and finance in recent decades has been of a little value and counterproductive. although economists have much to learn from the crisis i am going

to discuss, i think it calls for a radically reworking of the field. in particular, it seems to me that current parts of economics template three overlapping yet separate enterprises. i will call them economic science,nd economic engineering, and economic management. economic scice concerns itself primarily with the radical and empirical generalizations about the behavior of individuals, institutions, markets, and national economies. most academic research falls into this category. economic engineering is about the design and frameworks for achieving specific economic objectives. examples of such frameworks are the management systems of financial institutions and the financial regulatory system of the united states and other countries. economic management involves the

operation of the framework during a period of time. in the private sector, the management of complex management institutions. as you may have alreadyapplicats

crisis and what i have been calling in economic science -- that his basic economic research and analysis. i will provide a few examples of how economic principles and basic research, rather than having misled us, have significantly enhance o understanding of the crisis and are informing the regulatory response. the crisis did reveal some gaps in economists acknowledge that should be remedied. the financial crisis represented

an enormously complex set of interactions, indeed, a discussion and ball abilities in the financial system and financial regulations that allow the crisis to have such devastating effects will more than fill my time this afternoon. the complexity of our financial syst and the resulting difficulties of predicting relevanc in one financial markets and how it affects one system as a whole part -- presents challenges. in retrospect, economic principles and research are quite useful for understanding key aspects of the crisis and for designing appropriate policy responses. for example, the dependence on some financial firms on a stable short-term findings led to applications for the functioning of the system as a whole. the fact that dependents --

dependency on short-term funding could lead to runs, -- it has been a central issue in monetary economics sense someone wrote about this question in the 19th century. the recent crisis bears a striking resemblance to the bank runs from that era. in this case, the run occurred outside the banking system in the shadow banking system, such as securitization vehicles and investment banks. prior to the crisis, these institutions have become increasingly dependent on short- term wholesale funding as had some globally active commercial banks. examples of such funding include commercial paper and purchase agreements for repossessions and security funding. in the years before the crisis,

some of these forms of funding grew rapidly. repossession liabilities increased by a factor of 2.5% in e four years before the crisis. in his shortly -- retail depositors who heard rumors about the health of their banks whether true or untrue wld line up and withdraw their funds. if they continued, intervention by the central bank or some other providers of liquidity, the bank would run out of the cash necessary and would fail as a result. often the panic would spread as other ban with similar characteristics or which had a relationship with other banks would come into suspicion. money-market mutual funds and other investors as well as other

providers of short-term funding with the economic equivalent of short-term depositors. shadow banks depended on these estimates. after it began to decline, the quality of the securities that had been packaged -- although many shattered banks have limited exposure to subprime loans and other question of credit, the cplexity of the securities involved in the of bigness of the financial arrangements made it difficult for investors to distinguish relative risk. in an environment of heightened uncertainty, many as investors concluded that were showing their funds was the easier and more prudent alternative. in turn, financial institutions, knowing the risk held, began to hoard cash which

dried up liquidity and limited their llingness to extend new credit. because the runs of the shadow banking system occurred in a historic the unfamiliar concepts -- context, but the private sector and the -- the private sector underestimated the risk that these runs would occur. two centuries of economic thinking on runs and pic were available to form the diagnosis and the policy response. in the recent episode, central banks around the world followed the victims to avert war contained panic, central banks should lend freely. the federal reserve acted quickly to give liquidity to the banking system by easing lending terms at the discount window and a status thing regular auctions. invoking emergency powers not

used since the 1930's, the federal reserve found ways to provide liquidity to critical parts of the shattered banking system including securities dealers, the commercial paper market, money market mutual funds, and the securities market. for today's purposes, my point is not to review this history, but to point out that it is policy response to well- developed onomic ideas with historical roots. the problem in this case was not a lack of professional understanding. rather, the problem was a failure of both private and public sector actors to recognize the potential to run a context quiteifferent from the circumstances that have given rise to events in the past. this was partly the result of a regulatory structure that had not adapted adequately enough to the rise in shatter banking

