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Caruana Says Regulation Can’t Replace Monetary, Fiscal Policy

Bank of International Settlements General Manager Jaime Caruana said that tougher macro-prudential regulation cannot replace sound monetary and fiscal policies in protecting economic stability.

“Macro-prudential policy should not be considered a tool for the management of aggregate demand,” Caruana said in a speech delivered today in Kerala, India. “At a minimum, both fiscal and monetary policies need to play a more active role” in protecting stability “than they have in the past,” he said, according to the text.

The remarks reflect concern that governments around the world may be relying too heavily on regulation to prevent future financial crises, rather than tackling budget deficits and raising borrowing costs to counter threats of asset bubbles. Europe’s sovereign debt crisis shows how managing national budgets is vital to preserving financial stability, he said.

“The plight of the euro area is a telling example of how sovereign solvency is a prerequisite for financial stability,” Caruana said. “For fiscal policy, we need to apply the same principles that apply to a macro-prudential framework: namely, build up buffers in good times so that they can be drawn down in bad times. This means running prudent budget surpluses in good times,” he said.

Central banks at the same time need to broaden their perspectives beyond targeting inflation to consider longer-term financial developments including possible asset bubbles, he said.

Financial Imbalances

The crisis “reminded us that financial imbalances can build up even without inflation,” Caruana said. “Monetary policy makers will also need to keep an eye on longer-term trends if they are to take into account the gradual build-up and unwinding of financial imbalances and their economic and inflationary effects.”

As for macro-prudential regulation itself, authorities should aim to increase the resilience of the financial system and tackle bubbles as they develop, he said.

“A narrow aim would be to increase the resilience of the financial system,” he said. “A broader, more ambitious one would seek to constrain the upswing of the financial cycle itself. To achieve the narrow aim, all we need to do is to build up buffers during the boom so that they can be used as risk materialize during the bust,” he said.

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