Macro met finance, and the results were unhappy – a theme I shall return to later. For too long without success, monetary policymakers and international institutions called for resolution of the global imbalances. Perhaps with hindsight, the industrialised economies should have been clearer about their own course in a second-best world in which some important exchange rates have remained semi-fixed for longer than believed ideal. The second-best probably involved measures to generate more domestic saving; may have invited tolerance for temporarily lower inflation; and perhaps tighter regulation of liquidity provision by the commercial banking system. But whatever the hindsight, there remains a pressing need to evaluate now the continuing risks from the pattern of global current account positions and capital flows. For researchers, this unfinished episode in global economic history underlines the significance of international monetary economics, but perhaps also a need to integrate it not only with the theory of asset pricing but also with a rich appreciation of credit creation and risk. Risk premia, money, default and crises Indeed, an implicit theme running through various threads in my remarks this morning, which I shall now try to pull together, is the need for further progress in integrating macroeconomics and finance – applied as well as theory. I will give a few reasons why. As well as compensating for expected default, expected inflation and so on, yields on assets embody risk premia to compensate for uncertainty in future returns.

Early commentators on the developing international monetary system,  8  BIS Review 112/2008  combining a mixture of floating and fixed-rate exchange rates (so-called Bretton Woods II), 16 were inclined to the view that current account imbalances would prove sustainable – essentially because Asia would, they assumed, continue to finance the USA’s savings deficit. But, as has become apparent over time, that seemed to rely on the invisible hand smoothing over the counterpart imbalances within some net debtor economies, notably the USA; or, more crudely, of it making no difference that, in aggregate, American households had effectively given up saving. Given the now widely acknowledged ex ante imbalance a few years ago between global investment and Asian-fuelled global saving, this was associated with a compression of longterm risk-free rates and an associated rise in asset prices. And given frictions elsewhere in the system, including the US GSE’s guarantees reducing the headline returns on primemortgage securitisations, that contributed to compression in risk premia. And that, I fear, fuelled a “search for yield” in which investors, having enjoyed the extraordinary windfall gains that accompany rising asset prices, extrapolated forward their elevated ex post returns into ex ante requirements (Diagram A). 17 (Such extrapolation amounts to a bubble, but via the channel of a requirement or target rather than, directly, a simple expectation.) There’s only one way to deliver on such requirements in those conditions: take more risk and hope no one prices for it. Leverage and maturity transformation were the order of the day.