emplace insufficient evidence on systemic risk as opposed to risk to individual institutions and markets. economic research and analysis have proven useful for understanding other aspects of the crisis. one of the most important developments in economics of a recent decades has been deflowering of information ecomics, which studies out incomplete information or differences in information affects market outcomes. an important branch of the information of economics called principal agent theory considers the differees of information in the principles of the relationship, say the shareholder and the firm, and the agency work for the principles, say the firm's managers. says the agent generally has more information than the and because the

principles are not perfectly aligned, much depends on the contrast between the principal and the agent and in particular abt thcontract. currently structured incentives were pervasive in the crisis. compensation practices at financial institutions, which often tied bonuses to short-term relts and made insufficient adjustments for risk, contributed to an environment in wort-- in where excessive risk were taken. serious problems with the structure of incentives also emerged with the model for the subprime mortgage market. to satisfy the strong demand for securitized product, but the mortgage lenders and the receipt package the loans for investors were compensated primarily on the quantity of projects they moved to the system, not equality. as a result they pay less

attention to credit quality and many loans were made without sufficient documentation. conflict of interest that credit agencies were another example of bad incentives. consistent with key aspects of research and if information, the public policy response to these problems has focused on improving market participants incentives. for example, to address problems of compensation practices, the federal reserve in conjunction with other agencies has suggested compensation practices to supervisory review. the inner agency supervisory dinettes supports compensation practices that induce employees to take a longer-term perspective such as paying part of an employee cpensation in stop based on sustained strong

performance. to animate the problems with the model, recent legislation requires regulatory agencies to develop new standards that better align the incentives in the various stages of the securitization process. the securities and exchange commission has been charged with developing new rules to reduce conflict of interest in credit rating agencies. information economics or also essential to understanding the problems caused by so-called "too big to fail" institutions. prior to the crisis, large, complex, firms would not be allowed to fail during a financial crisis. authorities in the united states and abroad did intervene to

prevent the failure of some firms. this was not out of consideration for the owners, managers, or creditors of those firms, but because of legitimate concerns about damage to the financial system and the broader economy. all the instability caused by the failure or mere failure of some large firms did prove to be very costly, in some sense the real damage was done before the crisis. if creditors in good times believe that some firms would not be allowed to fail, they would weaken market disciplines. in addition, predators would not have much incentive to monitor risk-taking. as a result, firms thought to be too big to fail tend to take on more risk and they face little pressure from investors as they expect to receive assistance. this is a moral hazard.

the rulting buildup of risk in "too big to fl" firms increase the likelihood a recession would occur. one responseo excessive risk taking istronger oversight by regulators. in recent legislation, systemically critical firm shall be subjected to stricter supervision and requirements. the federal reserve is also involved in federal negotiations to raise the capital of liquidity that banks are required to hold. however, the problem of "too big to fail" can only be eliminated when market participants do not intervene to prevent failures. if the president believes that the government will not rescue firms with their desk of that, did the creditors will have more appropriate incentive to limit their risk taking in those firms

to which they land. the best way to achieve such credibility is to create institutional arrangements under which a failure would be allowed to occur without collateral damage. the failure can take place more saly. the authorities will no longer have an incentive to try to a boil them. -- to avoid them. we took an important step by creating a resolution under which large financial firms can be placed into receivership. it also gives the government the flexibility to take the actions needed to safeguard the stability of the financial system. this new rime should help restore market discipline by putting a greater burden on creditors and counterparties to monitor the risk of large financial firms. the insights of the economists prove valuable to policy makers in other contexts as well. capital standards and the

decision to provide the market with information during the stress tests in 2009, in the design of liquidity facilities for non depository institutions, the announcement of the collapse of the securitization market, and in the measures taken to protect consumers just to name a few areas. many of the key ideas were quite old, but some reflected recent research. recent work on monetary policy helped the federal reserve provide accommodation despite the constraints imposed by the interest rates. economic principles and research have been special to understanding and reacting to the crisis. with that said, the crisis and its lead up also challenged some important economic principles and research agendas. let me briefly indicate some areas that i believe would

