Monetary and Economic Studies Vol.31 / November 2013

On Keeping Your Powder Dry: Fiscal Foundations of Financial and Price Stability

Maurice Obstfeld

Banking systems have rapidly grown to a point where, for many countries, bank assets amount to multiples of GDP. As a consequence, governments’ capacities to provide stability-enhancing fiscal guarantees against systemic crises can no longer be taken for granted. As regulation of dynamic financial markets will inevitably be imperfect, prudent governments need to adjust other facets of macroeconomic policy to mitigate financial instability. A precautionary approach to fiscal policy, leading to moderate levels of public debt relative to GDP over the medium term, is essential for the credibility of government promises to support the financial system, as well as the broader economy.

Keywords: Fiscal policy; Financial stability; Monetary policy; Financial crisis; Banking crisis; Bank resolution

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2013 Bank of Japan All Rights Reserved.

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