WASHINGTON (MNI) – The following is 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:

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 founded the center a decade ago, we intended it to be a
place where students would learn about not only the technicalities of
modern financial theory and practice but also about the broader economic
context of financial activities. Recent events have made clear that
understanding the role of financial markets and institutions in the
economy, 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 response 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, the
Federal Reserve worked closely with other policymakers, both
domestically and internationally, to help develop the 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 normal 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 area of monetary policy, took aggressive and innovative
actions that helped to stabilize the economy and lay the groundwork for
recovery.

Despite these and other policy successes, the episode as a whole
has not been kind to the reputation of economic 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 approaching the full set of complex linkages 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
policy 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
an overhaul of economics as a discipline, arguing that much of the
research in macroeconomics 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 reworking of the field go too
far. In particular, it seems to me that current critiques 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 research 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
regulatory systems of the United States and other countries. Economic
management involves the operation of 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, my 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 in a complex
enterprise while dealing with myriad uncertainties. Success in any
practical undertaking requires all three components. For example, the
fight to control AIDS requires scientific knowledge about the causes and
mechanisms of the disease (the scientific 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 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.

I dont 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 than willful
human beings, can often be far more precise in their predictions. Also,
the 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 although I dont think the crisis by any
means requires us to rethink economics and finance from the ground up,
it did reveal important 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 implications for the broader
economy.

In the 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 directions for future research
that could ultimately help us achieve greater financial and
macroeconomic stability.

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** Market News International Washington Bureau: 202-371-2121 **

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