and written a lot about globalization, and how, in some ways, it has made the world a

smaller place. There is one aspect of globalization where the world is especially small:

the global community of scholars. Professor Pu Shan is part of that community. I

studied at MIT and several of the economists who studied with Professor Pu Shan

were my teachers and my good friends. Professor Samuelson was both my teacher and

my thesis adviser; Professor Klein, who wrote the remarks about Professor Pu Shan

contained in the program, is a very good friend. So this is a wonderful opportunity to

be able to honor Professor Pu Shan and at the same time to celebrate the scholars who

address issues of enormous global consequence. I was a member of the

Intergovernmental Panel on Climate Change, and a lead author in writing their 1995

assessment of climate change. We warned then, more than a decade and a half ago, of

the serious threat posed by greenhouse gases. It is very clear that we need more

relationship between greenhouse gas and economics.

The subject of my talk this evening, though, is macroeconomics. Let me begin with

than two centuries ago about how markets lead to efficient outcomes. His most famous

economists to understand the precise sense in which that was true (what is today

called Pareto optimality), and to understand the conditions under which it was true.

cases, free markets create efficient outcomes. But Smith himself was actually much

more circumspect. He understood that while markets were important, there were many

limitations. Unfortunately, though, many of the latter-day descendents of Adam Smith

Two of the great economists of the mid-20th century, Gerard Debreu and Kenneth

Arrow, proved an important theorem explaining that the conditions under which markets

were efficient were very restrictive. They pointed out that there were a whole set of

problems that today we call market failures, in which markets do not yield efficient

outcomes. The lesson is that markets are important, but they have limitations. An

illuminating example is the limitations associated with externalities. Of these,

environmental externalities are some of the most important; and the most important

global externality is greenhouse gases, which is the subject of one of the awarded

papers today.

But there are many other limitations to markets, as well. If, for example, competition is

of antitrust authorities all over the world to ensure that monopolies do not engage in

abusive practices, abusive pricing, stifling development, and interfering with economic

efficiency. (One can have some monopoly power even when there is some competition.

Monopolies can both suppress output and discourage innovation.)

My own work focused on one other set of problems: those that arise when

Market information is always imperfect, and risk markets are always incomplete. In

work with my colleague Bruce Greenwald at Columbia, we explained why the invisible

there. In general, whenever information is imperfect, and risk markets are incomplete,

markets are not efficient.

Modern macroeconomics forgot or ignored these very important lessons. It constructed

models that assumed that information is perfect, and that risk markets were essentially

perfect, or were unimportant. Modern macroeconomics made a set of assumptions under

The standard macroeconomic models (and the macroeconomists who relied on those models)

totally missed calling the most important economic event of the last 75 years.

A major crisis is the most important economic event that anybody could ask the science to

failed, and failed very badly.

series of events that actually led to the crisis were written off as impossible: according to

the bubble broke, those who were indoctrinated in these models, including the

economy.

Well, the Chairman was wrong. The models that have been used, on which the Fed has

based its economic policies for a long time, said the risks would be diversified. So when Ben

Bernanke made the statement that it was contained, he was making it on the basis of

economic models, economic models that were fundamentally wrong both in their economic

assumptions and their mathematical structure.

Now there is growing consensus about some of the mistakes that occurred both

before and after the crisis. Before the crisis, for instance, there was the view by

central banks (monetary authorities) that keeping inflation low and stable was

obviously wrong. The US kept inflation very low and very stable. In fact, Greenspan

the problem of inflation, and that had led the way to rapid economic expansion (so it

really China, which kept prices low and exchange rates stable so that many American

consumers could get goods at low prices. Greenspan may have claimed the victory,

but it was not really his.

But the fact is that despite the low inflation, we had a major economic crisis, from which

we are still suffering. Evidently, low inflation does not guarantee real economic stability or

high long-term growth. The models used by central banks (the standard macroeconomic

models) talked about the distortions that result from low inflation, changes in the relative

the losses that the economy has experienced because of the financial collapse. The US has

already lost trillions of dollars in the gap between our actual output and potential output.

The crisis has been enormously costly.

hand. Greenspan, in testimony before the Congress after the collapse, said that he

was surprised about what had happened. He and many other central bankers from

around the world talked about self-regulation, and how the markets could regulate

themselves. In his speech, he acknowledged that he made a mistake in thinking that

markets would manage their risks better, and that he was surprised about this. For my

part, I was surprised that he was surprised, because the economics I study say that

financial sector had incentives to engage in excessive risk-taking and in shortsighted

behavior. It was the logical reaction to these perverse incentives and the loose

regulatory environment that gave them free rein. If they had not behaved badly, we

would have had to revise our textbooks. But they did behave badly, just as the

incentives led them to behave.

