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The Lessons of the North Atlantic Crisis for Economic Theory and Policy

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In analyzing the most recent financial crisis, we can benefit somewhat from the misfortune of recent decades. The approximately 100 crises that have occurred during the last 30 years—as liberalization policies became  dominant—have given us a wealth of experience and mountains of data.  If we look over a 150 year period, we have an even richer data set.

With a century and half of clear, detailed information on crisis after crisis, the burning question is not How did this happen? but How did we ignore that long history, and think that we had solved the problems with the business cycle? Believing that we had made big economic fluctuations a thing of the past took a remarkable amount of hubris.

Markets are not stable, efficient, or self-correcting

The big lesson that  this crisis forcibly brought home—one we should have long known—is that economies are not necessarily efficient, stable or self-correcting.

There are two parts to this belated revelation. One is that standard models had focused on exogenous shocks, and yet it's very clear that a very large fraction of the perturbations to our economy are endogenous.  There are not only short‑run endogenous shocks; there are long‑run structural transformations and persistent shocks.  The models that focused on exogenous shocks simply misled us—the majority of the really big shocks come from within the economy.

Secondly, economies are not self-correcting.  It’s clear that we have yet to fully take on aboard this crucial lesson that we should have learned from this crisis: even in its aftermath, the tepid attempts to fix the economies of the United States and Europe have been a failure.  They certainly have not gone far enough.  The result is that we continue to face significant risks of another crisis in the future.

So too, the responses to the crisis have not brought our economies anywhere near back to full employment.  The loss in GDP between our potential and our actual output is in the trillions of dollars.

Of course, some will say that it could have been done worse, and that’s true. Considering that the people in charge of fixing the crisis included some of  the same ones who created it in the first place, it is perhaps  remarkable it hasn’t been a bigger catastrophe.

More than deleveraging, more than a balance sheet crisis: the need for structural transformation

In terms of human resources, capital stock, and natural resources, we’re roughly  at the same levels today that we were before the crisis.  Meanwhile, many countries have not regained their pre-crisis GDP levels, to say nothing of a return to the pre-crisis  growth paths. In a very fundamental sense, the crisis is still not fully resolved—and there's no good economic theory that explains why that should be the case.

Some of this has to do with the issue of the slow pace of deleveraging.  But even as the economy deleverages, there is every reason to believe that it will not return to full employment.  We are not likely to return to the pre-crisis household savings rate of zero—nor would it be a good thing if we did.  Even if manufacturing has a slight recovery, most of the jobs that have been lost in that sector will not be regained.

Some have suggested that, looking at past data, we should resign ourselves to this unfortunate state of affairs.  Economies that have had severe financial crises typically recover slowly.  But the fact that things have often gone badly in the aftermath of  a financial crisis doesn't mean they must go badly.

This is more than just a balance sheet crisis.  There is a deeper cause:  The United States and Europe are going through a  structural transformation.  There is a structural transformation associated with the move from manufacturing to a service sector economy.    Additionally, changing comparative advantages requires massive adjustments in the structure of the North Atlantic countries.

Reforms that are, at best, half-way measures

Markets by themselves do not in general lead to efficient, stable and socially acceptable outcomes.  This means we have to think a little bit more deeply about what kind of economic architectures will lead to growth, real stability, and a good distribution of income.

There is an ongoing debate about  whether we simply need to tweak the existing economic architecture or whether we need to make more fundamental changes.  I have two concerns.  One I hinted at earlier:  the reforms undertaken so far have only tinkered at the edges.  The second is that some of the changes in our economic structure (both before and after the crisis) that were supposed to make the economy perform better may not have done so.

There are some reforms, for instance, that may enable the economy to better withstand small shocks, but actually make it less able to absorb big shocks.  This is true of much of the financial sector integration that may have allowed the economy to absorb some of the smaller shocks, but clearly made the economy less resilient to fatter‑tail shocks.

