José De Gregorio: Macroeconomics, economists and the crisis
Speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the Annual
Meeting of the Society for the Chilean Economy (SECHI), Antofagasta, 4 September 2009.
I thank Luis Felipe Céspedes, Eduardo Engel, Pablo García and Mariana García for valuable comments.
* * *
This is certainly a great opportunity to speak about a subject that has triggered more than a
few reflections in me recently, and that was probably best said by Queen Elizabeth's famous
question, made when she was visiting the London School of Economics last year: Why did
nobody notice it?
As someone who has dedicated his professional life to academic activities
and policy making, the question is surely unsettling.
The current global financial crisis and recession, whose depth is unprecedented in recent
decades, has cast doubts about the work of macroeconomists, the usefulness of their
theories, and their capacity to anticipate and deal with crises. These are the issues I will
discuss today.
Macroeconomics
Over the past few decades, macroeconomic theory has evolved, on the one hand, as a
discipline whose purpose is solving problems similar to engineering, and, on the other hand,
whose purpose is to explain phenomena embodied in economic reality, similar to science
(Mankiw, 2006). In fact, macroeconomics was created to solve the problems of the Great
Depression. In its beginnings, it was devoted to building large models to evaluate
macroeconomic policies in the tradition of engineering. It is only in recent decades that its
focus has drifted toward its scientific dimension.
In any case, I prefer to think of economics as being closer to medical sciences (Harberger,
1993), as it diagnoses, analyzes evidence and proposes treatments. It is different from
physics because physics does not deliver prescriptions, at least not directly. Hence the
importance of the interaction between science and practice. Economics has an additional
complication, as it is a social science trying to explain human behavior.
The emphasis put on rigor and solid theoretical fundamentals has been a positive
development, because making policy recommendations requires a good and accurate
diagnosis of reality. Like in the past, we could have extensive, complex models, with many
sectoral interrelations, based on statistical estimations and calibrations. But if the models
aren't conceptually well-formulated and are based only on statistical patterns, their
usefulness is limited. This was the great contribution to economics by the rational
expectations revolution and, in the policy field, by the Lucas critique. Only preferences and
technology are invariant to policies, while the resulting behavior of agents is not; therefore,
policies will ideally be evaluated with models that specify both preferences and
technologies.1 Nonetheless, the current crisis has revealed that models are limited to deal
with all complexities of the real world. However, I believe that reduced-form models, with all
the caveats regarding their potential misuse, can still help in the design of policy, particularly
when more rigorous and, especially, more realistic models are not available.2 For this
reason, there is always a tension between rigor, realism and flexibility.
The tendency to base our models on ever more rigorous grounds has also had undesired
effects. The incentives of younger academics - the very ones who are supposed to push the
borders of knowledge, and who must publish or perish - limit their capabilities for innovation.
The required rigor ends up necessarily threatening realism. Nobody expects a model to
explain completely the economic reality, but the problem is that it can overlook elements that
are crucial to understanding and preventing disasters like the one we face today. It may be
more rewarding from an academic standpoint to write an equilibrium model explaining some
particular phenomenon, than trying to formulate a model that formalizes all of the distortions
of said phenomenon. It is harder and less rewarding for an academic to formulate distortions
- of which the real world has plenty - than to use tidy competitive models to explain
important stylized facts with a minimum of new ingredients.
Scientific advances and models help us think about and interpret the world; they provide us a
way to think about specific problems, but their scope is limited. We must avoid the temptation
of thinking that a theoretical simplification is a full description of reality. But we must also
avoid the other extreme, which totally dismisses what theory teaches because "reality is
much more complex". This is true, but it does not imply that all we have learned is just a
theoretical exercise without practical use in reality. Models must be taken realistically,
recognizing that they capture at most a small portion of reality.
As for the future, the current crisis will certainly provide material for many research studies
that will try to figure out what failed and how to avoid making the same mistakes again. Still, I
think it will be difficult to develop simple, manageable models that can make substantive
progress in having a complete description of reality. Some interesting efforts will most likely
be made, but it will not be easy for them to become part of the heart of macroeconomics,
since they will be necessarily complex. Many of the models we currently have available are
not only mathematically sophisticated, but their results are obtained by computer-based
calibrations whose essential mechanisms lack transparency when it comes to revealing how
they arrive at their results. Hence, it is difficult to assess their consistency. We have often
come across complicated models where an apparently innocuous condition ends up being
the determinant of the results.