That, however, raises deeper questions. Markets are supposed to provide good

incentives.

of incentive: corporate governance. But corporate governance (like the perverse incentives

in the financial markets) is a subject that is totally excluded from the standard macromodels.

The macro-models left out banks, they left out bankers, they left out corporate

out information.

The whole function of financial markets centers around risk and information, allocating

capital and managing risk. The financial sector mismanaged risk, created risk, and misallocated

capital. This is a massive market failure, which is totally excluded from the framework of the

macroeconomic models that were used in most countries around the world. In those models,

markets are always efficient.

because among the macro-models, there were almost none in which credit played an

important role. The crisis was a credit crisis, a crisis in our banking system. And since

the macro-models did not incorporate good models of credit and banking, they have

nothing to say.

The critical issue, then, that the US, the UK and other countries faced was what to

do with the banks, how to restructure them, how to provide them capital, how to get

even desirable.

enterprises. Unemployment in the US is still high, although the rate has come down to just

full-time job still cannot get one. The mortgage market is still in shambles, with real estate

prices continuing to decline.

In short, the US (and Europe) continues to face serious economic problems, but the

standard macro-models have provided inadequate guidance on how to get back to full

employment quickly.

There is a lot of discussion in the US about who is to blame for the crisis. In my interpretation,

at the core of the crisis was a failure of the banking system and the financial system, but the

regulators were also to blame. The regulators should have known that banks behave badly

market economies regularly for the last 200 years. Just since the deregulation movement

that began about 1980 with Reagan and Thatcher, the world has had more than 100 crises.

The mistake of the regulators was to not regulate, and instead promote self-regulation.

Thus, the banks are at the center of the crisis, but the regulators are also to blame because

including the models that said that markets are self-regulating. Policymakers, unfortunately,

opportunity.

Let me try to highlight the nature of the economic problem and the ways in which our

US are the same as they were beforehand. We have the same physical capital, the same

eliminate one of the distortions associated with mispricing of housing. One might

guess that since we now have the same resources as before the crisis, and since we

corrected a major market failure in pricing, we would have a higher output and our

economy should be working better, not worse. Output should be greater after the crisis

important question.

most part.

Right now, the debate in the US is going exactly the wrong way again because of the

influence of the economists: too many of the wrong macroeconomists are giving advice.

These economists looked at our budget deficit, said we had a problem, and recommended

austerity. But here again, they have misdiagnosed the problem. The deficit was caused

by the fact that the economy was weak; because the economy collapsed, revenues

went down and that created the deficit. The best way to deal with the deficit is very

simple: put Americans back to work. If all Americans were working, if the economy was

up to its potential, then we would not have the serious deficit problem that we have

today. Unfortunately, the recipe that many people are talking about for deficit reduction

would make the problem worse by weakening the economy, therefore lowering tax

revenue and exacerbating the deficit. So what should be done? It is actually fairly

simple.

First we have to fix the banks and the financial system. We have to get them back to doing

and a whole variety of other things that are necessary for the economy. It would take longer

to describe all the necessary steps than the time I have available this evening, but what is

clear is that what has been done is inadequate. And there are clear alternatives that could

have been undertaken.

The second thing is that we need fiscal policy; we need to stimulate the economy. We

can stimulate the economy by investing in the economy, make investment in

infrastructure, education, and technology. Investment in infrastructure, education and

technology stimulates the economy in the short run and promotes growth in the long

was the chief economist of the World Bank, I used to go around and say that what the

IMF was doing was exactly the opposite of what we teach in macroeconomics. By

advocating budget cuts and high interest rates, it was encouraging the countries to go

into recession and depression, and it succeeded! China followed Keynesian economics,

which unfortunately fell out of favor in much of modern macroeconomics, and it

stimulated its economy with investments that provided a basis for its rapid growth

overwhelming that fiscal policy works and over the long run, if you make good

investments, fiscal policy can actually reduce the national debt and provide a strong

basis for fiscal stability.

Prior to the crisis, many economists argued that fiscal policy was relatively ineffective.

In fact, some economists claimed that it was totally ineffective. Monetary policy was

clear that monetary policy is totally ineffective in getting us out of the current recession,

though flawed monetary and regulatory policy may have contributed to our getting into

the recession.

This should not come as a surprise. In the Great Depression, Keynes has pointed

out that in deep downturns like the current one, monetary policy is not going to work.

to these.

