#1: Humility is in order.
The Great Moderation [the economically tranquil period from 1987 to 2007] convinced too many of us that the large-economy crisis - a financial crisis, a banking crisis - was a thing of the past. It wasn’t going to happen again, except maybe in emerging markets. History was marching on.
My generation, which was born after World War II, lived with the notion that the world was getting to be a better and better place. We knew how to do things better, not only in economics but in other fields as well. What we have learned is that¹s not true. History repeats itself. We should have known.
#2: The financial system matters — a lot.
It’s not the first time that we¹re confronted with [former U.S. Defense Secretary Donald] Rumsfeld called “unknown unknowns,” things that happened that we hadn’t thought about. There is another example in macro-economics:
The oil shocks of the 1970s during which we were students and we hadn’t thought about it. It took a few years, more than a few years, for economists to understand what was going on. After a few years, we concluded that we could think of the oil shock as yet another macroeconomic shock. We did not need to understand the plumbing. We didn’t need to understand the details of the oil market. When there’s an increase in the price of energy or materials, we can just integrate it into our macro models - the implications of energy prices on inflation and so on.
This is different. What we have learned about the financial system is that the problem is in the plumbing and that we have to understand the plumbing. Before I came to the Fund, I thought of the financial system as a set of arbitrage equations. Basically the Federal Reserve would chose one interest rate, and then the expectations hypothesis would give all the rates everywhere else with premia which might vary, but not very much. It was really easy. I thought of people on Wall Street as basically doing this for me so I didn¹t have to think about it.
What we have learned is that that’s not the case. In the financial system, a myriad of distortions or small shocks build on each other. When there are enough small shocks, enough distortions, things can go very bad. This has fundamental implications for macro-economics. We do macro on the assumption that we can look at aggregates in some way and then just have them interact in simple models. I still think that¹s the way to go, but this shows the limits of that approach. When it comes to the financial system, it¹s very clear that the details of the plumbing matter.
#3 Interconnectedness matters.
This crisis started in the U.S. and across the ocean in a matter of days and weeks. Each crisis, even in small islands, potentially has effects on the rest of the world. The complexity of the cross border claims by creditors and by debtors clearly is something that many of us had not fully realized: the cross border movements triggered by the risk-on/risk-off movements, which countries are safe havens, and when and why? Understanding this has become absolutely essential. What happens in the part of the world cannot be ignored by the rest of the world. The fact that we all spend so much time thinking about Cyprus in the last few days is an example of that.
It’s also true in trade side. We used to think if one country was doing badly, then exports to that country would do badly and therefore the exporting countries would do badly. In our models, the effect was relatively small. One absolutely striking fact of the crisis is the collapse of trade in 2009. Output went down. Trade collapsed. Countries which felt they were not terribly exposed through trade turned out to be enormously exposed.
#4 We don’t know if macro-prudential tools work.
It’s very clear that the traditional monetary and fiscal tools are just not good enough to deal with the very specific problems in the financial system. This has led to the development of macro-prudential tools, which what may or may not become the third leg of macroeconomic policies.
[Macroprudential tools allow a central bank to restrain lending in specific sectors without raising interest rates for the whole economy, such as increasing the minimum down payment required to get a mortgage, which reduces the loan-to-value ratio.] In principle, they can address specific issues in the financial sector. If there is a problem somewhere you can target the tool at the problem and not use the policy interest rate, which basically is kind of an atomic bomb without any precision.
The big question here is: How reliable are these tools? How much can they be used? The answer — from some experiments before the crisis with loan-to-value ratios and during crisis with variations in cyclical bank capital ratios or loan-to-value ratios or capital controls, such as in Brazil — is this: They work but they don’t work great. People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere.
#5 Central bank independence wasn’t designed for what central banks are now asked to do.
There is two-way interaction between monetary policy and macro prudential tools. When Ben Bernanke does expansionary monetary policy, quantitative easing, and interest rates on many assets are close to zero, there’s a tendency by many players to take risks to increase their rate of return Some of this risk actually we want them to take. Some we don¹t want them to take. That is the interaction of monetary policy on the financial system.
You also have it the other way around. If you use macro prudential tools to, say, slow down the building in the housing sector but you have an effect on aggregate demand, which is going to decrease output.
The question is: How do you organize the use of these tools? It makes sense to have them under the same roof. In practice means the central bank. But that poses questions not only about coordination between the two functions, but also about central bank independence.
One of the major achievements of the last 20 years is that most central banks have become independent of elected governments. Independence was given because the mandate and the tools were very clear. The mandate was primarily inflation, which can be observed over time. The tool was some short-term interest rate that could be used by the central bank to try to achieve the inflation target. In this case, you can give some independence to the institution in charge of this because the objective is perfectly well defined, and everybody can basically observe how well the central bank does..
If you think now of central banks as having a much larger set of responsibilities and a much larger set of tools, then the issue of central bank independence becomes much more difficult. Do you actually want to give the central bank the independence to choose loan-to-value ratios without any supervision from the political process. Isn’t this going to lead to a democratic deficit in a way in which the central bank becomes too powerful? I¹m sure there are ways out. Perhaps there could be independence with respect to some dimensions of monetary policy - the traditional ones — and some supervision for the rest or some interaction with a political process.