Complexity also jeopardizes the capacity to move from scientific research to economic policy
proposals. For academic ideas to be useful in economic policy, they must be persuasive.
Perhaps that was the virtue of the IS-LM model that was used for many years in
macroeconomic policy discussions, or of Solow's growth model that to this day remains the
cornerstone of economic growth research. Fortunately, this is not a time where prescriptions
are taken by policy makers without scrutiny - and are later labeled as orthodox - and
therefore, the capacity to intuitively explain a result is essential.
The bulk of theoretical research will continue to proceed in areas where its results have a
good chance of being published, often at the expense of realism. It may not be very
profitable from the academic point of view to incorporate elements of irrational behavior,
confidence crises or other anomalies into general equilibrium models that are used in policy
design. Nor is it easy to include elements of political economy, in particular the influence of
interest groups, which in the US financial system are relevant to understanding the evolution
of regulation and the causes of the crisis.
Emphasis will undoubtedly be placed on the capacity of researchers to explain complex
phenomena, but their studies will be as realistic as the degrees of complexity will allow.
Therefore, it is important to insist: models are only a part of the reality that allows us to
organize our ideas before diagnosing and prescribing. The arguments' logic and a good deal
of judgment are also critical when it comes to making economic policy decisions.
General equilibrium models and finance
There are two categories of models that are commonly used in macroeconomics and that
require some specific references, namely the Real Business Cycle model (RBC) and the
New Keynesian model (NKM). Both share the characteristic of being general equilibrium
intertemporal models with complete markets and rational expectations.3 Under the RBC
model in its more traditional versions, the economy is fully flexible and there is no role for
macroeconomic policies, whereas under the NKM there are sticky prices that result in money
not being neutral, which assigns a role to monetary policy. These provide the conceptual
basis for the formulation of inflation-target regimes.
It is important to place both types of models in their right dimension. The strategy of RBC
models is to try to replicate economic fluctuations in the simplest, least distorted model
possible. It originated in the attempt to use the neoclassical growth model to explain the
business cycle as a result of productivity shocks, which is surely an interesting effort with
theoretical consistency. These are very elegant models, but the difficulty of solving them
analytically results in having to solve them using calibrations. As a result, there are often
doubts regarding the values of the parameters, which in general are unobservable. To the
extent that these models are free of distortions, there is no role for active monetary policies,
since economic fluctuations are socially optimal. Certainly this is an attractive theoretical
proposition, but it is absurd to think that this is how the world works. It will be difficult to
explain the financial collapse with this type of model, because it has no frictions and provides
very limited policy implications.
The New Keynesian model features no realistic frictions in financial markets either, at least to
generate problems as severe as the current ones, so it has nothing to say about the origins
of the crisis.4 These models are widely used in central banks to calibrate the monetary policy
that is consistent with an inflation target.5 In that sense, they are a very useful tool for
establishing well-specified, well-estimated transmission mechanisms, but they are certainly
limited, and it is unrealistic to believe that they can provide a full description of the economy.
Economies are exposed to many shocks that cause deviations - sometimes significant
deviations - from projection scenarios. However, they help to understand alternative courses
of action of monetary policy after the shocks have hit. Actually, the much praised
aggressiveness in interest rate cuts around the world, to unprecedented levels in many
cases, is largely justified by the sharp drop in inflationary pressures. It is likely that, without
the commitment to bringing inflation back up to normal rates, monetary policy actions could
have attained only part of the expansion. This is a practical demonstration of a wrong
criticism on inflation-targeting central banks, which is that they are not concerned with the
level of activity. Drops in activity and downward pressures on costs are the factors that
opened room for monetary policy, avoiding to repeat the mistakes made in the 1930s. This is
why the NKM will remain useful, while a different type of model will have to be found to
address the issue of financial stability, together with extensions that are yet to be formalized.
