Jean Boivin: Where the economy and finance meet
Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, to the Okanagan
CFA Society and University of British Columbia Okanagan (Faculty of Management),
Kelowna, British Columbia, 18 November 2010.
* * *
Introduction
Thank you for having me here tonight. I'm delighted to be in Kelowna to deliver my first public
speech as deputy governor of the Bank of Canada. As you heard in the introduction, I used
to be a business school professor, so I am especially happy to be back among a group of
business professionals, students and former colleagues.
As the title of my speech suggests, I would like to discuss the connections between the real
economy - the tangible world of jobs, goods and services - and the more intangible world of
finance - of money flows, interest rates and the stock market. They have a long and eventful
history.
When a crisis strikes, their connections are very evident and we pay attention. Our
understanding of these connections has been extremely useful in the development of a
timely and coordinated policy response at the onset of the last crisis. In times of stability,
however, we have an unfortunate tendency to downplay their connections. This is a mistake.
The main theme of my remarks tonight is that the connection between finance and the
economy is always relevant - not only in times of crisis. And while crises occur abruptly, their
seeds are sown long before they happen, during periods of stability.
For those of us working in economics and finance, this has two key implications:

First, we need better tools to understand the highly complex dynamics by which
financial imbalances build up and affect the real economy.

Second, we need to improve our understanding of how the real economy can
contribute to the development of financial imbalances, particularly through risktaking
behaviour.
As I will highlight, the Bank of Canada, together with international partners, is making
progress on both fronts, but we still have a long way to go.
Before I continue, I want to stress that this speech is not about what we could have done in
Canada to avoid the most recent financial crisis. The source of the crisis was outside of our
control and our financial sector has proven extremely resilient in the face of this huge global
shock.
But it did provide us with an opportunity to refine our understanding of the constantly evolving
economy and how to avoid future crises. We cannot be complacent.
Teaching economics in a pre-crisis world
I have been thinking
about the links between the real economy and finance for many years
now, starting with my career as a professor in the late 1990s, when I taught macroeconomics
to MBA students.
One of the most striking features of a business school environment is the palpable energy of
the students, their keen interest to learn, their drive and ambition. That made teaching
challenging, interesting and rewarding. But all this genuine interest and energy was not
automatically granted to a core macroeconomic course.
We need to remember the mood of the time. Buzzwords like: "new economy," "Dot Com,"
"Great Moderation," were on everyone's lips. Questions like "Is the business cycle dead?"
were seriously being asked and the Dow 36,000 was seen by some as the likely next frontier.
Many students wanted to pursue a career in finance. In such an environment, where
macroeconomic stability was taken as a permanent feature of the economy, students asked
why they should "waste time and money" sitting through a core macroeconomics class. Why
not jump immediately to the important stuff - finance? We even changed the name of the
course to make it more appealing: "Macroeconomics" became "The Global Economic
Environment."
I don't know that this was very effective...
To be fair to my former students, at the turn of the century, they weren't the only ones to
downplay the links between finance and the macroeconomy. Professionals and academics
alike shared this view. I noticed a big change in attitude, however, when I last taught this
course in the summer of 2009. Students took for granted that the connections between the
economy and finance were crucial.
There is an obvious explanation for this new-found awareness. Between the first and last
time I taught this course, the world experienced its worst financial crisis since the 1930s, with
real, dramatic consequences on people throughout the world. In the G-7, excluding Canada,
GDP fell by 5.6 per cent from the peak in 2008 to the trough in 2009, and almost 12 million
jobs were lost. The United States alone shed almost 9 million jobs, and even today, fewer
than 15 per cent of those have been regained. In Canada, things were better, thanks to a
financial system that has held up remarkably well and buffered us from the worst of the
financial storm. Nevertheless, in Canada, real GDP fell by more than 3 per cent from peak to
trough and more than 400,000 jobs were lost. We have now recouped those lost jobs, but not
the lost momentum and opportunities the crisis left behind. After living through this, how can
we ignore the obvious links between the economy and finance?
The short answer is that when times are good, we can make the mistake of becoming
complacent.
The economy and finance have been meeting for a long time
As I said at the outset, the economy and finance have a long and eventful history.
When financial markets are functioning well, they play a background role in the overall
behaviour of the real economy. At the same time, when the economy is stable,
macroeconomic considerations might appear to play a more secondary role in the functioning
of financial markets. Taken together, this suggests that in stable times it might be tempting to
analyze the behaviour of the real economy and financial markets separately, each of them
being a black box to the other, not worth opening.
