Monetary Policy, Fiscal Policy, and the Efficiency of Our ...

1 Monetary policy , Fiscal policy , and theEfficiency of Our Financial System: Lessonsfrom the Financial CrisisBenjamin M. FriedmanWilliam Joseph Maier Professor of Political EconomyHarvard UniversityI am enormously grateful to Rich Clarida and Jeff Fuhrer fortheir kind and thoughtful initiative, first in conceiving the idea forthis conference and then in organizing it so successfully; to EricRosengren and the Federal Reserve Bank of Boston for the mar-velous hospitality we have all enjoyed these past two days; to themany fine economists who devoted their valuable time to writingpapers and preparing discussions; to everyone who offered such gen-erous comments at last night s splendid dinner; and to so many ofmy former students, and my colleagues and other friends, simply forbeing here. Barbara and I have fond memories, accumulated overmore than four decades and still warmly treasured, revolving aroundevery person in this room.

2 It has been an extraordinary experienceto be with so many of you, all in the same place and at the sametime. Some of you have come here from the local area, and somefrom very faraway; Ithank you all. These past two days have beenan experience I shall never ever June 1772, in the midst of the worst banking and economiccrisis Scotland had suffered in two generations, David Hume wrotefrom Edinburgh to his closest friend, Adam Smith, who was thenin London. After recounting the industrial bankruptcies, the bankclosures, the widespread unemployment, and the other fallout fromthe banking crisis, Hume asked, Do these Events any-wise affectyour Theory ? Indeed they did. At the time, Smith was workingon what becameThe Wealth of Nations. Published just four yearslater, Smith s great book is replete with lessons he tookawayfrom301302 International Journal of Central BankingJanuary 2012the 1772 banking crisis including a call for far tighter restrictionson banking than anything we would imagine implementing organizers have arranged the program for this conference interms of three subjects: Monetary policy , Fiscal policy , and financialsystem design.

3 In my remarks I will try to draw lessons for each ofthe three from the severe financial crisis and subsequent economicdownturn through which our own economy, along with much of therest of the industrialized world, has recently Monetary PolicyOne highly useful lesson from the crisis is that although we con-ventionally use the label Monetary policy to refer to the macro-economic policy that central banks carry out, the way this policyworks revolves around credit, not money. The movements in finan-cial quantities that were so striking during the crisis involved non-money assets and liabilities, and much of what central banks did,both here and abroad, was intended to restore the functioning ofmarkets for the issuance and trading of non- Monetary retrospect, the economics profession s focus on money meaningvarious subsets of instruments on the liability side of the bankingsystem s balance sheet in contrast to bank assets, and correspond-ingly the deposit assets on the public s balance sheet in contrastto the liabilities that the public issues turns out to have been ahalf-century-long diversion that did not serve our profession implied way forward is clear enough in substance, thoughnot in execution.

4 It is easy enough to say that we should incorpo-rate within our models an important role for inside liabilities andthe markets in which they are issued and traded, and many econo-mists are now doing just that. But in order to do so we must alsoabandon one of the conventional shortcuts that we so often use inmacroeconomic analysis: namely, the representative agent all agents were identical, there would of course be no reason forany one of them to borrow from, or lend to, another. Hence turningour focus toward credit, at the substantive level, also bears immedi-ate methodological implications. The resulting analysis needs to bemore subtle and, regrettably, more complicated than if what mat-tered were simply money. But the crisis has usefully reminded usVol. 8 No. S1 Panel Comments: Friedman303that what mostly matters for macroeconomic outcomes is insteadcredit something we really should have known all second lesson from the crisis revolves around an issue that isexplicit in a few of the papers given at this conference but also, Ithink, implicit in many of the others: market participants simplydo not have the knowledge and understanding required to fulfill thespecifications of the conventional full-rationality assumption underwhich they know, or are nevertheless able to act as if they know,not only the joint distribution of all stochastic influences affectingthe financial markets and the non-financial economy but also thestructural relationships between those stochastic influences and theoutcomes to which they give too, making such a statement is easy enough, but it leads toa variety of difficult methodological implications.

5 Most obviously, webadly need some replacement for the full-rationality assumption as away of disciplining macroeconomic analysis. Simply jettisoning thefull-rationality assumption, without putting anything in its place,would only produce chaos. But it is becoming increasingly clear thatthe discipline provided by the full-rationality assumption is in realitya straightjacket. As we read the efforts of many fine economists toanalyze the recent crisis, or to explore new developments like centralbanks deployment of what we now call unconventional monetarypolicy, it is clear that these efforts are inevitably handcuffed if asan accumulating body of evidence shows to have been the case an important element in what happened was that not only smallinvestors and other individual market participants but even highlypaid professionals working at very large financial institutions did notunderstand the risks that they were facing and to which they wereexposing their own and their institutions balance sheets.

