the box, and kouri was one of them. complexity also jeopardizes the capacity to move from scientific research to economic policy proposals. for academic ideas to be useful in economic policy making, 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 analysis. fortunately, this is not a time where prescriptions are taken by policymakers without scrutiny – and are later labeled as orthodox – and therefore, the capacity to intuitively explain a result is essential. 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. indeed, the current crisis has revealed that models have a limited ability to deal with all the complexities of the real world. even current state - of - the - art dsge models, used in many central banks, have been unable to consider in a manageable and explicit way all the intricacies associated with financial markets ’ distortions and imperfect arbitrage, let alone the existence of default and credit losses. 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. 2 the origin of the crisis was closely related to financial innovation and the creation of instruments that should have diversified risks. most of financial innovation was used to circumvent regulation, allowing credit expansion with a weak capital base. 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. enormous efforts were made to price many extremely complex financial instruments, but even those 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. it is paradoxical that while asset price theories, and their application to the real world, are based on the existence of full arbitrage

be eroded over time, either by high inflation or by excessive taxation. where a sustainable public debt - to - gdp ratio is now absent, it should be achieved ; where it is present, it should be maintained. the second point is that authorities everywhere need to ensure that domestic policies are promoting well - functioning markets for goods, services, capital, and labour. in particular, labour markets need to be flexible enough to facilitate the movement of workers from sector to sector as the economy adjusts to events. by promoting domestic flexibility, policy - makers in all countries could support confidence and boost growth. this would be good for national economies, and it would also help to resolve global imbalances. there is also a need for policy - makers to recognize the positive role played by a well - functioning social safety net. here, i am referring to unemployment insurance, public health care, and public pension systems. consider the countries of emerging asia, where such systems are lacking. citizens in those countries need very high levels of savings to mitigate the risk of job loss and illness, and to provide for the years after they leave the workforce. an effective and efficient social safety net pools risk, so that citizens can have increased confidence about the future and reduce their need for precautionary savings. i know that the chinese authorities that we at the bank deal with are well aware of the need to create a well - functioning social safety net. authorities everywhere also need to follow policies that help a country's financial system to work well. this is critical if the financial system is to carry out its vital role of helping to match savings with productive investments. the financial system can also support confidence by giving households and businesses appropriate access to credit. i know all of you in this room are well aware of the importance of a well - functioning financial system, so i don't need to belabour the point. but i would add that, in terms of supporting confidence, appropriate monetary policy is also critical. it is important that central banks follow policies that anchor inflation expectations and thus promote confidence in the future value of money. a renewed international monetary order having spoken about what policy - makers can do domestically, let me now turn to international issues. essentially, the global economy needs a commitment by all countries to a renewed international monetary order, and a willingness to play by accepted rules within this order. let me explain what i mean. around the end of world war ii, the developed countries came together and reached a series of