Bernanke: "The crisis should motivate economists to think further about their modeling of human behavior"

Federal Reserve Bank Chairman Ben Bernanke spoke at a conference co-sponsored by the Center for Economic Policy Studies and the Bendheim Center for Finance, Princeton University on September 25th. A portion of that speech entitled Implications of the Financial Crisis for Economics, follows:

Economics and Economic Research in the Wake of the Crisis
Economic principles and research have been central to understanding and reacting to the crisis. That said, the crisis and its lead up also challenged some important economic principles and research agendas. I will briefly indicate some areas that, I believe, would benefit from more attention from the economics profession.

Most fundamentally, and perhaps most challenging for researchers, the crisis should motivate economists to think further about their modeling of human behavior. Most economic researchers continue to work within the classical paradigm that assumes rational, self-interested behavior and the maximization of "expected utility" — a framework based on a formal description of risky situations and a theory of individual choice that has been very useful through its integration of economics, statistics, and decision theory. An important assumption of that framework is that, in making decisions under uncertainty, economic agents can assign meaningful probabilities to alternative outcomes. However, during the worst phase of the financial crisis, many economic actors — including investors, employers, and consumers — metaphorically threw up their hands and admitted that, given the extreme and, in some ways, unprecedented nature of the crisis, they did not know what they did not know. Or, as Donald Rumsfeld might have put it, there were too many "unknown unknowns." The profound uncertainty associated with the "unknown unknowns" during the crisis resulted in panicky selling by investors, sharp cuts in payrolls by employers, and significant increases in households' precautionary saving.

Another issue that clearly needs more attention is the formation and propagation of asset price bubbles*. Scholars did a great deal of work on bubbles after the collapse of the dot-com bubble a decade ago, much of it quite interesting, but the profession seems still quite far from consensus and from being able to provide useful advice to policymakers. Much of the literature at this point addresses how bubbles persist and expand in circumstances where we would generally think they should not, such as when all agents know of the existence of a bubble or when sophisticated arbitrageurs operate in a market. As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles, "We do not have many convincing models that explain when and why bubbles start." I would add that we also don't know very much about how bubbles stop either, and better understanding this process — and its implications for the household, business, and financial sectors — would be very helpful in the design of monetary and regulatory policies.

Another issue brought to the fore by the crisis is the need to better understand the determinants of liquidity in financial markets. The notion that financial assets can always be sold at prices close to their fundamental values is built into most economic analysis, and before the crisis, the liquidity of major markets was often taken for granted by financial market participants and regulators alike. The crisis showed, however, that risk aversion, imperfect information, and market dynamics can scare away buyers and badly impair price discovery. Market illiquidity also interacted with financial panic in dangerous ways. Notably, a vicious circle sometimes developed in which investor concerns about the solvency of financial firms led to runs: To obtain critically needed liquidity, firms were forced to sell assets quickly, but these "fire sales" drove down asset prices and reinforced investor concerns about the solvency of the firms. Importantly, this dynamic contributed to the profound blurring of the distinction between illiquidity and insolvency during the crisis. Studying liquidity and illiquidity is difficult because it requires going beyond standard models of market clearing to examine the motivations and interactions of buyers and sellers over time. However, with regulators prepared to impose new liquidity requirements on financial institutions and to require changes in the operations of key markets to ensure normal functioning in times of stress, new policy-relevant research in this area would be most welcome.

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Bernanke: "The crisis should motivate economists to think further about their modeling of human behavior"

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