There is an important warning from the econometric work that suggested the

effectiveness of monetary policy and the ineffectiveness of fiscal policy. Of course, in

periods of full employment, fiscal expansions are not likely to increase GDP, because the

effects will be offset, for example by increases in interest rates by central banks. But today,

unemployment is high, and there is no reason that monetary policy would take offsetting

actions. One needs to take extreme caution when looking at studies showing what has

happened in the past on average and considering applying them to a situation such as the

current one, which is very different.

The third thing that has to be done is to restructure debt. Almost one out of four

Americans who have mortgages on their homes owe more on their home than the

value of the mortgage. This is an important lesson for anybody who says bubbles

large number of people who owe more money than the value of their house, because

when the bubble breaks, the value goes down and the amount they owe does not.

That has resulted in an enormous social and economic trauma. You can imagine what

their homes, and we expect another 2 million to lose their homes this year and millions

more to lose their homes in future years. (These numbers seem small: every time I

an economic and social crisis. People are not going to start spending when they are

so deeply in debt. The economy cannot really start going unless you restructure the

debt.

This is a principle we understand. We have bankruptcy laws for corporations that get

into trouble. We give them a fresh start. We restructure their debt and we let them start

restructuring is a basic part of a successful market economy. In my view, families are

important, but we are not allowing our families to restructure their debt, so the American

until we do that.

The point I raised just now has important ramifications that I want to note. When

people talk about market economies, they often forget that a market economy always

operates with a set of rules: a set of laws. We have laws on banking regulation and

antitrust. Now, you can have good laws and you can have bad laws. Market economies

can still work with bad laws, but the economic and social outcomes may be far from

desirable. For instance, the bankruptcy law the US passed in 2005 makes it much

harder for debtors to discharge their debts, encouraged the banks to engage in reckless

need a whole set of rules of the game. And you have to be very careful about writing

competition. You wind up with monopolies. You will get an inefficient economy.

These laws are important parts of the economic system. Right now, China is very

be very hard to change. When you have a particular legal framework, there are going

to be vested interests that develop within that framework and want to keep it, because

those interests make money from it. The banks like the way the banking system

things.

So we have had a very hard time changing our regulatory system.

I hope in the last few minutes I have been able to explain the way in which the conventional

macroeconomics that became popular in the past 20 years is very flawed. The good news is

research on microeconomics, banking and finance, but that research has to be put together

to form a model of the entire economy, a model of macroeconomics. This is in fact a very

progress in the coming years. The construction of a better macroeconomics is something

that is well within our grasp

There is, in fact, a global community of scholars that is now working on precisely this

lot of support from a variety of circles, including Paul Volcker, the former Fed chairman, and

UK regulator Adair Turner. At recent meetings held at Cambridge and at Bretton Woods,

there was a broad consensus that the macro-models that have dominated the economics

profession for the past 20 years were badly flawed and had contributed to getting the

global financial market and economy into their current troubles, and that there is a need for

new thinking in economics.

Among the ideas around which a consensus is building is that financial regulations

are needed and regulations matter; the regulations that existed before the crisis were

created something like a consumer product safety commission. Some of the financial

have them. Like a drug, you need to test these products, make sure that they do what

they claim to do, that they are safe for use by ordinary people. But while they said

Why should it be a good idea to allow predatory lending? It makes absolutely no

sense. The only reason is that the automobile lobby paid enough money to get an

exemption.

The more fundamental problem for global financial stability is that of the too-big-tofail

risks. If it succeeds, the risk pays off and the bank walks off with the profits. But if it fails,

losses.

fix this problem. The same incentives still exist. The system is dynamically unstable

because the banks that are too big to fail (and everyone knows which banks these are)

that the government will bail them out if they get in trouble. So the too-big-to-fail banks

are more successful not because they are more efficient, but because they get hidden

subsidies from the government. Economically, the case against these too-big-to-fail banks

is simple and compelling, but the politics works against reform: they have the money to

fix the system.

The problems in macroeconomics are global. An obvious example is that the

global financial crisis was made in the US and then exported around the world.

Regulations have to be global because if they are not global, there is going to be

anachronism in the 21st century that a single currency, the dollar, has a central role.

including that of inflation. The 21st century needs a global reserve system to match

the global economy.

In short, there is a rich policy agenda ahead: policies to resuscitate the economy

today and to ensure that a recurrence of such a crisis is less likely and less costly;

reforms in how monetary and fiscal policy are conducted; reforms in financial regulation

inform these reforms. Hopefully, those of your generation will do a better job than those

of the last.