This brings me to the theory of finance. If there ever was one discipline that should have
anticipated the vulnerabilities that were building up in financial markets, it was finance. Had
the origin of the problem been inflationary, then the problem would have been
macroeconomics, but the origin was financial. The origin of the crisis is closely related to
financial innovation and the creation of instruments that should have diversified risks. Low
interest rates, search for yields and a monetary policy that promised to rescue after severe
falls in asset prices prompted the creation of a housing bubble.6 Enormous efforts were
made to price many extremely complex financial instruments, but even those academic
efforts failed to build valuation models that realistically considered the instruments'
insolvency probabilities. No evidence is necessary to assert that these methods failed
because of an extreme event that struck everything. These failures were exacerbated by
severe liquidity shortages and widespread panic in the markets.7
Broadly speaking, the theory of finance has two branches: asset price theory and corporate
finance theory. It is paradoxical that while asset price theories, and their application to the
real world, are based on the existence of complete markets and full arbitrage (consider, for
example, CAPM), corporate finance theories that explain firms' financial decisions are
essentially dominated by information asymmetries and are plagued by frictions from principal
(owner)-agent (executives) problems. This dichotomy will have to be corrected over time to
ensure that more realistic models of how financial markets work become available, models
which will shed more light on economic policy recommendations.
Crisis prevention
As for the current crisis, one pending issue is whether it could have been anticipated. Once
again the question arises: "Where was the profession, its academics and authorities, such
that it failed to foresee the severity of the problem?" It is tautological to say that crises are
unpredictable, or else they would never occur. History is plagued with crises. Moreover,
crises have become more frequent in recent decades as compared with the Bretton Woods
period, although their severity and duration have not changed significantly (Bordo et al.,
2001).
Important efforts have been made to identify early warning indicators that could anticipate a
crisis (Berg et al., 2004). The recent episode clearly shows that they have not been very
successful, to say the least. In the current crisis it is hard to find clear regularities with
respect to early warning indicators (Rose and Spiegel, 2009). Furthermore, in small, open
economies, these crises can be triggered by external events on which policy makers have no
control.
Crises are very costly, but are also the result of innovation and risk taking, which are
important for progress. Obviously we must try to avoid them, especially their propagation and
amplification, with good economic policies that cushion the impact of a large global crisis, but
certainly they cannot be eliminated altogether. In the extreme, to prevent global financial
crisis, the economy would have to be totally isolated from the world, forbid risk-taking
completely, and close financial markets altogether. Naturally this is not the best way to
progress. Making an analogy with car accidents, the best way to avoid them would be to ban
the existence of cars. However, it seems more reasonable to build safer cars, buckle up and
drive prudently.
Crises will continue to happen, but the proper way to act is to strengthen the financial system
and macroeconomic policies, in order to minimize their consequences and probability of
occurrence.
We must not remain in the notion that a crisis cannot be prevented and thus there is nothing
we can do about it. Going back to the car analogy, the fact that accidents will always happen
does not mean that we must allow driving at any speed and with no regulation. Quite the
contrary, we know that crises are especially severe when they affect the financial system, so
it is reasonable to improve regulatory mechanisms, particularly to allow financial innovation
while keeping vulnerability under control.
Meanwhile, it is necessary to continue devoting efforts to the detection of early alerts,
although, as I have already pointed out, unambiguous indicators are impossible to find. But
there are symptoms of fragility, very common in emerging economies. High and persistent
current-account deficits, misaligned exchange rates, currency mismatches in the financial
and corporate sectors, excessive increases in the prices of assets and credit, all signal a
potential problem, although they do not result necessarily in a crisis.8 Therefore, a look at the
indicators is not enough, it is important to put them together to detect fragilities. This is
precisely what we try to do in our financial stability reports, which allow us to gain an overall
vision of vulnerabilities, although, once again, it does not provide a final verdict. Finally, new
financial realities require new sets of information to examine, or to compile when not
available.9
Crisis management
That this is the worst financial crisis since the Great Depression nobody disputes. Moreover,
the initial shock on the global economy does not differ much from the one that hit in the
1930s. There are many similarities in the initial conditions and effects of the two
(Eichengreen and O'Rourke, 2009; IMF, 2009). Worth noting are the initial fall in
manufacturing output and trade, the collapse of stock prices and credit, and the increase in
bond spreads. In their origins there was also the same rapid expansion in credit and financial
innovation that increased the leverage of financial intermediaries. These remarkable
similarities in the first months of this crisis were alarming.
