by BS Bernanke · 2010 — On the Implications of the Financial Crisis for Economics. Remarks by. Ben S. Bernanke. Chairman. Board of Governors of the Federal Reserve
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For release on delivery 4:30 p.m. EDT September 24, 2010 On the Implications of the Financial Crisis for Economics Remarks by Ben S. Bernanke Chairman Board of Governors of the Federal Reserve System at the Conference co -sponsored by the Bendheim Center for Finance and the Center for Economic Policy Studies Princeton , New Jersey September 24, 2010
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Thank you for giving me this opportunity to return to Princeton. It is good to be able to catch up with old friends and colleagues and to see both the changes and the continuities on campus. I am particularly pleased to see that the Bendheim Center for Finance is thriving. When my colleagues and I found ed the c enter a decade ago, we intended it to be a place where students would learn about not only the technicalities of modern financ ial theory and practice but also about the broad er economic context of financial activities. Recent events have made clear that understanding the role of financial markets and institutions in the eco nomy, and of the effects of economic developments on finance, is more important than ever. The financial crisis that began more than three years ago has indeed proved to be among the most difficult challenges for economic policymakers since the Great Depression. The policy re sponse to this challenge has included important successes , most notably the concerted international effort to stabilize the global financial system after the crisis reached its worst point in the fall of 2008. For its part, t he Federal Reserve worked closely with other policymakers, both domestic ally and international ly, to help develop t he collective response to the crisis, and it played a key role in that response by providing backstop liquidity to a range of financial institutions as needed to stem the panic. The Fed also developed special lending facilities that helped to restore norm al functioning to critical financial markets , including the commercial paper market and the market for asset -backed securities ; led the bank stress tests in the spring of 2009 that significantly improved confidence in the U.S. banking system ; and , in the a rea of monetary policy, took aggressive and innovative actions that helped to stabilize the economy and lay the groundwork for recovery .
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-2- Despite these and other policy successes, the episode as a whole has not been kind to the reputation of economi c and economists , and understandably so . Almost universally , economists failed to predict the nature, timing, or severity of the crisis ; and those few who issued early warnings generally identified only isolated weaknesses in the system, not anything approachin g the full set of complex linkag es and mechanisms that amplified the initial shocks and ultimately resulted in a devastating global crisis and recession. Moreover, although financial markets are for the most part functioning normally now, a concerted poli cy effort has so far not produced an economic recovery of sufficient vigor to significantly reduce the high level of unemployment. As a result of these developments , some observers have suggested the need for a n overhaul of economic s as a discipline , arguing that much of the research in macro economics and finance in recent decades has been of little value or even counterproductive . Although economists have much to learn from this crisis, as I will discuss, I think that calls for a radical re working of the field go too far. In particular, it seems to me that current critique s of economics sometimes conflate three overlapping yet separate enterprises, which , for the purposes of my remarks today, I will call economic science, economic engineering, and economic management. Economic science concerns itself primarily with theoretical and empirical generalizations about the behavior of individuals, institutions, markets, and national economies . Most academic re search falls in this category . Economic engineering is about the design and analysis of frameworks for achieving specific economic objectives . Examples of such frameworks are the risk -management systems of financial institutions and the financial regulat ory system s of the United States and other countries . Economic management involves the operation of
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-3- economic frameworks in real time –for example, in the private sector, the management of complex financial institutions or, in the public sector, the day -to-day supervision of those institutions . As you may have already guessed, m y terminology is intended to invoke a loose analogy with science and engineering . Underpinning any practical scientific or engineering endeavor, such as a moon shot , a heart transplant , or the construction of a skyscraper are : first, fundamental scientific knowledge ; second, principles of design and engineering , derived from experience and the application of fundamental knowledge ; and third, the management of the particular endeavor, often including the coordination of the efforts of many people i n a complex enterprise while dealing with myriad uncertainties. Success in any practical undertaking requires all three components. For example, the fight to control AID S requires scientific knowledge about the causes and mechanisms of the disease (the scien tific component ), the development of medical technologies and public health strategies (the engineering applications ), and the implementation of those technologies and strategies in specific communities and for individual patients (the management aspect ). Twenty years ago, AIDS mortality rates mostly reflected gaps in scientific understanding and in the design of drugs and treatment technologies; today, the problem is more likely to be a lack of funding or trained personnel to carry out programs or to apply treatments. With that taxonomy in hand, I would argue that the recent financial crisis was more a failure of economic engineering and economic management than of wha t I have called economic science. The economic engineering problems were reflected in a number of structural weaknesses in our financial system . In the private sector, these
