This essay was prepared for the joint BIS-ECB Workshop on "Monetary policy and financial stability", Basel, Switzerland, 10-11 September 2009.
Reflecting on the financial crisis that is not yet over, it is natural to ask whether our macroeconomic models are still relevant. For all of their elegance and beauty, with their microeconomic foundations and complex endogenous dynamics, they provided the basis for monetary policy that delivered a quarter of a century of stability. The Great Moderation was great - inflation was low, growth was high, and both were stable. At least, that's what we thought. In retrospect, signs of smugness abounded. Academic journals are filled with papers explaining that this stability was, in large part, a result of good policy. And policymakers listened. The economy was inherently stable, with strong self-correcting forces. The financial crashes that were so common before the mid-20th century were banished by our deep and profound understanding that had been translated into mathematical models.
What a difference a year makes!
The models neither stopped the crisis from happening nor provided guidance on how policies could cushion its impact. They failed utterly in guiding our construction of an institutional framework capable of preventing systemic financial failure. Yes, there were warnings.1 And yes, there were models that hinted at the sources of the difficulties we now face. And yes, the economic reasoning provides the lens through which we can start to understand what happened and why. But, in the end, we ignored the risks.
In this essay, we begin with a brief review of the pre-crisis consensus that provided the basis for stabilisation policy as it has been conducted since around 1980. Our main conclusion is obvious: we need to build economic models that integrate the financial sector in a serious way, accounting for the role of intermediaries with all of their linkages, both with each other and with the real economy. And, most importantly, these models must be capable of endogenously creating financial stress that can build up until the pressure leads to a crisis - that is, models in which booms and busts are normal.