benefit with more attention. most fundamentally and most challenging for researchers, the crisis should motivate economist about how they model human behavior. most economic researchers continue to work within the classical paradigm that a sense rational self-interest and behavior and the maximization of expected utility -- a framework based on the formal description of risky situations at individuals was that has been very useful in many concepts. however, an important assumption of this basic framework is that in making decisions about uncertainty, economic agents can assign meaningful probabilities to alternative outcomes. during the worst days of the financial crisis, many economic actors including investors, employers, and consumers metaphorically threw up their hands and the admitted that given the extreme and unprecedented nature of the

crisis, they did not know what they did not know. or is donald ross film may have put it, "there were too many unknowns. this resulted in panicky selling by a investors, sharp cuts to payroll by employers, and increases in discretionary savings. the idea that at certain times decision makers cannot assign meaningful probabilities to outcomes and cannot think about the possibleutcomes is known as nightean uncertainty. although economists and psychologists have long recognized the challenges this presents an have analyzed the distinction between rk aversion and ambiguity of version, much of this work is relatively abstract and little progress has been made in describing --

research could renew -- another issue that needs more attention from economists is the rmatn of propagated asset prices bubbles. a lot of work was done on bobbles after the collapse of bubble.com bubbles exist and expand in situations where we think they should not. as it was put by my former colleague who has done research

of bubbles out, we dot have any convincing models that explain how and why bubbles start. in understanding this process will be very helpful in the design of monetary d regulatory policy. a third issue brought to the fore by the crisis is the need for better understanding of the determinants of liquidity in financial markets. the notion that financial assets can all -- always be sold is built into most economic analysis. before the crisis, the liquidity of major markets were oftenaken from iraq -- for granted by participants and regulators alike. the crisis shows that risk aversion and market dynamics could scare away buyers and impair price discovery. market illiquidity interacted with financial panic in

dangerous waste. we should -- a circle sometimes develop in which combustor -- investor concern led to runs and firms were forced to sell asts quickly and drove down prices and reinforce investor concerns about the solvency of the firm's. and the circle continues. this dynamic achieve it did to the propeled blurring of liquidity and solvency during the crisis. setting illiquidity and liquidity is difficult because it requires: beyond standar models to examine the motivations and interactions of buyers and sellers over time. as regulators prepared to impose new liquidity requirements and to require changes to the shirt normal functions during times of stress, the research in this area would be most welcome.

i am been discussing research, but have not yet touched on macroeconomics. standard macroeconomic models did not prect the crisis and nor did they incorporate very easily the affect of financial instability. these failures mean that they are irrelevant or significantly flawed. economic models are useful only in the context for which ty are designed. most of the time, including during recessions, serious financial instability is not an issue. the standard models were designed for these non-crisis periods anthey have proven quite useful in these contests. the reportf the intellecal framework that help deliver low inflation a macroeconomic stability to mr. countries in during the two decades that began in the 1980's. with that said, understanding

the relationship between financial and economic stability in a macro economic context is a critical unfinished task for researchers. earlier work that intended to incorporate credit into the study of economic fluctuations and the transmission and monetary policies represents one possible starting point. to give an examplehat i never particularly well, much my own research as an academic focused on the role of financial factors in propagating and amplifying the cycles. others have further developed the basic framework and look at the macroeconomic effect of the financial crisis. i am encourage to see the recent studies that have incorporated banking and credit creation in standard macroeconomic models. most of this work is still some distance from capturing the complex interactions of risk- taking, liquidity, and capital

in our financial system. it would also be fruitful if macro economist with look more carefully at other countries. join us essential experience, international economist could examine the origins ofhe banking and currency crises in some detail. they have devoted considerable research to the international contagion of financial crises, a related topic of obvious relevance to our recent experience. finally, macroeconomic modeling st accommodate the possibility of unconventional monetary policies and number of which have been used during the crisis. earlier work on th topic relies on the example of japan, now, unfortunately, we have more data points. the experience o the united states andhe united kingdom with large-scale asset purchases

could be explored this is that we can understand the aect of these transactions and how they coulde incorporated into modern models. i began my remarks by drawing a distinction between the scientific, engineering, and managent aspects of economics. for the most part, the financial crisis reflected problems in economic engineeng and economic management. this private-sector arrangements, for example rk management and funding, and the financial regulatory framework were flawed in design and execution. these witnesses were the primary reason that the finanal crisis had its economic -- and its economic effects were so severe. disasters require urgent action to prevent repetition. engineers seek to enhance the reliability of a complex machine through improvements to basic design.