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-4- weaknesses included inadequate risk -measurement and risk -management systems at many financial firms as well as shortcomings in some firms™ business models , such as overreliance on unstable short -term funding and excessive leverage . In the public sector , gaps and blind spots in the financial regulatory structure s of the United States and most other countries proved particularly damaging. These regulatory structures were designed for earlier eras and did not adequately adapt to rapid change and innovation in the financial sector , such as the increasing financial intermediation taking place outside of regulated depository institutions through the so -called shadow banking system . In the realm of economic management, the leader s of financial firms, market participants, and government policymakers either did not reco gnize important structural problems and emerging risks or, when they identified them, did not respond sufficiently quickly or forcefully to address them . Shortcomings of what I have called economic science, in contrast, were for the most part less central to the crisis; indeed, a lthough the great majority of economists did not foresee the near -collapse of the financial system , economic analysis has proven and will continue to prove critical in understanding the crisis, in developing policies to contain it, and in designing longer -term solutions to prevent its recurren ce. I don™t want to push this analogy too far. Economics as a discipline differs in important ways from science and engineering ; the latter, dealing as they do with inanimate objects rather th an willful human beings, can often be far more precise in their predictions. Also, t he distinction between economic science and economic engineering can be less sharp than my analogy may suggest , as much economic research has direct policy implications. And alt hough I don™t think the crisis by any means requires us to
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-5- rethink economics and finance from the ground up, it did reveal importan t shortcomings in our understanding of certain aspects of the interaction of financial markets, institutions, and the economy as a whole , as I will discuss . Certainly, the crisis should lead –indeed, it is already leading –to a greater focus on research related to financial instability and its implica tions for the broader economy. In t he remainder of my remarks, I will focus on the implications of the crisis for what I have been calling economic science , that is, basic economic research and analysis . I will first provide a few examples of how economic principles and economic research , rather than having misled us, have significantly enhanced our understanding of the crisis and are informing the regulatory response. However, the crisis did reveal some gaps in economists™ knowledge that should be remedied. I will discuss some of these gaps and suggest possible direction s for future research that could ultimately help us achieve greater financial and macro economic stability . How Economics Helped Us Understand and Respond to the Crisis The financial crisis represented an enormously complex set of interactions –indeed, a discussion of the triggers that touched off the crisis and the vulnerabilities in the financial system and in financial regulation that allowed the crisis to have such devastating effects could more than fill my time this afternoon .1 1 For a more comprehensive discussion of vulnerabilities and triggers during the financial crisis , see Ben S. Bernanke (2010), ﬁCauses of the Recent Financial and Economic Crisi s,ﬂ testimony before the Financial Crisis Inquiry Commission, September 2, www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm. The complexity of o ur financial system , and the resulting difficulty of predicting how developments in one financial market or institution may affect the system as a whole , present ed formidable challenges. But, at least in retrospect, economic principles and research were quite useful
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-7- factor of 2-1/2 in the four years before the crisis , and a good deal of this expansion reportedly funded holdings of relatively less liquid securities. In the historically familiar bank run during the era before deposit insurance , retail depositors who heard rumors about the health of their bank –whether true or untrue –would line up to with draw their funds. If the run continued, then, absent intervention by the central bank or some other provider of liquidity, the bank would run out of the cash necessary to pay off depositors and then fail as a result . Often, the panic would spread as othe r banks with similar characteristics to, or having a financial relationship with, the one that had failed came under suspicion. In the recent crisis, money market mutual funds and their investors, as well as other providers of short -term funding , were the economic equivalent of early -1930s retail depositors. Shadow banks relied on these providers to fund longer -term credit instruments, including securities backed by subprime mortgages. After house prices began to decline, concerns began to build about the quality of subprime mortgage loans and, consequently, about the quality of the securities into which these and other forms of credit had been packaged. Although many shadow banks had limited exposure to subprime loans and other questionable cre dits, the complexity of the securities involved and the opaqueness of many of the financial arrangements made it difficult for investors to distinguish relative risks. In an environment of heightened uncertainty, many investors concluded that simply withd rawing funds was the easier and more prudent alternative. In turn, financial institutions, knowing the risk s posed by a run, began to hoard cash, which dried up liquidity and significantly limit ed their willingness to extend new credit .3 3 See Gary B. Gorton (2008), ﬁThe Panic of 2007,ﬂ paper presented at ﬁMaintaining Stability in a Changing Financial System,ﬂ a symposium sponsored by the Federal Reserve Bank of Kansas City, held in Jackson