However, both differ in the subsequent evolution of the global economy.10 Between 1930 and
1932, world activity (measured at PPP) dropped by an average of 4.8%. In particular, the
U.S. experienced an average annual fall of 9.9%. The current situation is very different, and
while the pace of the recovery is yet to be seen, forecasts for the three-year period
20092011 point at the world economy growing by an average of 2.1% per year, 0.8% for the
U.S.11 In the 1930s, U.S. unemployment soared to 25%, much higher than the 10% projected
this time. Also, the world faced a severe deflation in the early 1930s, in some cases sinking
below -10%. We do not see that today, and while inflation has fallen dramatically around the
world, it remains far from the levels seen during the Great Depression.
Another aspect making a big difference is the performance of emerging economies. Latin
America, excluding Chile, posted an average annual fall of 4.2% between 1930 and 1932,
while Chile, where the crisis compounded with the downfall of the nitrate industry, fell an
average of 17.6%. For the three-year period 2009-2011, private forecasts indicate that Latin
America will grow by an average of 1.2%, while Chile will grow by 2.1%. These are just
projections, not definitive figures, but data released so far this year indicates that the effects
of the crisis, although far from negligible, are much milder than they were in the 1930s. This
is an encouraging fact. Usually, whenever developed countries go into a recession, its effects
are amplified into our region. That has not been the case this time; on the contrary, our
region today is outperforming the developed economies.
That the current crisis did not turn into a Great Depression proves that lessons have been
learned. Economies are much stronger, and also the policies applied have gone in the proper
direction of mitigating the tremendous financial shock of last year.
For one thing, the task of stabilizing the financial system was assumed decisively, which
prevented its collapse. Uncertainties remain, but are more focused and less dramatic than at
the end of last year. Also, the lessons of Friedman and Schwartz (1963) on monetary policy
and the role of central banks as lenders of last resort, of Keynes (1935) on the role of
expansionary policies, and of Bernanke (1983) on the role of the financial channel for the
transmission of policy actions, have been essential in policy decisions adopted since the
onset of the current crisis. Many subsequent studies have shed additional light on the
characteristics of good policies and have provided the base for the aggressive monetary and
fiscal policies that have been applied around the world, and should also illustrate the way in
which the stimulus must be withdrawn.
Finally, the use of the gold standard accounted largely for the depth of the Great Depression
(Bernanke and James, 1991; Eichengreen, 1992). Moreover, in the midst of the crisis in
1931, the U.S. raised the interest rate to defend the dollar parity, aggravating the crisis and
causing deflationary pressures.
In Latin America, thanks to lessons learned from mistakes of the past, it has been
understood that macroeconomic stability, in both monetary and fiscal terms, foreign
exchange flexibility, and a well regulated financial system are crucial to mitigate the effects of
external scenarios as adverse as this one.
This reflects major progress in economic policy, which has benefited from important practical
lessons and advances in research following the debt crisis.
Final remarks
There will be plenty of time to continue analyzing where was the profession such that it did
not warn of the magnitude of the crisis. As I have discussed here, this is a multifaceted issue
that must consider crisis predictability, management, and the role of research in providing
rigorous frameworks - albeit incomplete ones - with which to analyze reality.
Nonetheless, that macroeconomic theory has failed is an overstatement. In particular, the
comparatively better performance of emerging economies - with the exception of a few
cases such as Eastern Europe that remind us of our mistakes of the past - demonstrate that
economic research has taught us something. In particular, the majority of macroeconomic
policies have sought not to replicate past mistakes. Now it is necessary to analyze more
carefully the role of financial markets, their virtues and, of utmost importance, their
vulnerabilities.
This crisis is an admonishment to professional arrogance. We must recognize that the real
world is much more complex than what our models can explain. This is why so-called
professional orthodoxy is discredited. However, we must also avoid the arrogance that
comes from ignorance, which leads to abandoning all we have learned about the
fundamentals of good macroeconomic policies.
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