WASHINGTON (MNI) – The following is the fourth of five 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:

One response to excessive risk-taking is stronger oversight by
regulators, and the recent legislation and the rules and procedures
being developed by the Federal Reserve and other agencies will subject
systemically critical firms to tougher regulatory requirements and
stricter supervision. The Federal Reserve has also been involved in
international negotiations to raise the capital and liquidity that banks
are required to hold. However, the problem of too-big-to-fail can only
be eliminated when market participants believe authorities’ statements
that they will not intervene to prevent failures. If creditors believe
that the government will not rescue firms when their bets go bad, then
creditors will have more-appropriate incentives to price, monitor, and
limit the risk-taking of the firms to which they lend. The best way to
achieve such credibility is to create institutional arrangements under
which a failure can be allowed to occur without widespread collateral
damage; if failures can take place more safely, the authorities will no
longer have an incentive to try to avoid them. The financial reform
legislation took an important step in this direction by creating a
resolution regime under which large, complex financial firms can be
placed in receivership, but which also gives the government the
flexibility to take the actions needed to safeguard systemic stability.
This new regime should help restore market discipline by putting a
greater burden on creditors and counterparties to monitor the
risk-taking of large financial firms.

The insights of economists proved valuable to policymakers in many
other contexts as well: in the setting and oversight of bank capital
standards, in the decision to provide the market with extensive
information gleaned during the bank stress tests in the spring of 2009,
in the design of the Feds liquidity facilities for nondepository
institutions, in the analysis of the collapse of the securitization
market, and in the measures taken to protect consumers from deceptive or
inappropriate lending, to name a few. Many of the key ideas, like those
of Thornton and Bagehot, were quite old, but some reflected relatively
recent research. For example, recent work on monetary policy helped the
Federal Reserve provide further policy accommodation despite the
constraints imposed by the zero lower bound on interest rates.8

Economics and Economic Research in the Wake of the Crisis

Economic principles and research have been central to understanding
and reacting to the crisis. That said, the crisis and its lead up also
challenged some important economic principles and research agendas. I
will briefly indicate some areas that, I believe, would benefit from
more attention from the economics profession.

(8The Federal Reserve did so by, for example, (1) acting rapidly
when confronted with the zero lower bound, as discussed in David
Reifschneider and John C. Williams (2000), “Three Lessons for Monetary
Policy in a Low-Inflation Era,” Journal of Money, Credit and Banking,
vol. 32 (November), pp. 936-66; (2) providing forward guidance regarding
short-term interest rates, as discussed in Gauti Eggertsson and Michael
Woodford (2003), “The Zero Bound on Interest-Rates and Optimal Monetary
Policy,” Brookings Papers on Economic Activity, vol. 2003 (1), pp.
139-211; and (3) expanding the Federal Reserves balance sheet through
purchases of longer-term securities, as discussed in Ben S. Bernanke,
Vincent R. Reinhart, and Brian P. Sack (2004), “Monetary Policy
Alternatives at the Zero Bound: An Empirical Assessment,” Brookings
Papers on Economic Activity, vol. 2004 (2), pp. 1-78.)

Most fundamentally, and perhaps most challenging for researchers,
the crisis should motivate economists to think further about their
modeling of human behavior. Most economic researchers continue to work
within the classical paradigm that assumes rational, self-interested
behavior and the maximization of expected utility–a framework based
on a formal description of risky situations and a theory of individual
choice that has been very useful through its integration of economics,
statistics, and decision theory.9

An important assumption of that framework is that, in making
decisions under uncertainty, economic agents can assign meaningful
probabilities to alternative outcomes. However, during the worst phase
of the financial crisis, many economic actors — including investors,
employers, and consumers — metaphorically threw up their hands and
admitted that, given the extreme and, in some ways, unprecedented nature
of the crisis, they did not know what they did not know. Or, as Donald
Rumsfeld might have put it, there were too many “unknown unknowns.” The
profound uncertainty associated with the “unknown unknowns” during the
crisis resulted in panicky selling by investors, sharp cuts in payrolls
by employers, and significant increases in households precautionary
saving.

(9 Herein I use the extension of Von Neumann-Morgenstern expected
utility, which focused on objective probabilities over risks, to
situations in which individuals assign subjective probabilities over
risks. For a review of some classic contributions in this area, see
Jacques H. Drze (1974), “Axiomatic Theories of Choice, Cardinal Utility
and Subjective Probability: A Review,” in Jacques H. Drze, ed.,
Allocation under Uncertainty: Equilibrium and Optimality (London:
Macmillan), pp. 3-23. Some authors have used risk to refer to a
situation of objective probabilities and uncertainty to refer to a
situation of subjective probabilities (see, for example, David M. Kreps
(1990), A Course in Microeconomic Theory (Princeton, N.J.: Princeton
University Press)). As highlighted below, others refer to uncertainty as
a situation in which subjective probabilities cannot be assessed. As
this discussion makes clear, it is probably best to focus on the context
in which the terms risk and uncertainty are used.)

The idea that, at certain times, decisionmakers simply cannot
assign meaningful probabilities to alternative outcomes–indeed, cannot
even think of all the possible outcomes–is known as Knightian
uncertainty, after the economist Frank Knight who discussed the idea in
the 1920s. Although economists and psychologists have long recognized
the challenges such ambiguity presents and have analyzed the distinction
between risk aversion and ambiguity aversion, much of this work has been
abstract and relatively little progress has been made in describing and
predicting the behavior of human beings under circumstances in which
their knowledge and experience provide little useful information. 10
Research in this area could aid our understanding of crises and other
extreme situations. I suspect that progress will require careful
empirical research with attention to psychological as well as economic
factors.

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.” 11
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.

(10 The classic reference on ambiguity aversion is due to Daniel
Ellsberg (1961), “Risk, Ambiguity, and the Savage Axioms,” The Quarterly
Journal of Economics, vol. 75 (4), pp. 643-69; for a more recent, and
abstract, theoretical treatment, see Larry G. Epstein (1999), “A
Definition of Uncertainty Aversion,” Review of Economic Studies, vol. 66
(July), pp. 579-608.
11 See Markus K. Brunnermeier (2008), “Bubbles,” in Steven N.
Durlauf and Lawrence E. Blume, eds., The New Palgrave Dictionary of
Economics, 2nd ed. (New York: Palgrave Macmillan).)

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