The ‘New Economics’ and Policies
for Financial Stability
Philip Arestis
University of Cambridge
University of the Basque Country
Malcolm Sawyer
University of Leeds
1. Introduction
2. Theoretical Background
3. Economic Policies
4. Summary and Conclusions
1. Introduction
2. Theoretical Background
3. Economic Policies
4. Summary and Conclusions
 The purpose of this contribution is to discuss
economic policies that could potentially replace
the ones that helped to produce the ‘Great
 We emphasize a neglected notion of economic
policy, namely financial stability;
 Clearly, macroeconomic policy formulation is
heavily conditioned by the underlying theoretical
framework that should underpin it;
 We, thus, begin with a brief summary of the
essential elements of such a theoretical
1. Introduction
2. Theoretical Background
3. Economic Policies
4. Summary and Conclusions
Theoretical Background
 The overall focus of macroeconomic analysis
should be: sustainable and equitable economic
development and growth;
 The objective of economic policy should be: full
employment of the labour force;
 Achieving such objective requires the
maintenance of a high levels of aggregate
demand and sufficient productive capacity.
Theoretical Background
 The general background to the theoretical
framework is of a monetary production
economy in which finance and credit play a
significant role;
 It relates to an economy which has degrees of
instability in the sense of being subject to the
ups and downs of the business cycle and
prone to crisis;
 It accounts for distributional effects, which are
always important and highlighted recently in
view of inequality being a root cause of the
‘Great Recession’.
1. Introduction
2. Theoretical Background
3. Economic Policies
4. Summary and Conclusions
Economic Policies
 The objectives of economic policy:
 Full employment of the available labour
 Inflation rate consistent with output growth
rather than an inflation rate target;
 Financial stability;
Economic Policies
 The
instruments of economic policy to
achieve these objectives are:
 Fiscal policy is paramount both in the short
run and in the long-run;
 In the short run, variations in the fiscal stance
can be used in conjunction with automatic
stabilisers to offset fluctuations in economic
Economic Policies
 In the long run, the general fiscal stance
should be set to underpin the desired level of
output and employment;
 Interest rate policy should be set so that the
real rate of interest is as low as possible, but
in line with the trend rate of growth;
 This of course may be constrained by world
levels of interest rates;
Economic Policies
 Evidence suggests that under fiscal and monetary
policy coordination fiscal multipliers are higher than
when no policy coordination prevails (even bigger
than the Keynesian ones);
 Clearly under such policy coordination Central Bank
Independence should be abolished;
 Such coordination is possible so long as the fiscal
and monetary authorities have a common objective,
for example maximization of social welfare;
Economic Policies
 Exchange
rate policy is also important.
Changes in the exchange rate affect the
domestic economy primarily in terms of the
level of demand and inflation;
 Intervention by the central bank in the foreign
exchange market with the specific aim to
stabilise the exchange rate is important in this
Economic Policies
 Industrial and regional policies are required to ensure
that supply constraints are not present;
Public expenditure, particularly investment, can also
be structured to ease supply constraints;
There is often a mismatch between available
productive capacity and the labour force and its
geographical distribution; higher levels of
employment require more productive capacity, and
regional policies;
There is the need to develop policies to tackle
inflation when it reaches high levels;
Such approach involves the development of an
incomes policy to maintain low inflation.
Economic Policies
 Most important, though, the operation of the central
bank should ultimately be directed towards financial
stability and this objective of financial stability should
be placed as the most significant one for the Central
 This requires the development of alternative policy
instruments alongside the downgrading of interest
rate policy and of any notion of inflation targeting;
 Financial stability should entail two types of toolkits,
both under the banner of the policy makers avoiding
rules and employing judgement and thus discretion;
Economic Policies
 The macroprudential toolkit should account
for the failures of the system: low levels of
liquid assets; inadequate levels of capital with
which to absorb losses; too big a financial
sector; too leveraged with high risks to the
taxpayer and the economy;
 Thus, macroprudential financial instruments
should be able to control the size, leverage,
fragility and risk of the financial system;
 Microprudential instruments relate to the
structure and regulation of individual banks;
Economic Policies
 Two relevant proposals have been put forward: the
US President’s proposal, initially known as the
Volcker Rule, which eventually became the DoddFrank Act of 2010; and the Basel III proposal. We
begin with the first;
 The rule contains a number of important constituent
elements; the ones relevant to this contribution are as
 Eliminate proprietary investments (namely to prohibit
banks that take insured deposits from running their
own trading operations) and also ownership of hedge
funds by banks; in the final Act this was modified to
the banks being allowed to hold proprietary
investments of 3 percent of their core capital;
Economic Policies
 Size matters: no financial firm should be allowed to
become ‘too big to fail’;
 End of taxpayer bailouts: the legislation grants
government the power to wind down failing
institutions, not just banks, if they threaten the
financial system; a new ‘orderly liquidation’ authority
is equipped with the power to seize a failing
‘systemically important’ institution;
 Credit rating agencies: this is another important
aspect of the Dodd-Frank Act, which is the
introduction of a new Office of Credit Ratings to
supervise credit rating agencies;
 ‘Shadow banking’ and non-bank financial services
companies are also to be regulated;
Economic Policies
 The ‘Basel III package’ is concerned with bank capital
and liquidity standards.
 It requires banks to hold equity requirements to 7
percent of the risk-weighted assets (RWA); liquidity
standards include a liquidity coverage ratio, which is
a ratio of high quality liquid assets to net cash
outflows over a 30-day horizon;
 The new ruling will be phased in from January 2013
with full implementation planned to be achieved only
by January 2019. This is actually a victory for the
banks, especially the small banks in Germany, in
view of their undercapitalization;
Economic Policies
 A problem is that unlike the US Dodd-Frank Act,
which provided relevant regulations in the case of
banks migrating to the ‘shadow banking’ sector and
to the lightly supervised non-bank financial services
companies, Basle III does not contain such provision;
 A further problem concerns the definition of the
capital ratio, which is defined in relation to riskweighted assets, not total assets;
 An implication of this is that toxic leverage is highly
probable: when the RWA is a small proportion of total
assets, the exposure of the banking sector to risk
would be very high indeed;
Economic Policies
 Clearly, then, Basel III has not managed very
well in correcting the mechanism through
which the main cause of the ‘great recession’
emerged; it should not, then, be surprising if
another similar crisis were to take place;
 All in all, neither the Dodd-Frank Act, which
initially intended to separate banks, nor the
Basel III proposals, have managed to sort out
financial stability;
 It remains unresolved and elusive; and yet it
is of vital importance.
1. Introduction
2. Theoretical Background
3. Economic Policies
4. Summary and Conclusions
Summary and Conclusions
 The alternative perspective advanced here
can be summarised as:
 Use coordinated fiscal and monetary policy in
the short term and in the long term to address
demand issues;
 Employ regional and industrial policies to
create the required capacity;
 Develop incomes policy to maintain low
inflation if necessary;
Summary and Conclusions
 Central
bank intervention in the foreign
exchange market is necessary to control the
exchange rate;
 Central bank role should be financial stability.
 All policies discussed should include ‘green’

Presentation - The Cambridge Trust for New Thinking in Economics