It should be clear that many of the "improvements" in markets before the crisis actually increased countries' exposure to risk.  Whatever the benefits that might be derived from capital and financial market liberalization (and they are questionable), there have been severe costs in terms of increased risk.  We ought to be rethinking attitudes towards these reforms—and the IMF should be commended for its rethinking in recent years.  One of the objectives of capital account management, in all of its forms, can be to reduce domestic volatility arising from a country's international engagements.

More generally, the crisis has brought home the importance of financial regulation for macroeconomic stability.  But as I assess what has happened since the crisis, I feel disappointed.  With the mergers that have occurred in the aftermath of the crisis, the problem of too-big-to- fail banks has become even worse.  But the problem is not just with too-big-to-fail banks.  There are banks that are too intertwined to fail and banks that are too correlated to fail.  We have done little about any of these issues. There has, of course, been a huge amount of discussion about too- big-to-fail. But being too correlated is a distinct issue.  There is a strong need for a more diversified ecology of financial institutions that would reduce incentives to be excessively correlated and lead to greater stability.  This is a perspective that has not been emphasized nearly enough.

Also, we haven't done enough to increase bank capital requirements.  Missing in much of the discussion is an assessment of the costs vs. benefits of higher capital requirements.  We know the benefits—a lower risk of a government bailout and a recurrence of the kinds of events that marked 2007 and 2008.  But on the cost side, we’ve paid too little attention to the  fundamental  insights of the Modigliani‑Miller Theorem, which explains the bogusness of arguments that increasing capital requirements will increase the cost of capital.

Deficiencies in reforms and in modeling

If we had begun our reform efforts with a focus on how to make our economy more efficient and more stable, there are other questions we would have naturally asked; other questions we would have posed.    Interestingly, there is some correspondence between these deficiencies in our reform efforts and the deficiencies in the models that we as economists often use in macroeconomics.

The importance of credit

We would, for instance, have asked what the fundamental roles of the financial sector are, and how we can get it to perform those roles better.  Clearly, one of the key roles is the allocation of capital and the provision of credit, especially to small and medium-sized enterprises, a function which it did not perform well before the crisis, and which arguably it is still not fulfilling well.

This might seem obvious. But a focus on the provision of credit has neither been at the center of policy discourse nor of the standard macro-models.  We have to shift our focus from money to credit.  In any balance sheet, the two sides are usually going to be very highly correlated.  But that is not always the case, particularly in the context of large economic perturbations.  In these, we ought to be focusing on credit.  I find it remarkable the extent to which there has been an inadequate examination in standard macro models of the nature of the credit mechanism. There is, of course, a large microeconomic literature on banking and credit, but for the most part, the insights of this literature has not been taken on board in standard macro-models.

But failing to manage credit is not the only lacuna in our approach.  There is also a lack of understanding of different kinds of finance.  A major area in the analysis of risk in financial markets is the difference between debt and equity.  And in standard macroeconomics, we have barely given this any attention. My book with Bruce Greenwald, Towards a New Paradigm of Monetary Economics ((Cambridge University Press, 2003) was an attempt to remedy this.


As I have already noted, in the conventional models (and in the conventional wisdom) market economies were stable.  And so it was perhaps not a surprise that fundamental questions about how to design more stable economic systems were seldom asked.  We have already touched on several aspects of this:  how to design economic systems that are less exposed to risk or that generate less volatility on their own.

One of the necessary reforms, but one not emphasized enough, is the need for more automatic stabilizers and fewer automatic destabilizers—not only in the financial sector, but throughout the economy. For instance, the movement from defined benefit to defined contribution systems may have led to a less stable economy.

Elsewhere, I have explained how risk sharing arrangements (especially if poorly designed) can actually lead to more systemic risk:  the pre-crisis conventional wisdom that diversification essentially eliminates risk is just wrong.  I’ve explored this is some detail in this article, along with this paper and this one.


Distribution matters as well—distribution among individuals, between households and firms, among households, and among firms.  Traditionally, macroeconomics focused on certain aggregates, such as the average ratio of leverage to GDP.  But that and other average numbers often don't give a picture of the vulnerability of the economy.

