jose de gregorio : macroeconomics, policymaking and the crisis keynote speech by mr jose de gregorio, governor of the central bank of chile, at the bank of finland and bank of italy conference on challenges of the global crisis to macroeconomic theory and international finance, in honour of pentti kouri, helsinki, 11 june 2010. * * * i am grateful for useful discussions and comments from mariana garcia and pablo garcia. it is an honor to participate in this tribute to pentti kouri. i did not have the pleasure to be close to him, but i not only know well who he was and his work, but we also share some things in common. we both study at mit and did international finance. we were very close to rudi dornbusch. there is a group of economists from all over the world, chile and finland for example, which had the privilege to work close to him, as students or as colleagues, and to enjoy his unconditional friendship and intellectual influence. in this conference there are a few of this fortunate group. kouri and dornbusch had pathbreaking work explaining exchange rate fluctuations as movements of asset prices. kouri ’ s papers were always an important reference in our course ’ s work. by the time i was student, late 80s, reading kouri ’ s papers, he was a successful investor living in connecticut. i remember a couple of times when rudi told me that he would visit this great friend, economist and successful investor to get some funds for the department. he succeeded, proof of which is that the department now has the pentti j. k. kouri career development associate professor of economics. today, rather than attempting to elaborate on kouri ’ s contribution, i think this is a good opportunity to address some issues on the state of macroeconomics and policymaking, which is the purpose of the conference, and are two aspects to which rudi and pentti contributed a lot. if they were here with us today, their deep insights and provocative ideas, regardless of whether we agreed with them or not, would certainly make us think. changes in the world economy, macroeconomics, and policymaking more than 30 years after kouri ’ s influential work, the world has changed dramatically, and so have economic theory and policymaking, especially in emerging market economies. there is a growing role of markets in the determination of prices, in particular interest rates and exchange rates. there is much

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