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-8- Because the runs on the shadow banking system occurred in a historically unfamiliar context, outside the commercial banking system, both the private sector and the regulators insufficiently anticipated the risk that such runs might occur . However, once the threat bec ame apparent , two centuries of economic thinking on runs and panics were available to inform the diagnosis and the policy response . In particular, in the recent episode, central banks around the world followed the dict um set forth by Bagehot in 1873 : To avert or contain panics, central banks should lend freely to solvent institutions, against good collateral. 4 Hole, Wyo., August 21 -23; the paper is available at www.kan sascityfed.org/publications/research/escp/escp -2008.cfm . A lso s ee Markus K. Brunnermeier (2009), ﬁDeciphering the Liquidity and Credit Crunch 2007 -2008,ﬂ Journal of Economic Perspectives , vol. 23 (Winter), pp. 77 -100. The Federal Reserve indeed acted quickly to provide liquidity to the banking system , for example, by easing lending terms at the discount wind ow and establishing regular auctions in which banks could bid for term central bank credit . Invoking emergency powers not used since the 1930s, the Fed eral Rese rve also found ways to provide liquidity to critical parts of the shadow banking system, includ ing securities dealers, the commercial paper market, money market mutual funds, and the asset -backed securities market. For today™s purposes, my point is not to review this history but instead to point out that, in its policy response, the Fed was relying 4 Bagehot also suggested that ﬁthese loans should only be made at a very high rate of interestﬂ ( Lombard Street, p. 99 ; see note 2 ). Some modern commentators have rationalized Bagehot™s dictum to lend at a high or ﬁpenaltyﬂ rate as a way to mitigate moral hazard –that is, to help maintain in centives for private -sector banks to provide for adequate liqu idity in advance of any crisis. However, the risk of moral hazard did not appear to be Bagehot™s principal motivation for recommending a high rate; rather, he saw it as a tool to dissuade unnec essary borrowing and thus help protect the Bank of England™s own finite store of liquid assets. See Bernanke, ﬁLiquidity Provision,ﬂ in note 2 for further documentation. Today, potential limitations on the central bank™s lending capacity are not nearly s o pressing an issue as in Bagehot™s time, when the central bank™s ability to provide liqui dity was far more tenuous. Generally, the Federal Reserve lent at rates above the ﬁnormalﬂ rate for the market but lower than the rate prevailing in distressed and illiquid markets. This strategy provided needed liquidity while encouraging borrowers to return to private markets when conditions normalized.
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-9- on well -developed economic ideas that have deep historical roots .5Economic research and analysis have proved useful in understanding many other aspects of the crisis as well . For example, o ne of the most important developments in economic s over recent decades has been the flowering of information economics, which studies how incomplete information or differences in information among economic agents affect market outcomes. The problem in this case was not a lack of professional understanding of how runs come about or how central banks and other a uthorities should respond to them . Rather, the problem was the failure of both private – and public -sector actors to recognize the potential for runs in an institutional context quite different than the circumstances that had given rise to such events in the past . These failures in turn were partly the result of a regulatory structure that had not adapted adequately to the rise of shadow banking and that placed insufficient emphasis on the detection of systemic risks, as opposed to risks to individual inst itutions and markets. 6 5 A substantial modern literature has updated and formalized many of the insights of Bagehot and Thornton. A cla ssic example is Douglas W. Diamond and Philip H. Dybvig (1983), ﬁBank Runs, Deposit Insurance, and Liquidityﬂ Journal of Political Economy , vol. 91 (3 ), pp. 401 -19. An important branch of information economics, principal -agent theory, considers the implications of differences in information between the principal s in a relationship (say, the shareholder s of a firm ) and the agents who work for the principal s (say, the firm™s managers ). Because the agent typically has more information than the principal –managers tend to know more about the fi rm™s opportunities and problems than do the shareholders , for example –and because the financial interests of the principal and the agent are not perfectly aligned, much depends 6 George Akerlof, A. Michael Spence, and Joseph Stiglitz shared the 2001 Nobel Prize in Eco nomics for their leadership in the development of information economics.
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-10- on the contract (whether explicit or implicit) between the principal and the agent, and, in particular, on the incentives that the contract provide s the agent. Poorly structured incentives were pervasive in the crisis. For example, compensation practices at financial institutions, which often tied b onuses to short -term results and made insufficient adjustments for risk, contributed to an environment in which both top managers and lower -level employees , such as traders and loan officers, took excessive risks. Serious problems with the structure of in centives also emerged in the application of the so -called originate -to-distribute model to subprime mortgages. To satisfy the strong demand for securitized products, both mortgage lenders and those who packaged the loans for sale to investors were compens ated primarily on the quantity of ﬁproductﬂ they moved through the system. As a result , they paid less attention to credit quality and many loans were made without sufficient documentation or care in underwriting . Conflicts of interest at credit agencies , which were supposed to serve investors but had incentives to help issuers of securities obtain high credit ratings, are another example. Consistent with key aspects of research in information economics, t he public policy responses to these problems hav e focused on improving market participants ™ incentives . For example, t o address problems with compensation practices, the Federal Reserve, in conjunction with other supervisory agencies, has subjected compensation practices of banking institutions to supervisory review. The interagency supervisory guidance supports compensation practices that induce employees to take a longer -term perspective, such as paying part of employees ™ compensation in stock that vests based on sustained strong performance . To ameliorate the problems with the originate -to-
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