Bernanke Text: Econ Science Has Many Post-Crisis Assignmts-5

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WASHINGTON (MNI) – The following is the fifth of six sections of
the text of Federal Reserve Chairman Ben Bernanke’s remarks prepared for
the Bendheim Center for Finance and the Center for Economic Policy
Studies at Princeton University Friday afternoon:

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.12 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.

I have been discussing needed research in microeconomics and
financial economics but have not yet touched on macroeconomics. Standard
macroeconomic models, such as the workhorse new-Keynesian model, did not
predict the crisis, nor did they incorporate very easily the effects of
financial instability. Do these failures of standard macroeconomic
models mean that they are irrelevant or at least significantly flawed? I
think the answer is a qualified no. Economic models are useful only in
the context for which they are designed. Most of the time, including
during recessions, serious financial instability is not an issue. The
standard models were designed for these non-crisis periods, and they
have proven quite useful in that context. Notably, they were part of the
intellectual framework that helped deliver low inflation and
macroeconomic stability in most industrial countries during the two
decades that began in the mid-1980s.

(12 Good work has been done in this area; see, for example,
Franklin Allen, Elena Carletti, Jan P. Krahnen, and Marcel Tyrell, eds.
(forthcoming), Liquidity and Crises (New York: Oxford University

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.13

(13 See Mark Gertler and Nobuhiro Kiyotaki (forthcoming), Handbook
of Monetary Economics; the paper is available at

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. 14

It would also be fruitful, I think, if “closed-economy”
macroeconomists would look more carefully at the work of international
economists on financial crises. Drawing on the substantial experience in
emerging market economies, international economists have examined the
origins and economic effects of banking and currency crises in some
detail. They have also devoted considerable research to the
international contagion of financial crises, a related topic that is of
obvious relevance to our recent experience.

Finally, macroeconomic modeling must accommodate the possibility of
unconventional monetary policies, a number of which have been used
during the crisis. Earlier work on this topic relied primarily on the
example of Japan; now, a number of data points can be used. For example,
the experience of the United States and the United Kingdom with
large-scale asset purchases could be explored to improve our
understanding of the effects of such transactions on longer-term yields
and how such effects can be incorporated into modern models of the term
structure of interest rates.15

(14 See, for example, Marvin Goodfriend and Bennett T. McCallum
(2007), “Banking and Interest Rates in Monetary Policy Analysis: A
Quantitative Exploration,” Journal of Monetary Economics, vol. 54 (5),
pp.1480-1507; and Lawrence J. Christiano, Roberto Motto, and Massimo
Rostagno (2009), “Financial Factors in Economic Fluctuations,” paper
presented at “Financial Markets and Monetary Policy,” a conference
sponsored by the Federal Reserve Board and the Journal of Money, Credit
and Banking, held in Washington, June 4-5. For examples of studies that
emphasize bank capital as a constraint on financial intermediation, see
Skander J. Van den Heuvel (2008), “The Welfare Cost of Bank Capital
Requirements,” Journal of Monetary Economics, vol. 55 (March), pp.
298-320; Csaire A. Meh and Kevin Moran (2008), “The Role of Bank
Capital in the Propagation of Shocks,” Bank of Canada Working Paper
2008-36 (Ottawa, Ontario, Canada: Bank of Canada, October); and Mark
Gertler and Peter Karadi (2009), “A Model of Unconventional Monetary
Policy, manuscript, New York University, June.
15 An example of recent research on this subject is: Joseph Gagnon,
Matthew Raskin, Julie Remache, and Brian Sack (2010), Large-Scale Asset
Purchases by the Federal Reserve: Did They Work? Staff Report no. 441
(New York: Federal Reserve Bank of New York, March), available at See also Gertler
and Karadi (2009), footnote 14.)


I began my remarks by drawing the distinction between the
scientific, engineering, and management aspects of economics. For the
most part, in my view, the financial crisis reflected problems in what I
referred to as economic engineering and economic management. Both
private-sector arrangements (for example, for risk management and
funding) and the financial regulatory framework were flawed in design
and execution, and these weaknesses were the primary reasons that the
financial crisis and its economic effects were so severe.

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