economic policymakers efforts should proceed along analogous lines. first, the recent reform legislation has improve the design of the regulatory framework, closing important gaps such as the lack of oversight of the shadow banking system. likewise, in the private sector firms have taken significant steps to improve their systems for managing risk and liquidity. second, to reduce the probability of severity of a future crisis, the system will be monitored more intensely. the recent legislation creates a financial stability oversight nceled made up of the heads of the -- oversight council made up of the heads of the regulatory agencies. they will identify regulatory gaps and coordinate the efforts of the various agencies. enhanced market discipline is

the result of the new regime. a number of measures to increase as mayor terence c. -- to increase transparency will complement the oversight. we will work to make our financial system more resilience to shock. examples include rules that will strengthen key utilities, toughen bank capital and liquidity standards, and require that more derivative the estimates be standardized and traded to exchanges rather than over the counter. in economic engineering is effective only in combination with good economic management. for its part, the federal reserve has revamped its operations to provide more effective --

we are focused on risk to the system as a whole as well as risk to individual institutions. together, better designed a private, public sector framework for managing risk, better managing and supervision do not guarantee a crack -- a crises will not occurred. they should reduce the risk of crises and mitigate the effects. in short, the financial crisis did not discredit the usefulness of economic research and alysis by any means. both older and reset ideas drawn from economics have proven invaluable to policy makers attempting to diagnose and respond to the financial crisis. the crisis has raised an important question. as i have discussed today, more work is needed on the behavior of economic agents in times of

profound uncertainty. much of that work is already underway in the department of economics here at princeton. thank you very much. [applause] >> thank you very much. this was as good a capstone to the conference that took place today and a beginning of the conference that the starting right now. it will continue tomorrow. the studts in the audience can

extrapolate fr this that this was a very good teacher of economics. it is a pretty interesting job that you have right now. thonly thing i want to take issue with is that i can asre you that economics 101 has never been offered at 8:00 a.m. [laughter] that is an exaggeration. [laughter] a small sum. we have a lot more back up. [laughter] the floor is now open for questions. we'll start right here in the front. >> [inaudible]

[laughter] could the question be heard? >> no. >> the question was broadly about the fed balance sheets and the answers rate on long-term securities. what was the exit strategy, i

suppose, would be one way to describe it. i am not sure i can answer that question. we are trying to oppressed conditions as they arise. i would first began by saying that the fed now has about $2.40 trillion balance sheet and with the exception of a small portion of that, it is not toxic assets that we hold. we hold government guarantees securities. we hold mostly either treasury securities or fannie and freddie mortgage backed securities that have a government guarantee and are traded on liquid markets with the strong presumption of saty. the fed? she is actually try to secure from a credit perspective. the reason that we purchased the additional securities, and as you point out we purchased $1.50

trillion relative to our balance sheet was before the crisis -- had to do with the fact that conventional military policy methods ran out of room. we had reduced the federal funds rate which is the typical tool for monetary policy. we reduced it to its lowest level ever almost two years ago in december of 2008. as a result, this standard conventional monetary policy is no longer available. there was a view some years ago that was the short-term interest-rate was so severe that the central bank was out of ammunition. i argued that that was not the case. we demonstrated that there were other things the fed could do, in particular by buying mortgages backed securities and

treasurys we did additionally stimulate the economy. the research supports that. we did that in a couple of ways. first, the purchases of reduced interest rates directly by raising the prices of the assets that we purchase. secondly, the with all of the supply from the market pushed investors. as we pulled mortgage-backed securities out of the market, investors who uld normally like to hold a safe, liquid, longer-term fixed-income estimates moves into high- quality corporate bonds, thereby lowering yields over there. we have been able to, through this process, these financial conditions broadly above and beyond the usual policy of reducing short-term interest- rate. the reason we have such support

