economists have been unable to anticipate sharp reversals in confidence. collapsing confidence is generally described as a bursting bubble, an event incontrovertibly evident only in retrospect. to anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific investments that make up our broad price indexes of stocks and other assets. nevertheless, if episodic recurrences of ruptured confidence are integral to the way our economy and our financial markets work now and in the future, the implications for risk measurement and risk management are significant. probability distributions estimated largely, or exclusively, over cycles that do not include periods of panic will underestimate the likelihood of extreme price movements because they fail to capture a secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic. furthermore, joint distributions estimated over periods that do not include panics will underestimate correlations between asset returns during panics. under these circumstances, fear and disengagement on the part of investors holding net long positions often lead to simultaneous declines in the values of private obligations, as investors no longer realistically differentiate among degrees of risk and liquidity, and to increases in the values of riskless government securities. consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account. the uncertainties inherent in valuations of assets and the potential for abrupt changes in perceptions of those uncertainties clearly must be adjudged by risk managers at banks and other financial intermediaries. at a minimum, risk managers need to stress test the assumptions underlying their models and set aside somewhat higher contingency resources – reserves or capital – to cover the losses that will inevitably emerge from time to time when investors suffer a loss of confidence. these reserves will appear almost all the time to be a suboptimal use of capital. so do fire insurance premiums. more important, boards of directors, senior managers, and supervisory authorities need to balance emphasis on risk models that essentially have only dimly perceived sampling characteristics with emphasis on the skills, experience and judgment of the people who have to apply those models. being able to judge which structural model best describes the forces driving asset pricing in any particular period is itself priceless. to paraphrase my former colleague jerry corrigan, the advent of sophisticated

donald l kohn : expertise and macroeconomic policy comments by mr donald l kohn, vice chairman of the board of governors of the us federal reserve system, on " insiders versus outsiders in monetary policy - making, " by timothy besley, neil meads, and paolo surico, at the american economic association session, allied social science associations annual meeting, new orleans, louisiana, 4 january 2008. * * * this panel is dealing with an important topic – in effect, the design and functioning of monetary policy committees. monetary policy decisions are judgment calls, informed by forecasts and discussions about how the economy is likely to evolve, alternative possibilities, and potential responses to policy actions. the question is how to bring the best possible judgments to bear on these questions. besley, meads and surico's contribution is to ask whether certain characteristics of the policymakers matter for the how they vote on the monetary policy committee. for the monetary policy committee ( mpc ) at the bank of england, they find heterogeneous views among voters, but no systematic differences based on whether the mpc member is an insider – that is part of the hierarchy at the bank – or an outsider appointed for a short term just to the mpc ; whether the person comes from an academic background ; or whether that person has worked at the treasury. i found the piece well done and interesting, and i have only a few comments before moving on to some questions and observations about the federal open market committee ( fomc ) sparked by reading this research. 1 my first comment is that i'm not surprised by the results. the mpc has a well - defined objective given by the government. to be sure, members may differ about the precise time frame in which to meet that objective, but these distinctions should be small relative to the importance of the overall objective. in addition, at every policy meeting, each member of the mpc is operating with the same information from the staff, and before the quarterly meetings that precede an inflation report, the members have sat through a number of discussions covering all aspects of the forecast. everyone should be equally familiar with the key issues and analysis. finally, dissent is accepted, indeed encouraged in some respects, by insiders as well as outsiders, reducing any differences in incentives facing the two groups. nonetheless, some aspects of the paper raised questions in my mind about the robustness of the results. for one, the authors, in testing for differences in policy