##turn. nonetheless, so long as markets are free and human beings exhibit swings of euphoria and distress, the business cycle will continue to plague us. but even granting human imperfections, flexible economic institutions appear to significantly ameliorate the amplitude and duration of the business cycle. the benefits seem sufficiently large that special emphasis should be placed on searching for policies that will foster still greater economic flexibility while seeking opportunities to dismantle policies that contribute to unnecessary rigidity. let me raise one final caution in this otherwise decidedly promising scenario. disoriented by the quickened pace of today ’ s competition, some in the united states look back with nostalgia to the seemingly more tranquil years of the early post - world war ii period, when tariff walls were perceived as providing job security from imports. were we to yield to such selective nostalgia and shut out a large part, or all, of imports of manufactured goods and produce those goods ourselves, our overall standards of living would fall. in today ’ s flexible markets, our large, but finite, capital and labor resources are generally employed most effectively. any diversion of resources from the market - guided activities would, of necessity, engender a less - productive mix. for the most part, we in the united states have not engaged in significant and widespread protectionism for more than five decades. the consequences of moving in that direction in today ’ s far more globalized financial world could be unexpectedly destabilizing. i remain optimistic that we and our global trading partners will shun that path. the evidence is simply too compelling that our mutual interests are best served by promoting the free flow of goods and services among our increasingly flexible and dynamic market economies.

a job pricing assets in the face of such uncertainty. so too do academics, though some attempts have been made. 12 the theory of asset pricing under knightian uncertainty throws up at least two striking results. first, in the face of such uncertainty, asset prices are not precisely determined but instead lie in a range. this indeterminacy in prices is larger the greater is uncertainty and the greater agents ’ aversion to it. second, asset prices exhibit a downward bias relative to fundamentals. uncertainty gives the appearance of “ pessimistic ” expectations. both of these theoretical predictions match pretty closely the moments of many asset prices in the world today. many appear to lack a clear compass relative to fundamentals. most are excessively volatile. among investors, pessimism is the new optimism, with talk of a lost decade in succession to the golden one. risk models – or the failure thereof – have played their part in generating these foggy outcomes. that is the diagnosis. what of the prescription? in their recent consultation paper, the financial services authority has outlined some very good proposals for improving stresstesting practices among financial institutions. 13 based on my reading of the identified failures in stress - testing, let me put forward a complementary “ five - point plan ”. • first, setting the stress scenario. the key elements here are devising a multifactor risk scenario that is sufficiently extreme to constitute a tail event. arguably, designing such a scenario is better delegated to the authorities than to individual firms, in part because they ought to be more immune to disaster myopia. in its financial stability report ( fsr ), the bank describes such stress scenarios. in future, the bank aims to be able to offer through the fsr some greater clarity to financial firms about the sorts of vulnerability scenario it thinks they could use as one ( and only one ) input to their stress - testing machinery. this might include both solvency and liquidity - type scenarios. as the fsa have proposed, banks should also test to destruction their balance sheets through “ reverse ” stress tests, in order to identify potential areas of balance sheet weakness. • second, regular evaluation of common stress scenarios. having banks conduct regular evaluations of their positions relative to a set of common scenarios ( provided by the authorities ) would be an improvement on current practices in several respects. first, it would allow some degree of benchmarking of results across institutions ; second, it would allow a degree of benchmark