for monetary policy is because the onomy continues to need support. as you know, the recession was officially declared over as of last year. that just means that the economy is contracting. it has been growing, but not very quickly. we are using these tools to support economic growth and to maintain price stability. we guessed that a lot of time -- and i think it is constructive because, for example, lower interest rates in the corporate bond world make it easy for firms to finance investments and to improve their balance sheets, which is mother to for growth. the day will come, as you indicated, when we have to exit from this situation. it is not a permanent state of affairs. we spent quite a bit of effort deveping -- we have been

quite creative in figuring out a wide range o tools we can use to exit from the situation over and above selling assets. we have found other ways we can tighten policy rates at the appropriate time. i want to be very clear, when we talk about extra set -- will we talk about exit strategies, it was never a point to say we were about to exit, rather it was important to say how we could exit so we would have the competence of investors in the public that we had control of the situation and we would be able to exit at the appropriate time. at some point the time will come. i do not know where that is. the time will come when the fed will normalize monetary policy. at that point, we have a list of tools that will allow us to drain reserves from the system and normalize interest rates to bring us back to a more normal water policy.

-- in normal monetary policy. >> is that correct? ther is a microphone right behind you. >> think you for your marks. i wanted to ask you briefly, in regards to the shattered banking system which he spoke at length about, what have we learned about -- what have we learned and what do we need to learn about how the -- about the traditional undstandings of monetary policy. >> as i discussed in my remarks, the main problem -- there are many problems, but the single

most important problem is we have a regulatory system which was designed fundamentally for the 1930's, which was a period when our financial system was essentially banks. there were some innovations and changes in financial regulate -- regulation. we tried to monetize the financial regulatory system. unfortunately the animation in the system which created the use of off-balance sheet funding and the use -- and original as the distribute model which brought subprime mortgages and the securitization of vehicles which were sold with aaa ratings, all these things have developed and were innovations that were

either not cover appropriately by the the financial regulatory system or were not addressed adequately might regulators and not by the private sector either. one reason for thabesides the fact that there were gaps in the structure that did not keep up with the innovation is that our system was designed to the -- regulators were focused on individual institutions. a bank regulator might say that the bank get rid of the subprime mortgages and everything is fine. the question is where? there was nobody looking at the whole system and try to figure out how to change the regulator response as these innovations occurred. the shadow banking system had is

partular problems with credit quality and with funding. those were at the heart of the crisis. although they were a direct ways for various regulators to look at parts of the system -- for example,ank regulators to look at the off-balance the vehicles -- ourystem simply did not catch those problems. the shot that hit the system -- the shot that hit the system allowed it to become severe. what is new and different about our regulatory approach going forward as was captured in the new legislation and in the new federal reserve practices is that from now on we are going to be much more aware of the

system. what risks are emerging that could bring down the overall financial system? we have a bunch of mechanisms to do that. we had the oversight council. within the federal reserve, we are restructuring our supervisions. we have explicit attention to the whole system. financial stability is the primary goal. that change in perspective and the new skills we are bringing in, -- nothing is ever guaranteed. the system is complex and this can happen. but this will give us a fighting chance to identify any problems that arise as the system evolves aninnovates. >> a question right here on the aisle. >> thank you. what i am is wondering, i think the next financial crisis will ha to do with the social security trust fund. it is my understanding that the

social security trust fund has been added to the 1.3 jury in dollar deficit. i am wondering if there are any plans to rcind the upper end, limits for social security. i have asked this question of everyone from washington. i think it is important that we pay attention to this now. 14% of americans 65 and over depend upon what better% from social security, about another 50% -- i am wondering if that is something that may be addressed? >> there is a much more general, broad based problem in which the security is part and that is the long-term fiscal stability of the u.s. government. every analysis done by every responsible party of any stripe, including the congressional

budget office and the office of management and budget's and everyone else, showshat on current policies, the u.s. federal debt will become unsustainable within a few decades. that is a very serious concern and one that needs to be addressed. as i once put it, the only all that i want to stand up for is the law of arithmetic which says that the deficit is equal to the difference between spending and taxes. you have to figure out some combination of spending and taxes that adds up. the question then is what they do to try to address these long- term deficits. ultimately, it is a decision for the american people and for the congress. the federal reserve does not make fiscal policy.

