Transcript of an Interview with Ricardo Caballero, Ford International Professor of Economics, Massachusetts Institute of Technology, about The Shock of Financial Crises
November 6, 2009
Transcript
Video of the interview  |
MR. CROWE: This year we were pleased to have Professor Ricardo Caballero from MIT deliver the Mundell-Fleming Lecture at the IMF's Annual Research Conference here in Washington, D.C.
Over a 20-year career, Professor Caballero has become a leading authority in the areas of international macroeconomics and finance. During his talk at the IMF, Professor Caballero argued that financial crises of the kinds that engulfed global markets in the last 2 years are the economic equivalent of sudden cardiac arrest. He joins me now to explain the analogy in more detail. Professor Caballero, thank you for taking the time to talk to me today.
MR. CABALLERO: It's a pleasure to be here.
MR. CROWE: It's not hard to know when one is suffering a heart attack. What are the main symptoms of sudden financial arrest?
MR. CABALLERO: Let me go back to sudden cardiac arrest so we can see the analogy. Sudden cardiac arrest is essentially the sudden stop of your heart and the blood stops flowing to your organs, through your system, and death takes place within a few minutes unless you defibrillate the individual within 4 or 5 minutes. The probability of surviving beyond 4 or 5 minutes are very limited.
Sudden financial arrest is essentially the complete collapse in the trust towards and within the financial system and credit therefore stops flowing into the real economy, and unless you intervene very quickly, there is also partial death of the real sector. You can prolong the life of the sector without doing defibrillation with what is called CPR, cardiac pulmonary resuscitation, and that's what you can do with SCA, but it's not the right way of dealing with the crisis. You have to defibrillate the system which is a shock to the system to restart it.
MR. CROWE: Taking the analogy further, you argue that policymakers need better financial defibrillators, policies in place to deal with crises when they occur. What sorts of things do you have in mind?
MR. CABALLERO: Let me say the reason I think you need is that is because something we know from SCA, sudden cardiac arrest, is that you need to intervene very, very quickly in order to be successful. Unless you have the policies in place, you are highly unlikely to intervene in the span of time that you need to contain a panic without major damage to the real sector of the economy. So the type of instruments you need are instruments that can be used very, very quickly once something happens.
We have such a facility, the lender of last resort, and it was used very effectively in this crisis, but sometimes when the panic is sufficiently large and destroys the value of assets and the capital of the banking sector, it's not enough. So the types of policies I have in mind are policies that can insulate somehow the balance sheets of the financial sector to these panics and therefore insulate capital from these panics and therefore reduce the panic itself.
MR. CROWE: One problem that people have identified with these sorts of policies is that if you essentially have policies to help banks if they get into trouble, it only encourages them to go out, take risks and get into trouble more often, what economists refer to as moral hazard. In your talk you minimized these problems. Why do you think moral hazard is overplayed?
MR. CABALLERO: I think moral hazard is a real issue but not in relation to the insurance types of policies which are the financial defibrillators we're talking about, and the reason is the following. One of the main factors behind the boom which, in principle, is when you would want people not to think they have a subsidy; is that people minimize the risks of an extreme event. But since they've minimized the risk of an extreme event, they are also going to minimize the value of having a policy that they will have in the case of something very extreme. So if you believe that people are going to euphoria during the boom, then you must believe as a matter of logical consistency that they undervalue whatever is the value of this insurance.
MR. CROWE: Listening to your talk yesterday I was struck that on a number of occasions your views seemed to depart from the traditional sort of economic rational view of human behavior. For instance, you argued that people face deep uncertainty and they behave in nonrational ways which create herd-like behavior bubbles. Do you think that if we're going to understand phenomena like financial crises, as economists we need to move away more from this traditional rational agent—efficient markets type of viewpoint?
MR. CABALLERO: You said it well. Most of the time I think our paradigm is the right paradigm, but there are moments of deep confusion, and our normal paradigm is not well designed for that. I mentioned the concept of night and uncertainty which is really the fear of the unknown, the truly unknown, and I think it's in the nature of modern financial markets to be very, very complex. We normally don't need to understand the complexity and we're all fine living in that environment, but in the middle of a crisis you need to understand some things which is beyond what you can comprehend and then the natural response of human beings, and leveraged institutions in particular, is to withdraw from the game rather than react in a normal portfolio or smooth way.
MR. CROWE: One body which can never withdraw from the game particularly in a crisis episode is the IMF. How do you think this crisis has changed the way we should think about crises, how we should respond and how we should behave?
MR. CABALLERO: I think the IMF has done a great job. I think the IMF has the kinds of things I'm talking about. You worry about incentives, you worry about preconditions, but you also have extended credit lines, have expanded your credit lines, which is the kind of financial defibrillator you need at the international level. I think this is a good stepping stone into what I think is the next stage for the IMF which is really helping to develop the international dimensions of the kinds of financial defibrillators we were talking about yesterday.
MR. CROWE: Your Mundell-Fleming Lecture will be the lead article in the IMF's new journal, the "IMF Economic Review." What sorts of topics do you think this journal should be tackling going forward?
MR. CABALLERO: I really hope this enterprise will succeed and I have expectations that it will succeed. I think it covers an important gap in more academic research I would say. Academic research has specialized too much on non-context-based questions. And to me if this journal works perfectly it should be a journal about real world problems analyzed from an academic perspective.
MR. CROWE: Professor Caballero, thank you very much for joining us.
MR. CABALLERO: It's a pleasure.
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