DESPITE the internationalization of financial markets and the growing links between national financial systems, for the most part, economic policy is still conducted at the national level. The creation of global capital markets can therefore make it more difficult for countries to assess, diagnose, and prescribe macroeconomic policies. The platitude that markets will swiftly and brutally punish deviations from prudent policies is well worn but not the full truth. In fact, markets often seem quite capricious from the domestic point of view: sometimes they seem to tolerate imprudent behavior for a remarkable stretch of time, and sometimes they react preemptively; usually, their reactions are governed by a wide array of domestic and international considerations.
The financial aspects of national economic analysis—and IMF health checks of member countries, known as surveillance—therefore need to be more sophisticated in three distinct but related areas.
• Monitoring of the interactions between financial markets and macroeconomic conditions. A sophisticated analysis of high-frequency data from financial markets—that is, parsing the data for signals about market expectations, volatility, risk, default probabilities, arbitrage potential, and the like—can be an important diagnostic tool for macroeconomic advice and policy prescription.
• Analysis of the financial sector itself—that is, its robustness or fragility, whether it will cushion or amplify shocks, and how it is regulated and supervised.
• Assessment of both underlying vulnerabilities in the economy and potential events that could interact with these vulnerabilities to trigger a financial crisis.
The analytics we would want to bring to bear on these issues span a broad range, with no simple “cookbook” guide. But at the conceptual level, there are useful general characterizations: what we refer to as the balance sheet approach and the prevention of financial and capital account crises. These terms recognize that open economies must be viewed as sets of globally interlinked balance sheets that are vulnerable to exposure and counterparty risk.
Policymakers and country authorities should therefore be concerned about the potential for problems to spill over to other sectors, the economy as a whole, and the regional or global economy. This is what former IMF Managing Director Michel Camdessus (1987-2000) was alluding to when, with extraordinary insight, he referred to the Mexican crisis of the mid-1990s as the “first crisis of the 21st century.” That crisis and those that followed in Asia, Latin America, and central and eastern Europe over the ensuing decade have forced us to rethink the relationship between finance and macroeconomics. This article explores the centrality of finance to macroeconomic analysis by focusing on three rather practical cases: the first centered on balance sheet vulnerabilities, the second on the interaction of domestic monetary policy with global financial markets, and the third on a national stabilization program in a highly integrated capital market.