we do not advise, at least on specific aspects of this policy. an issue thatill have to be addressed is the issue of entitlements. we have an aging population, we have a situation where no costs are rising more quickly than incomes -- where medical costs are rising more quickly than incomes. all the entitlement programs together in not too many years will be the entire federal budget. most people believe that in order to solve the long-term fiscal issues, we will have to do something about entitlements one way or another. social security is actually a much more manageable program than medicare, medicaid, etc. there have been a lot this suggestions about how to address that problem. the president appointed a commission that is supposed to

report later this year. one of the things they may be looking at, i do not know personally, will be tools for stabilizing the long-term finances of social security. there are lots of ways to do that. one thing i would say in relation to your question is that i trust that if they make any changes, they will not make changes that affect people who are already retired or close to retireme. obviously those people are dependent or have not had time to plan. it is unlikely that those changes would have significant impacts on our deficit in the next few years. we will see what they come up with. th is one area where they may want to look. the budget is a big thing as lots of other components as well. >> one last question. right over there. i cannot see who it is.

>> thank you, chairman. what the things you mentioned it was the fact that all the deep recession is officially over, the economy is growing slowly. earlier, you said there was some uncertainty about the economy. an interesting manifestation of this is the fact that among your colleagues there seems to be a wider variety of opinions. i am thinking about the distinction between government science -- economic science in economic management, your colleagues of a different view of how the world works. what is it that you think about the fed having a more optimistic view about where the economy is going than others in the economy? is the question one of a difference between how this will

work? on the receiving different information? what is it that the fed is saying that is not being seen in the market that makes you more optimistic than some survey measures and market expectations and things like that? >> first of all i would stay your premise a little bit. you can try to defer what markets thing by looking at things -- you can try to infer what markets think by looking at inflation rates in things like that. those are barry didn't -- indirect references. the reflect a whole range of views thatre being abrogated in thearket process. if you look at private sector forecasters, they are typically qualitatively as similar to what

the federal reserve believes on a quarterly basis. i do not think it is really true that the fed is more optimistic than private-seor forecasters. i think they are pretty comparable for the most part. in particular, we have followed the view that most private- sector forecasters have. since the spring, there has been something of a slowing within the economy. that is something we have taken careful note of. the question about why it is lowe is a good question. we have a lot of evidence that recovery is that followed a financial crisis tend to be slower than other recoveries. unfortunately this is an observation that comes from looking at lots of different experiences. it is not necessarily tell you

why. it could be that financial crises lead to slower recoveries because of the head winds created by be leveraging, by bad assets, but problems in the banking system. i am sure there is somof that. we try to incorporate that in our forecasting. there could be some episodes in the past where governments and policymakers were not aggressive enough in fixing their financial systems. the federal reserve has been quite aggressive. we try to be very proactive, both in addressing financial issues and in addressing the macro economy. we hope for better results. certainly it is the case that given the tremendous blow that our financial system took, i think it could have been much

worse. we avoided what could have been a global meltdown. even so, we got a taste of how powerful a financial crisis is on real activity. that blow which not the world economy into a deep recession in the second half of 2008, we are only recovering from back a pace slower than we would lik >> we will continue to monitor this and do our best to understand. i think it is an issue that all forecasters at of those that would be making investments are faced with, there are my aspects of this episode that are not the same as previous episodes. we have to draw inferences based on what we have seen and using economic science that i discussed in my remarks. >> thank you, stay aggressive. [laughter]

please join me in thanking ben bernanke. [applause] [captioning performed by national captioning institute] [captions copyright national cable satelite corp. 2010] >> coming up, "washington journal." after that, the senate investigation on ponzi scheme. after that, treasury secretary timothy geithner. .