed most. Brazil, Chile, Colombia, and Mexico all felt benefits from this. Asian countries, as is their wont, were more reluctant to allow their currencies to fluctuate, although there were sharp declines in the Korean won and Indonesian rupiah. The existence of coherent inflation targeting regimes in all these countries allowed exchange rates to adjust without expectations becoming unanchored. In some cases, there was the feeling that fluctuations were excessive, leading the authorities to intervene in the foreign exchange market. This is a reminder that even a well-developed commitment to inflation targeting does not entirely allow for neglect of exchange rate fluctuations.

In the longer run, this episode of heightened currency volatility will undoubtedly encourage more discussion of collective currency pegs, common currency baskets, and regional monetary unions. These topics are hardy perennials, and recent events will do nothing to make them go away—nor bring discussions to an early conclusion. The more immediate policy question is how to modify the conduct of inflation targeting. Recent events suggest that the standard inflation targeting framework, where the monetary policy instrument is adjusted in response to deviations of expected future inflation and the output gap from their respective targets, is seriously incomplete; it has to be augmented by attaching a weight to financial-stability concerns. Monetary policymakers can not treat threats to financial stability with benign neglect or dismiss those threats as the responsibility of the regulators. But the question of how, exactly, to modify the conduct of monetary policy to incorporate those macro-prudential concerns remains unanswered. Until analysis of that question at least has more structure, central bankers will be flying by the seats of their pants.

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