"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Saturday, September 25, 2010

Really good link - Ben Bernanke and failure of economic engineering and management

Ben Bernanke - Failure of economic engineering and economic management - "I would argue that the recent financial crisis was more a failure of economic engineering and economic management than of what 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 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 structures 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 leaders of financial firms, market participants, and government policymakers either did not recognize 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, although 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 recurrence. <..>

        The fact that dependence on unstable short-term funding could lead to runs is hardly news to economists; it has been a central issue in monetary economics since Henry Thornton and Walter Bagehot wrote about the question in the 19th century. Indeed, the recent crisis bore a striking resemblance to the bank runs that figured so prominently in Thornton's and Bagehot's eras; but in this case, the run occurred outside the traditional banking system, in the shadow banking system--consisting of financial institutions other than regulated depository institutions, such as securitization vehicles, money market funds, and investment banks. Prior to the crisis, these institutions had become increasingly dependent on various forms of short-term wholesale funding, as had some globally active commercial banks. Examples of such funding include commercial paper, repurchase agreements (repos), and securities lending. In the years immediately before the crisis, some of these forms of funding grew especially rapidly; for example, repo liabilities of U.S. broker-dealers increased by a 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.<..>

        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 on well-developed economic ideas that have deep historical roots. The problem in this case was not a lack of professional understanding of how runs come about or how central banks and other authorities 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 institutions and markets. <..>

        Another issue that clearly needs more attention is the formation and propagation of asset price bubbles. Scholars did a great deal of work on bubbles after the collapse of the dot-com bubble a decade ago, much of it quite interesting, but the profession seems still quite far from consensus and from being able to provide useful advice to policymakers. Much of the literature at this point addresses how bubbles persist and expand in circumstances where we would generally think they should not, such as when all agents know of the existence of a bubble or when sophisticated arbitrageurs operate in a market. As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles, "We do not have many convincing models that explain when and why bubbles start." I would add that we also don't know very much about how bubbles stop either, and better understanding this process--and its implications for the household, business, and financial sectors--would be very helpful in the design of monetary and regulatory policies. <..>

        Another issue brought to the fore by the crisis is the need to better understand the determinants of liquidity in financial markets. The notion that financial assets can always be sold at prices close to their fundamental values is built into most economic analysis, and before the crisis, the liquidity of major markets was often taken for granted by financial market participants and regulators alike. The crisis showed, however, that risk aversion, imperfect information, and market dynamics can scare away buyers and badly impair price discovery. Market illiquidity also interacted with financial panic in dangerous ways. Notably, a vicious circle sometimes developed in which investor concerns about the solvency of financial firms led to runs: To obtain critically needed liquidity, firms were forced to sell assets quickly, but these "fire sales" drove down asset prices and reinforced investor concerns about the solvency of the firms. Importantly, this dynamic contributed to the profound blurring of the distinction between illiquidity and insolvency during the crisis. Studying liquidity and illiquidity is difficult because it requires going beyond standard models of market clearing to examine the motivations and interactions of buyers and sellers over time. However, with regulators prepared to impose new liquidity requirements on financial institutions and to require changes in the operations of key markets to ensure normal functioning in times of stress, new policy-relevant research in this area would be most welcome. <..>

        That said, understanding the relationship between financial and economic stability in a macroeconomic context is a critical unfinished task for researchers. Earlier work that attempted to incorporate credit and financial intermediation into the study of economic fluctuations and the transmission of monetary policy represents one possible starting point. To give an example that I know particularly well, much of my own research as an academic (with coauthors such as Mark Gertler and Simon Gilchrist) focused on the role of financial factors in propagating and amplifying business cycles. Gertler and Nobuhiro Kiyotaki have further developed that basic framework to look at the macroeconomic effects of financial crises. More generally, I am encouraged to see the large number of recent studies that have incorporated banking and credit creation in standard macroeconomic models, though most of this work is still some distance from capturing the complex interactions of risk-taking, liquidity, and capital in our financial system and the implications of these factors for economic growth and stability. <..>

        In short, the financial crisis did not discredit the usefulness of economic research and analysis by any means; indeed, both older and more recent ideas drawn from economic research have proved invaluable to policymakers attempting to diagnose and respond to the financial crisis. However, the crisis has raised some important questions that are already occupying researchers and should continue to do so. As I have discussed today, more work is needed on the behavior of economic agents in times of profound uncertainty; on asset price bubbles and the determinants of market liquidity; and on the implications of financial factors, including financial instability, for macroeconomics and monetary policy."

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