This approach is also convenient: Economists can build economic models without
introducing too many financial details; financial wizards can price assets without thinking too
much about macroeconomic risks; and business schools can build curricula where
economics and finance are taught with little reference to each other.
This is all very well in a stable world. But a stable world is not a perfect world. And
imperfections can eventually break the stability.
It has long been understood that imperfections in the financial market can generate and
amplify economic fluctuations, driving the dynamics of a crisis. These imperfections typically
stem from transaction costs or asymmetric information.
This is economist jargon, but let me give you an example.
An entrepreneur who needs to borrow funds typically knows more about the quality of her
project than the lender. Moreover, the success of the project - and the likelihood of the loan
being repaid - will depend on the behaviour of the entrepreneur. This information gap is an
imperfection that the financial system needs to address. Financial intermediaries - for
instance, banks - play an important role in partly bridging this information gap through
screening and monitoring of prospective borrowers. Another way is for the borrower to put
some skin in the game by pledging collateral - for example, real estate - which becomes a
key determinant of borrowing capacity.
Appreciating the role of information and the importance of collateral helps to explain how a
financial crisis, such as the Great Depression, can unfold by setting in motion an adverse
feedback loop between the real economy and financial markets. Collateral facilitates credit. If
a weakening economy reduces the value of collateral, access to credit will be reduced.
Reduced access to credit constrains consumption and capital investment, further weakening
the economy and - closing the loop - the value of collateral that can be pledged. And if along
the way, some banks are forced to shut their doors, the information gap at the origin of this
problem becomes even harder to bridge.1
These are crucially important mechanisms. They have been understood for a long time and
formed part of the economist toolkit.2 This understanding proved to be a huge asset during
the last crisis, motivating policy-makers throughout the world to act swiftly to break the
adverse feedback loop once the crisis started.
Meeting in unsuspected places
Many of the connections between the economy and finance were perceived to be relevant
mainly to countries in crisis, limiting interest to the study of historical episodes or economies
with poorly developed financial markets. Consequently, many of the models used by
economists to analyze usually stable, advanced economies abstracted from features of the
financial sector. This was seen as a reasonable approximation.
But as we know, the recent crisis detonated in advanced economies after a long period of
exceptional calm, often referred to as the "Great Moderation."
How does the economy shift from stability to crisis?
While the links between the financial sector and the real economy are sometimes smooth
and continuous, they can also be highly non-linear. These non-linear effects can manifest
themselves by the slow buildup of imbalances in stable times - when many have been lulled
into a false sense of security - followed by abrupt crashes.
This underlines the need to improve our understanding of where the economy and finance
meet during stable times and how crises erupt:

First, we need better tools to understand the highly non-linear dynamics through
which financial imbalances build up and affect the real economy. This involves
improving our models, but also developing indicators that can help us to better track
the risk of potential financial disruptions to the overall economy.
 Second, we need to improve our understanding of how the real economy and
system-wide forces can contribute to the development of financial imbalances,
particularly through risk-taking behaviour.
Developing better tools
Regarding better tools, we are developing a new generation of models that, unlike those that
came before, consider the financial sector, including banks, not just as a transmitter of
shocks, but as a potential shock in its own right.
We are developing macroeconomic frameworks that take into account the balance sheets of
financial intermediaries, multiple interest rates and credit spreads so that we can understand
better how developments in the financial sector affect economic performance. This work is
being done by academics and central bank researchers, including those at the Bank of
Canada.3
Research at the Bank of Canada has made important strides in modelling balance sheets of
banks into standard macroeconomic frameworks with financial frictions.4 Bank staff have
also introduced multiple financial assets into the Bank of Canada's main policy model
(ToTEM), as well as credit and banking into the Global Economic Model (BoCGEM-FIN).
The Bank of Canada has used this research to make important contributions to international
reports by the Financial Stability Board (FSB) and the Basel Committee on Banking
Supervision (BCBS), assessing the impact of stronger capital and liquidity requirements on
economic activity. Bank staff ran simulations to provide a comprehensive assessment of the
potential impact on the Canadian economy of the new Basel III global capital and liquidity
standards. A report was published summarizing the Bank's core results for Canada, including
a comparison with the results published by the FSB and the BCBS.5
It is also critical that economists and financial professionals develop empirical tools that
provide statistical indicators of increased risks to the whole financial system - including
various measures of credit. A credit boom - a positive feedback loop sparked by a sustained
increase in collateral value - is a key feature of the buildup towards financial crisis.
