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Noted for April 4, 2013

"Reconstructing Macroeconomics" Exchange: Mervyn King, Ben Bernanke, Olivier Blanchard, Axel Weber, Larry Summers

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LSE: What should economists and policymakers learn from the financial crisis? Q&A:

Mervyn King: There were many interesting comments that were made [during the presentations]. There were fascinating views about the future roles of central banks, about which I am sure many of you will have questions. But before I throw it open to [audience] questions, I cannot resist taking Larry [Summers's] challenge that we need to "reconstruct macroeconomics", and getting the views of others around the table. Ben [Bernanke], how would you "reconstruct macroeconomics"?

Ben Bernanke: Well I was thinking about Olivier [Blanchard's] comments. Certainly I agree that bringing financial markets into macroeconomics is obviously critical. I think back at the work I did--that I was involved with academically--and in some ways we had taken steps in that direction. I did work thirty years ago on the role of credit in the Great Depression. We had done work on the financial accelerator, and how financial factors could play a role in exacerbating a downturn, and so on.

But the point that Olivier made was very important: the details really matter. Here is a fundamental question: the decline in wealth associated with the tech bubble bursting [in 2001] and the decline in wealth associated with the decline in house prices as of, say, late 2008 was about the same--maybe even more on the [2001] stock [market] bubble. From a standard macro model or even one elaborated with financial factors, you would not have really thought that the housing bubble would have been more damaging than the stock bubble. Now the reason it was more damaging, of course, as we know now, is that the credit intermediation system, the financial system, the institutions, the markets, were far more vulnerable to declines in house prices and the related effects on mortgages and so on than they were to the decline in stock prices. It was essentially the destruction of the ability of the financial system to intermediate that was the reason the recession was so much deeper in the second than in the first. To understand that, you really have to know the details of how banks and individual institutions are exposed to housing and to mortgages, in ways that the institutions themselves did not fully understand at the time.

I think this goes to something that Axel [Weber] was saying. I don't think that you can completely separate central banking and financial regulation. It's important for central banks as a lender of last resort and to understand the transmission of monetary policy, macroeconomic dynamics, and financial stability, to have that expertise and ability to understand the details of the financial system.

Mervyn King: Olivier [Blanchard], is it just a question of getting the right details in the financial models, or is there something more profound?

Olivier Blanchard: It is good to go second, because while Ben Bernanke was talking…

Mervyn King: You were reconstructing macroeconomics…

Olivier Blanchard: I have the answer. Suppose you are writing two textbooks, one undergrad, one grad. In the undergraduate textbook, it seems to me that when teaching the IS-LM, we have the same interest rate on the IS and the same interest rate on the LM. Basically, the policy rate that the central bank chooses by the LM curve goes into the IS curve when corrected for expected inflation. I think what we have learned is that these [two interest rates] can be incredibly different. So I would have an r and an rb, and have a machine in the middle--the banking system which would, depending on its health, determine the spread. It seems to me that if I want to communicate one message, that message is what I would communicate to undergrads.

At the graduate level, we now have this explosion of DSGE models which put one friction and another into the model. Again, targeting pedagogy, it seems to me that there are two mechanisms which are central. The first is leverage, which starting with Ben [Bernanke's] work and earlier work we have, I think we know how to deal with it. The second is liquidity. And I think there we are much less far along the way. Again, I am hoping that someday we will put it together and have a simple way of thinking about leverage and a simple way of thinking about liquidity. These two things will come into our New Keynesian model, and we will be able to tell a simple story. We are at the stage at which the DSGE models have much too much in them to be fully understood. This is a very engineering-based answer to your question. But that is what I would try to do.

Mervyn King: Thank you. Axel [Weber], with your practical experience more recently, have you changed your views as to how you think about leverage and liquidity?

Axel Weber: No. I think one of the things that really struck me was that, in Davos, I was invited to a group of banks--now Deutsche Bundesbank is frequently mixed up in invitations with Deutsche Bank. I was the only central banker sitting on the panel. It was all banks. It was about securitizations. I asked my people to prepare. I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions. When I was at this meeting--and I really should have been at these meetings earlier--I was talking to the banks, and I said: "It looks to me that since the buyers and the sellers are the same institutions, as a system they have not diversified". That was one of the things that struck me: that the industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them.

What was missing--and I think that is important for the view of what could be learned in economics--is that finance and banking was too-much viewed as a microeconomic issue that could be analyzed by writing a lot of books about the details of microeconomic banking. And there was too little systemic views of banking and what the system as a whole would develop like. The whole view of a systemic crisis was just basically locked out of the discussions and textbooks. I think that that is the one big lesson we have learned: that I now when I am on the board of a bank, I bring to that bank a view, don't let us try to optimize the quarterly results and talk too much about our own idiosyncratic risk, let's look at the system and try to get a better understanding of where the system is going, where the macroeconomy is going. In a way I take a central banker's more systemic view to the institution-specific deliberations. I try to bring back the systemic view. And by and large I think that helps me understand where we should go in terms of how we manage risks and how we look at risks of the bank compared to risks of the system.

Mervyn King: Thank you. Larry [Summers], how are your fellow panelists doing at "reconstructing macroeconomics"?

Larry Summers: You know I was tempted to blast off at Dynamic-Stochastic General-Equilibrium models. That is, actually, my inclination. But on the other hand it occurred to me to ask the question: "What wouldn't be a Dynamic-Stochastic General-Equilibrium model?" That would be a Static-Certain Partial-Equilibrium model. It is hard to see how that represent any kind of an improvement. So I can't be against DSGE on principle.

Having said that, I think that, and maybe I will be proven wrong over time, there is a central question: Should we think of macroeconomics as being about--as it was thought about before Keynes, and came to be thought of again in the 1990s--cyclical fluctuations about a trend determined somewhere else, where the goal if you were successful was to reduce [the fluctuations'] amplitude; or as centrally about tragic accidents where millions of more people were unemployed for millions more person-years at costs of trillions of dollars in ways that were avoidable with more satisfactory economic arrangements.

Unless and until we adopt the second view, I think we are missing what is our principal opportunity to engage in human betterment. And as long as the question is conceptualized as "what friction should we insert into the existing DSGE model and we will have it?", I don't think we will get to the kind of perspective that I am advocating.

Now it is easy to say this, it is easy to say this. It is much harder to provide a constructive vision of just how to do it. But there are a number of schools of work that to date I think have been sufficiently abstract that they have not made easy connection with practical policy problems--schools that involve multiple equilibria, fragile equilibria, and so forth--that have the prospect of capturing the kind of notion that there are these periods in which you have a very bad outcome that you somehow could have avoided without compromising the future in a very serious way. It really is true that a little bit of avoiding what has happened over the past six years is worth a lot of making the amplitude of fluctuations around trend smaller. It seems hard to observe the past six years, which did not in fact achieve that much disinflation, and not think that it should somehow have been possible to avoid that waste.

Mervyn King: That's the perfect point to give you [the audience] the chance to ask the panelists your questions…