Unity in diversity: Protecting the common market with divergent macroprudential policies

Aerdt Houben, Jan Kakes 30 July 2013



The credit crisis and ensuing sovereign crisis powerfully illustrate the limitations of traditional macroeconomic policies to contain financial imbalances. Despite debate on the desirability to dampen credit cycles and asset-price fluctuations, countries have long been reluctant to include this in policy objectives.

The conventional view was that macroeconomic stabilisation policies should primarily aim at dampening the economic cycle and maintaining stable prices (see Baldwin and Gros 2013). Indeed, monetary and fiscal policies were remarkably successful in reducing output fluctuations and bringing down inflation from the 1980s until the outbreak of the financial crisis. There was little recognition that stabilisation policy should also directly address macro-financial imbalances, which have become much more important over the past decades.1 But this is changing.

A new type of macroeconomic policy

Specific macroprudential tools are being developed for a new type of macroeconomic policy, alongside monetary and fiscal policies (Goodhart and Perotti 2012). Examples include:

  • Countercyclical capital buffers.
  • Loan-to-value (LTV) restrictions.
  • Adjustments to sectoral risk weights.
  • Extra capital requirements for systemically important institutions.

Such macroprudential policy instruments are particularly relevant for countries that are part of the Eurozone, as monetary policy can no longer be tailored to domestic circumstances and fiscal policy is constrained by institutional barriers such as the Stability and Growth Pact (see Persaud 2013). 

At the same time, however, important factors that drive the financial cycle – like housing markets, mortgages and tax policy – are still predominantly domestic. In these circumstances, these other instruments can mitigate the risks associated with divergences in national financial cycles.

In recent research, we examine the interaction of financial imbalances and macroeconomic policies for the countries that joined the Eurozone at the start in 1999 or – in the case of Greece – soon afterwards.

We find that country-specific imbalances surged once the euro took effect. With economic prospects differing between countries, the uniform monetary policy translated into divergent national monetary conditions, thereby fuelling unsustainable economic developments. Our key message is that, especially in a currency union with heterogeneous financial cycles, macroprudential tools at the country level are needed to address financial imbalances.

Divergent financial cycles in the Eurozone

After the start of the Eurozone, the development of financial imbalances became increasingly related to domestic monetary conditions. This is illustrated by the tight relationship between credit gaps and the domestic monetary policy stance in the right-hand panel of Figure 1. The credit gap is the deviation of the credit-to-GDP ratio from its long-term trend, which is widely considered to reflect the buildup of financial imbalances. The domestic monetary policy stance is measured by the deviation of the actual policy rate – set by the ECB – from the country-specific Taylor rate. Interestingly, the large cross-national differences in monetary stance before the start of the common monetary policy did not decline hereafter and became closely related to credit imbalances.

Figure 1. Country-specific imbalances before and after EMU

Notes: Correlations between monetary stance and credit gaps, sub-period averages by country. Monetary stance is the Taylor interest rate minus the actual policy rate; the credit gap is calculated according to the Basel Committee methodology (trend deviation credit/GDP based HP filter). Significant correlation (99%) level) is indicated by **

Source: Own calculations, based on BIS credit data (Dembiermont et al 2013), OECD statistics and several national sources.

Following the creation of the Eurozone, the monetary-policy stance was most expansionary for those economies that turned out to be most vulnerable in the crisis: Greece, Ireland, Italy, Portugal and Spain (the GIIPS countries). At the same time, monetary policy was closer to neutral for the other Eurozone members, including the two biggest ones – Germany and France. Figure 2 presents the annual development of credit gaps for the Eurozone as a whole and the individual GIIPS economies. In particular Ireland, Spain and Portugal have been at the upper side of the distribution –even above the 10-90% range – for extended periods. These developments suggest that inappropriate interest rates facilitated an economic expansion in the GIIPS countries, financed with rising debt ratios. This expansion was not sustainable, as it was accompanied by growing current account deficits and an erosion of competitiveness. High indebtedness and overvalued asset prices made these countries vulnerable to macroeconomic and financial shocks.

Figure 2. Credit gap: distribution EMU economies

Note: Percentage deviation credit-GDP-ratio from long-term trend; EMU aggregate 10-90 percentile interval and GIIPS countries.

Policy implications: Making a real difference

Would macroprudential policies have been effective to reduce imbalances? This is difficult to prove for a past period in which these instruments were not available, as we do not know how banks would have responded. Nonetheless, Table 1 illustrates the order of magnitude of banks’ capital buffers in the GIIPS countries if macroprudential policies had been implemented in line with the prospective European policy framework.

Given large credit gaps, the countercyclical capital buffer would probably have been accumulated to the maximum level of 2½% (or even more, if the authorities had courageously so decided). In addition, a substantial part of the banking sectors in these countries would have been considered systemic, implying an additional capital buffer of at least one to two percentage points.