There is a final remark I want to make. When I was an undergraduate student

beginning my study of economics, I sometimes felt a moment of sadness, because it

seemed I was born just a little bit too late: all the great ideas had already been

discovered. Keynesian economics, I thought, was a brilliant idea. I wished I had been

around before Keynes so I could have discovered those ideas. But I came to find out

that there were some other holes in economic theory that I could spend my time

fruitfully working on. For you students here, this is a very exciting time because now

It is a historical moment in which we have realized that much of what we knew, or we

the kind of encouragement of research that your prize engenders is really important.

We really do need to rethink principles of not only macroeconomics, but also other

aspects of economics, including how to achieve growth that is stable and sustainable,

and growth with benefit that is widely shared. We clearly need a better understanding

of how economic systems work.

I wish all of you luck in your future research endeavors.

problems before the crisis took place in 2007?

Steagall Act (which separated commercial and investment banking activities). I very

issues. One, it could contribute to the problem of too-big-to-fail banks, which I

mentioned just some minutes ago. Secondly, we have two kinds of banks, commercial

banks and the investment banks. Commercial banks are supposed to take savings of

ordinary individuals, protect them, and invest them conservatively; investment banks

exactly what happened. That was the second objection. The third was that there are

many conflicts of interest that can arise when people who are issuing securities (the

investment banks) are also people who are lending to the firms whose securities they

are issuing (in their role as a commercial bank). The reality of these conflicts came out

very strongly in the Enron and WorldCom scandals around 2001. So I was very

strongly against this repeal. I can say that as long as I was in the Clinton

Act, but after I left, they did.

many other factors in the politics.

I talked about conflict of interest. The Secretary of Treasury came from one of the big

investment banks, and upon his departure, he went to one of the commercial banks, the

real source of the repeal.

create Chinese walls, but you will walk right over them or you will knock them down when

if you really create the Chinese walls so that they are separate, then why put them

together? The only reason that you want to put them together is that there must be

now know what the answer was. Some banks made a lot of money after the repeal of

of millions of Americans.

Now, on the more specific question: Did I see the crisis coming in the years before?

I gave a large number of speeches as the bubble began, expressing my concern. And as

it got bigger and bigger, I said that this is a serious problem and that we had an

US was related to the real estate sector, either directly (through real estate investment)

or indirectly, as people borrowed on the basis of real estate. I said this was not a solid

economy; this was an economy that was likely to have a problem. In early 2007, at

Davos, I gave a talk about where I thought the economy was going. I said: This is a

happened so far. There are two conclusions you can make. One is that my theory about

what is going on is wrong. The second one is that we will have a crisis but, when it

occurs, it will be all the worse because we have let the bubble get bigger and bigger.

Well, unfortunately for the economy, I was right. The crisis was all the stronger for

having been delayed.

Policy-makers, unfortunately, took these models seriously. But Bernanke and Greenspan

inflation until after you have it, but central banks are supposed to take action before

inflation gets very high. One might not be 100-percent certain, but one could have been

was very likely.

ideology, this religion that the market economy is efficient, and in this religion a bubble is

impossible.

The other argument they gave was also flawed: they said that the interest rate is a

asset price bubble with the same instrument used to stabilize the rest of the economy.

Trying to stabilize asset prices with this blunt instrument risked destabilizing the rest

raise the margin requirements, it can raise the down payment requirements, it can take

administrative measures and impose lending restrictions and take other regulatory

measures: there are, in fact, a whole host of instruments at its disposal. But for ideological

reasons, they said we can only use interest rates as a mechanism for controlling the

economy. Regrettably, some central banks of other parts of the world are coming under

the influence of the same idea: that you should only use interest rates. Controlling a

range of price and non-price instruments available.

Because the Fed was so committed to the ideology that free markets always work,

they refused to do anything, to make use of any of the instruments at their disposal. In

the end, the cost to our society and our economy of that commitment to that ideology

was enormous.

The blinders that economic theory and ideology put on policy-makers made it

impossible for them to see the bubble as it was forming, to recognize the consequences

of its breaking, and to do things that they could have done and should have done to

deal with the aftermath. But for these blinders, the bubble, its bursting, and the

aftermath were completely foreseeable. We in the West have all paid a high price for

these failures.

1 Two papers received the 2010 Pushan Award: “Economic transformation and Balassa-Samuelson effects,” by

Wang Zetian and Yang Yao, and “Embodied energy in China’s foreign trade and policy implications,” by

(Edited by Xiaoming Feng)

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