In the case of the financial crisis, such numbers didn’t give us warning signs. Yet it was the fact that a large number of people at the bottom couldn't make their debt payments that should have tipped us off that something was wrong.

Across the board, our models need to incorporate a greater understanding of heterogeneity and its implications for economic stability.

Policy Frameworks

Flawed models not only lead to flawed policies, but also to flawed policy frameworks.

Should monetary policy focus just on short term interest rates? 

In monetary policy, there is a tendency to think that the central bank should only intervene in the setting of the short-term interest rate.  They believe "one intervention" is better than many.  Since at least 80 years ago with the work of Ramsey  we know that focusing on a single instrument is not generally the best approach.

The advocates of the "single intervention" approach argue that it is best, because it least distorts the economy.  Of course, the reason we have monetary policy in the first place—the reason why government acts to intervene in the economy—is that we don't believe that markets on their own will set the right short-term interest rate.  If we did, we would just let free markets determine that interest rate.  The odd thing is that while just about every central banker would agree we should intervene in the determination of that price, not everyone is so convinced that we should strategically intervene in others, even though we know from the general theory of taxation and the general theory of market intervention that intervening in just one price is not optimal.

Once we shift the focus of our analysis to credit, and explicitly introduce risk into the analysis, we become aware that we need to use multiple instruments.  Indeed, in general, we want to use all the instruments at our disposal.  Monetary economists often draw a division between macro-prudential, micro-prudential, and conventional monetary policy instruments.  In our book Towards a New Paradigm in Monetary Economics, Bruce Greenwald and I argue that this distinction is artificial. The government needs to draw upon all of these instruments, in a coordinated way.  (I'll return to this point shortly.)

Of course, we cannot "correct" every market failure. The very large ones, however—the macroeconomic failures—will always require our intervention.  Bruce Greenwald and I have pointed out that markets are never Pareto efficient if information is imperfect, if there are asymmetries of information, or if risk markets are imperfect.  And since these conditions are always satisfied, markets are never Pareto efficient.  Recent research has highlighted the importance of these and other related constraints for macroeconomics—though again, the insights of this important work have yet to be adequately integrated either into mainstream macroeconomic models or into mainstream policy discussions.

Price versus quantitative interventions

These theoretical insights also help us to understand why the old presumption among some economists that price interventions are preferable to quantity interventions is wrong.  There are many circumstances in which quantity interventions lead to better economic performance.


A policy framework that has become popular in some circles argues that so long as there are as many instruments as there are objectives, the economic system is controllable, and the best way of managing the economy in such circumstances is to have an institution responsible for one target and one instrument.  (In this view, central banks have one instrument—the interest rate—and one objective—inflation.  We have already explained why limiting monetary policy to one instrument is wrong.)

Drawing such a division may have advantages from an agency or bureaucratic perspective, but from the point of view of managing macroeconomic policy—focusing on growth, stability and distribution, in a world of uncertainty—it makes no sense.  There has to be coordination across all the issues and among all the instruments that are at our disposal.  There needs to be close coordination between monetary and fiscal policy.  The natural equilibrium that would arise out of having different people controlling different instruments and focusing on different objectives is, in general, not anywhere near what is optimal in achieving overall societal objectives.  Better coordination—and the use of more instruments—-can, for instance, enhance economic stability.

Take this chance to revolutionize flawed models

It should be clear that we could have done much more to prevent this crisis and to mitigate its effects.   It should be clear too that we can do much more to prevent the next one. Still, through this conference and others like it, we are at least beginning to clearly identify the really big market failures, the big macroeconomic externalities, and the best policy interventions for achieving high growth, greater stability, and a better distribution of income.

To succeed, we must constantly remind ourselves that markets on their own are not going to solve these problems, and neither will a single intervention like short-term interest rates. Those facts have been proven time and again over the last century and a half.

And as daunting as the economic problems we now face are, acknowledging this will allow us to take advantage of the one big opportunity  this period of economic trauma has afforded: namely, the chance to revolutionize our flawed  models, and perhaps even exit from an interminable cycle of crises.