Suppose that each GIIPS country would thus have imposed four percentage points extra capital buffers which banks were allowed to draw down during the crisis. This would have protected banks’ balance sheets and alleviated the taxpayers’ burden significantly. Moreover, it would have countered the buildup of these imbalances prior to the crisis.

In the cases of Italy, Portugal and Spain, the buffers would have absorbed most, if not all banking system losses in 2009-2012. In the case of Ireland, buffer requirements for systemically important banks would have had to have been higher to provide the necessary safeguards. Only Greece’s public-debt problems were far too large to shield banks with macroprudential policies.

Table 1. Indication of macroprudential buffers

Note: The size of the buffer is calculated on the basis of total risk-weighted assets in 2008. All figures are in EUR billions.

Source: Consolidated Banking Data (ECB).

In addition, specific macroprudential instruments would have mitigated risks in real estate markets. In Ireland and Spain, Loan-to-Value restrictions may have been effective to dampen the increase in house prices and to ensure adequate buffers at the level of households. In Greece, Italy and Portugal it would have been more effective to bring down government debt at an earlier stage. In all cases, additional capital buffers would have contributed to breaking the negative spiral of deteriorating public finances and risks in the financial sector, thereby also limiting the credit crunch after the cycle turned.

An essential element of macroprudential policy is an effective institutional set-up. All jurisdictions have now established macroprudential authorities, or intend to do so in the near future, as recommended by the International Monetary Fund (IMF) and the European Systemic Risk Board (ESRB).2 National macroprudential authorities are probably in the best position to assess domestic imbalances and related country-specific circumstances. With the right mandates, they also have the incentive to activate macroprudential instruments. At the same time, coordination at the European level is important to avoid undesired cross-border effects and to further discipline national authorities. Various degrees of centralisation are possible (Schoenmaker 2013). According to the draft regulation for the new European Single Supervisory Mechanism, the ECB and national authorities are co-responsible for macroprudential policies relating to banks. In practice, this means that national authorities may generally take the initiative to activate macroprudential instruments. Such measures are binding for the ECB, allowing only upward departures – i.e. higher requirements or more stringent measures – from national proposals. This creates incentives at both the national and European level to build up buffers as vulnerabilities develop and therewith to ensure buffers are actually available when the downturn sets in. This asymmetric set-up counters the inaction bias that has been evident in policymaking in the past and fosters macroprudential requirements above the minimum level set by microprudential regulation.

Concluding remarks

The global financial crisis calls for a re-orientation of stabilisation policies, with a new role for macroprudential policy instruments. This is particularly relevant for the Eurozone, where country-specific imbalances cannot be offset by the uniform monetary policy and hardly by the institutionally constrained fiscal policy.

With limited labour mobility and market flexibility, the move to banking union will add harmonised microprudential requirements for the banking sector. In this context, it is crucial that macroprudential policies are developed and implemented at the domestic level to offset divergences in national financial cycles.

Looking back, appropriate macroprudential policies would have fostered the banking systems’ solvency (with the exception of Greece) throughout the recent crisis years. Ironically, differences in macroprudential policies will thus serve to safeguard the common European internal market. By acknowledging the primarily domestic nature of financial imbalances, these instruments will help protect Europe’s economic and financial integration.

Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.


Baldwin, Richard and Daniel Gros (2013), “Augmented inflation targeting: Le roi est mort, vive le roi”, VoxEU.org, 17 April.

Borio, C (2003), “Towards a macroprudential framework for financial supervision and regulation?”, BIS Working Papers, No. 128.

Crockett, A (2000), “Marrying the micro- and macro-prudential dimensions of financial stability”, speech at the Eleventh International Conference of Banking Supervisors, Basel.

Dembiermont C, M Drehmann and S Muksakunratana (2013), “How much does the private sector really borrow – a new database for credit to the private non-financial sector”, BIS Quarterly Review, March, 65-81.

European Systemic Risk Board (ESRB) (2011), “Recommendation of the European Systemic Risk Board of 22 December 2011on the macro-prudential mandate of national authorities”, Official Journal of the European Union.

Goodhart, Charles AE, and Enrico Perotti (2013), “Preventive macroprudential policy”, VoxEU.org, 29 February.

International Monetary Fund (IMF) (2011), “Macroprudential policy: an organizing framework”, staff paper.

Persaud, A (2013), “Vive la difference”, The Economist, 26 January.

Schoenmaker, D (2013), “An integrated framework for the banking union: don’t forget macro-prudential supervision”, Economic Papers, No. 495, European Commission.

1 Exceptions include Crockett (2000) and Borio (2003).

2 See IMF (2011), ESRB (2011).



Topics:  Global crisis International finance

Tags:  Italy, Spain, Ireland, Greece, Eurozone crisis, Portugal, macroprudential tools, GIIPS

Director Financial Markets, De Nederlandsche Bank; Professor, University of Amsterdam

Senior Economist in the Financial Stability Division, De Nederlandsche Bank


CEPR Policy Research