What Have We Learned from Financial Crisis? --Macroeconomic Policy after the Crisis Lectured by Len-Kuo Hu Monetary Policy A. Should central banks explicitly target activity? B. Should central banks target financial stability? C. Should central banks care about the exchange rate? D. How should central banks deal with the zero bound? E. To whom should central banks provide liquidity?

II. Fiscal Policy A. What are the dangers of high public debt? B. How to deal with the risk of fiscal dominance? C. At what rate should public debt be reduced? D. Can we do better than automatic stabilizers?

III. Macroprudential Instrument A. How to combine macro-prudential policy with micro-prudential regulations? B. What macro-prudential tools do we have, and how do they work? (a) Cyclical capital ratios and dynamic provisioning (b) Loan-to-value and debt-to-income ratios (c) Capital controls C. How to combine monetary and macro-prudential policies

IV. Impact on emerging markets Emerging markets have traditionally struggled to keep inflation under control by tethering their exchange rates to the dollar and borrow in hard currencies at the insistence of foreign creditors. This institutional anchoring helped them attract inflows of foreign capital which often financed large current-account deficits. But their anchors also acted as shackles. They forced the central banks slavishly to follow the Fed’s monetary policy so as to preserve their currency’s standing against the dollar. And they left their economies vulnerable to any interruption in foreign lending and investment.

Whenever foreign capital inflow dried up, emerging markets wrestled with a painful dilemma. To appease foreign investors and defend their currencies, they could raise interest rates to high level; but that would bankrupt many domestic companies. Or they could ease monetary policy and let their currencies drop; but that would also bankrupt any companies with dollar debts. When the Fed raised interest rates to 20% to fight inflation in 1979-81, Latin American governments could no longer afford to service the vast dollar loans. The debt crisis that followed condemned the region to a “lost decade”. Something similar happened to Mexico in 1994. And a broader wave of crises struck emerging markets from July 1997, when the Thai baht broke its peg to the dollar, to January 2002, when Argentina abandoned the peso’s parity with the dollar. These blows rid them of both their shackles and their anchor. Without the external discipline provided by the dollar, they had to build their own institutional defenses against inflation.

This self-control has brought in a number of benefits This self-control has brought in a number of benefits. First, it has allowed emerging market governments to sell bonds denominated in their own currencies. And it enables them to have begun to break the shackles of the procyclicality trap and to pursue countercyclical policies. In addition to this fiscal flexibility, it has won them an unaccustomed degree of monetary freedom. When the Fed tightens monetary policy, they can keep interest rates steady, letting their currency fall against the dollar, without worrying as much about the increased threat of inflation or the heavier weight of dollar debt. But some sources of vulnerability remains. Broader financial conditions, including longer-term interest rates, credit growth and capital flows, are driven by a forceful and synchronized global financial cycle that is beyond the control of local central banks. Policymakers must either submit to them or repel them by erecting capital controls.

The floating currencies could not insulate emerging economies entirely from global financial forces. The credit growth from low interest rate causes great concern among emerging economies especially in China. It stock of outstanding credit as a proportion of its GDP has exceeded 250%. Some bearish investors are counting on it. They have bet heavily against the yuan in the belief that a financial bust in China will oblige its authorities to ease monetary policy and cheapen its currency. It faces an invidious choice between vigorously tightening monetary policy to defend the yuan, or letting the currency fall. But China had four defenses that other economies lacked. Its dollar debts were modest relative to the size of its economy; it still had a large current-account surplus, which brought in a steady stream of dollar earnings; it was sitting on a bigger stockpile of foreign-exchange reserves, and it had retained closer controls on capital outflows.