##dels that had been the focus of so much work in the 1960s came under attack on two fronts. most prominently, greater recognition of the importance of expectations suggested that those models, which for the most part incorporated autoregressive expectations, were excessively reduced - form and backward - looking in nature and thus insensitive to changes in economic structure and the policy process. in addition, some researchers observed that simple time - series models often produced better forecasts than the large macromodels of that period. 4 one prescription was to focus on uncovering, at a more fundamental level, the structural parameters of the economy. needless to say, this task has proven to be a very tall order that has yet to be filled. partly in response to these difficulties, a substantial body of research focused on improvements in empirical modelling, such as vector autoregressions for forecasting, and in some cases, for policy analysis. see romer, christina d. and david h. romer, " the evolution of economic understanding and postwar stabilization policy, " nber working paper no. 9274 ( october 2002 ), p. 39. friedman, milton. " the role of monetary policy ", american economic review, vol. 58, no. 1 ( march 1968 ) pp. 1 - 17. phelps, edmund s. " the new microeconomics in inflation and unemployment theory ", american economic review ( may 1969 ) pp. 147 - 160. friedman, milton and anna jacobsen schwartz. a monetary history of the united states, 1867 - 1960. princeton university press, princeton, nj, 1963. sims, christopher a. " macroeconomics and reality ". econometrics, vol. 48, no. 1 ( january 1980 ). pp. 1 - 48. each one of these approaches has proven useful, and their descendants are currently employed in various forms in central banks throughout the world. but as yet, none of these approaches is capable of addressing the full range of policymakers'needs. at various points in time, some analysts have held out hope that a single indicator variable - such as commodity prices, the yield curve, nominal income, and of course, the monetary aggregates - could be used to reliably guide the conduct of monetary policy. if it were the case that an indicator variable or a relatively simple equation could extract the essence of key economic relationships from an exceedingly complex and dynamic real world, then broader issues of economic

manoeuvre is in fact very constrained by the two dimensions of the negative feedback loop problem. the central dilemma is that for microprudential regulators more capital is a good thing – but that from a macroprudential perspective there is a concern about how fast to get that and at what cost. perhaps the safest course of action, then, is for a breathing space in terms of further initiatives on the capital front. the eba ’ s decision to postpone its next stress test exercise into 2013 is therefore a sensible development. there is also an argument for breathing space to let the political decisions on the sovereign debt crisis be fully implemented, both with respect to fiscal discipline and to building a firewall with adequate resources and sufficient operational flexibility. indeed, if this does happen, and has a sustained positive impact, it could eventually give scope to the eba to revisit the necessity for the full scale of the current capital buffer. i would like to see that we use this breathing space wisely to consider the future design of stress tests and the operational flexibility of firewall structures. it seems that the role of the stress test as a diagnostic tool needs to be reasserted. recent eu stress tests have evolved into what might be described as a “ capital shortfall ” calculation : setting a single scenario and a specially created threshold to effectively prescribe additional capital even where not required by eu law or basel rules. interestingly, the us stress tests are now focused on dividend and share repurchase approval rather than closing a capital gap in a prescribed timeline. the eu stress test approach therefore is in addition to – and potentially cuts across – the new basel 3 minimum capital requirements which are coming in anyway. also, i fear that trying to satisfy insatiable market expectations of conservatism in a stress test risks being very procyclical. stress tests were originally conceived as diagnostic tools, considering a range of scenarios and providing the basis for management and supervisory judgement, rather than as an automatic capital formula. given that the introduction of basel 3 already requires increased capital and in light of the changing balance of risks of procyclical regulatory action, it would be sensible to recalibrate the european approach to stress testing in the next period. what about the second negative feedback problem that i mentioned, which might be described as “ backstop burdens ”. the problem here is if countries with sovereign debt concerns need to borrow more to recapitalise their banks, which