6 Given theapparent centrality of this misunderstanding in what happened bothbefore and during the crisis, any analysis that proceeds on the basisthat everyone understands the joint distribution of the stochasticinfluences and the ensuing relationships is bound to come up as well, I have no specific replacement for the full-rationalityassumption to offer as a superior form of discipline on macroeco-nomic analysis. I am confident that in time one will come along,however, and I am confident too that when it does, thoughtful econ-omists will welcome it in the same way that the rational expecta-tions assumption was initially welcomed forty years ago. There is,304 International Journal of Central BankingJanuary 2012therefore, a fundamental assignment to be undertaken, and I look tothe younger members of the audience present today with optimismin that regard. The benefits to macroeconomics will be the meanwhile, our responsible officials have to go ahead andmake Monetary policy .

7 To paraphrase a recent secretary of defense,one goes to the crisis with the Monetary economics one has. Igive today s central bankers, especially ours in the United States,extremely high marks for their execution of this responsibility in theface of the challenges presented by the recent crisis. I have alwaystaken pride in my peripheral, albeit by now quite longtime, associa-tion with the Federal Reserve System. I do so all the more in light ofthe way our central bank has conducted itself in these extraordinaryand very trying Fiscal PolicyI have no specific lessons to draw about Fiscal policy , but rather apair of observations that, in conjunction, I find highly first observation is that there is today no political constituencyin the United States for paying more in tax. On some thought, thisin itself is quite an extraordinary phenomenon. Not so long ago onewould have been greeted by disbelief to suggest that even if thecountry were to be attacked at home, and go to war in consequence,citizens of the republic would refuse as a matter of principle to payany more in tax to finance that effort.

8 But this nonetheless is thecurrent state of second observation is that there is also no political con-stituency for reduced government spending. There is a differencebetween being opposed to specific government programs that onesimply does not happen to like and wanting to reduce governmentspending in a sense that bears on the macroeconomics of Fiscal political debate on this issue today is increasingly a shoutingmatch between people who seem to find no line item of spendingthat they would be willing to delete and those who are determinedto shrink the role of government to its most essential functions suchas subsidizing NASCAR racing. (This is not a joke; I refer to a recentvote in the House of Representatives.) This impasse is leadingthe country nowhere good. I believe that much of the pessimism onthis front displayed at this conference is, alas, well 8 No. S1 Panel Comments: Friedman3053. Financial System DesignThe third subject that our organizers have posed for us is the designof financial systems, and here I draw two further lessons.

9 The first isthat market self-regulation imposed by creditors, to which many peo-ple such as Alan Greenspan had looked to police the conduct of bothindividuals and institutions, is not sufficient for the complex financialworld in which we live today. There is no lack of explanations forthis failure. One is market participants failure to understand thepertinent risks, to which I have already referred in the context ofmonetary policy . A second is the entire familiar range of principal-agent problems most obviously, in the recent experience, officersof banks not acting in the interests of their shareowners and thusexposing these institutions to risks that the shareowners would nothave assumed on their own. A third is a whole array of governmentpolicies ranging from lender-of-last-resort actions, to housing subsi-dies, to even such basic institutions as limited liability. A fourth iswhat Justice Brandeis, in a phrase he made famous a century agoby using it as a book title, called Other People s Money : the over-whelming majority of the professionals working at banks that hadto be rescued by the government during the crisis did very well forthemselves financially and have little reason, as a personal matter,to regret their actions; it is only their institutions shareholders, andthe taxpayers and other citizens who participate in the economy,who regret what they did.

10 For any of these reasons, and probablyfor all four of them, market self-regulation imposed by lenders is a parallel lesson is that if the voters elect to positions of pub-lic office individuals who do not believe in regulation, and if thoseoffice holders appoint people of like mind to head the major agenciesof the government s regulatory apparatus, then there also will notbe effective regulation by government no matter what the pertinentrules and statutes say. Regulation has to be applied, not just autho-rized. What we saw in the United States in the recent crisis wasa failure not just to have regulation in place although in fact theregulations in place were inadequate but also to enforce what wasactually , then, should we go from here? For this purpose it is use-ful to distinguish between what Bob Solow famously called little306 International Journal of Central BankingJanuary 2012think and big think. At the little-think level, part of what welearned from the latest crisis is that we urgently need enhanced cap-ital requirements on financial institutions of all kinds.