Historically, finding such indicators has been a difficult task and we should not expect a
magic bullet. But the information gleaned from a collection of these indicators could serve as
an important guide for stabilization policies, including a system-wide regulatory policy. In that
respect, I am encouraged to see the large amount of work being done at the International
Monetary Fund, the Financial Stability Board and the Bank for International Settlements in
developing statistical tools to serve as "early warning indicators" and evaluating a variety of
statistical indicators of excessive credit growth.6 The Bank of Canada and other central
banks are also actively developing tools to support their financial system surveillance
activities.7
Financial imbalances, risk-taking behaviour and system-wide forces
The second key area of work for economists and financial professionals concerns the need
to understand better risk-taking behaviour and how system-wide forces contribute to the
development of imbalances.8
We see excessive risk-taking behaviour develop during periods of stability when people
become complacent and believe the good times are here to stay. They become
overconfident and underestimate risk. Contract incentives can also induce excessive
risktaking behaviour.
Let's take an example of an insurance company that has promised premium holders returns
of 6 per cent, while the long-term bond rate is 4 per cent. To meet its obligations when the
short-term rate is low, the insurance company has no choice but to take on greater risk,
either directly or through investments in alternative assets.9
We also see how incentives encourage risk-taking at financial institutions where
compensation depends on short-run returns. Although, the financial crisis is seen as having
many significant causes, the compensation structure of some institutions is viewed as an
important contributing factor.
Through these channels, a tranquil macroeconomic environment can lead to the buildup of
risks and financial imbalances on the balance sheets of banks. These imbalances can
increasingly expose the wider economy to the risk of financial crisis. If confidence
disappears, banks call back credit, balance sheets shrink and a difficult readjustment is
needed, with negative effects on financial and economic stability. In particular, the buildup of
big leverage within the financial system can unwind swiftly, causing more stringent general
financing conditions.
So what needs to be done?
First, we need to be collectively aware of these connections and better understand their
importance. Firms are run by people. Risk is taken by people. The more complete the
understanding, the better the chance of properly assessing risk and designing appropriate
contracts.
But there is also a need to adopt measures to make the financial system as a whole more
resilient. This includes enhanced system-wide supervision and regulation.
The recent Basel III agreement will go far to enhance supervision and regulatory practices in
the financial sector. G-20 leaders have agreed to strengthen their banking systems by raising
the amount and quality of capital and liquidity that financial institutions must carry. These
higher standards will lower the incidence of financial crises, reduce their severity and provide
for smoother economic cycles. They will also reduce the risk that resources are misallocated.
The agreement also includes a countercyclical capital buffer that provides for additional
capital to be built up during the periods of excessive credit growth that are associated with an
increase in system-wide risk. This will provide additional loss-bearing capacity in a downswing
in a credit cycle. The countercyclical buffer itself should also help dampen excess credit
growth.
Recent research at the Bank of Canada estimated that for Canada, the net economic
benefits to be gained from improving the safety and robustness of the Canadian and
international financial system could amount to about $200 billion - or about 13 per cent of
GDP.10
While it is neither possible, nor desirable, to eliminate risk-taking, by understanding it,
identifying it, tracking it, and spotting dangerous trends, we can do much to prevent the
buildup of imbalances that can lead to a crisis erupting.
There is no magic bullet to safeguard the financial system. We work in an exceedingly
complex and dynamic environment, one that presents new - and very difficult - challenges.
The task we have set for ourselves is far from easy, but when the best and the brightest in
the fields of economics and finance combine their efforts and work together, we can make
important progress. Complacency is the enemy.
Conclusion
As we move away from the crisis, we all have an obligation to remember that imbalances
build during periods of calm. Our vigilance is required at all times, not just during a crisis.
Better tools will help us to identify risks and better understand the human behaviour behind
risk-taking. And certainly, system-wide supervision and regulation will do much to improve
the global financial system.
However, as I conclude tonight, I would like to reinforce the fact that all of us here are part of
the "system." Economists, finance professionals, business school professors and students
are part of this "system." We have a role, and a responsibility, to improve our understanding
of, and account for, the system-wide consequences of our individual actions. We have a
chance to ensure that the painful lessons of the last few years lead to a better financial
system, and by extension, to a more prosperous and stable world.
Thank you very much.
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