speeches · January 2, 2009
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 11 30 09
Long-Term Economic Challenges
Allied Social Science Associations
San Franciso, CA
If I were here to address this group simply as an economic researcher, I might start with something like this Both the Federal
Reserve and the Treasury have taken actions recently in order to address exceptional problems in nancial markets Without
these moves, the costs to our nancial infrastructure and real economy would have soared far beyond those we are
experiencing today But these necessary actions also have the unfortunate consequence of distorting incentives for future
behavior Unchecked, they could lead to costly future problems in the functioning of markets
Some might say that incurring such future costs would simply be reaping what is being sown today by ignoring the lessons of
the "rules v discretion" literature Although I don't subscribe to this view, it does cause me some concern But, I think the
current environment is also one in which we have to worry about the evil agent in Hansen and Sargent's robust control
analyses Recall that the "evil agent" is a parable for how we might end up in states of the world that fall outside of our typical
probability distributions and entail huge downside costs to the economy Robust policy guards against these outcomes, and I
interpret the Fed's aggressive and innovative lending programs to be "robust responses" to probability distortions caused by a
particularly evil agent
But, of course, I'm not here to speak simply as an economic researcher so let me give you my perspective as a Fed president
instead As always, these are my own views and not necessarily those of my colleagues in the Federal Reserve System
Today, the U S economic and nancial systems are facing their greatest challenges since World War II Turmoil in the housing
market accelerated in the summer of 2007 We have experienced large-scale disruptions to nancial intermediation and the
1
destruction of something on the order of ten trillion dollars of U S household wealth We are now a full year into a recession:
Many non- nancial industries are facing substantial risks of long-term structural impairment; and according to most economic
forecasts, the unemployment rate will likely exceed 8 percent this year
Beyond these serious immediate concerns, the U S economy is facing a number of diverse and di cult longer-term challenges
First, signi cant weaknesses have been revealed in our system of nancial regulation Market discipline did not prevent
excessively leveraged portfolios and inadequate risk-management, and a patchwork of regulatory authorities failed to curb
excessive risk-taking or detect systemic vulnerabilities These failures call for a reassessment of the roles of market discipline
and our regulatory structures in supporting the e cient functioning of nancial markets
Second, the Federal Reserve has undertaken policy actions of historic proportion We have aggressively cut the federal funds
rate, our traditional policy lever We have also created multiple new lending facilities and transformed the asset side of our
balance sheet And, going forward, we will be expanding nontraditional policies now that the fed funds rate is approximately
zero Accordingly, we are faced with the challenge of calibrating these unfamiliar policies and, in the future, determining the
appropriate time and methods for winding them down
Third, public policy responses have increasingly moved toward scal interventions To date, these have mostly been aimed at
improving market functioning: the Treasury's TARP program, FDIC guarantees, and the Hope for Homeowners Act, and other
programs to re-work mortgages Looking ahead, we expect large amounts of more traditional types of scal stimulus to
increase aggregate demand I believe a big stimulus is appropriate But it is also sobering to be deploying large amounts of tax-
payer funds at a time when our scal balance sheet is already coming under signi cant stress: The federal debt held by the
public is 38 percent of GDP, states have large unfunded liabilities, and growing numbers of retiring baby-boomers will further
pressure the unfunded liabilities for Social Security and Medicare Furthermore—especially in light of current economic
di culties—many taxpayers already consider their tax burdens to be very high
Finally, the monetary and scal policy interventions have been fast-moving and complex responses to extraordinary events As
such, they are di cult to communicate succinctly, require periodic re-calibrations as events change, and are often
misunderstood—even by well-informed segments of the public There is a great need for e ective communications and
transparency in policy-making This extends beyond communications with nancial market participants E orts to enhance the
general public's understanding of economic and nancial issues are essential In a democracy, an informed public is critical if
government o cials are to carry out policies for the public good So it is important that policy makers and informed private
citizens—like you in the NABE—continue to enhance communication e orts
Although each of these topics is worthy of an extensive discussion, time will allow me to make only a few modest observations
on these long-term challenges
If I were here to address this group simply as an economic researcher, I might start with something like this Both the Federal
Reserve and the Treasury have taken actions recently in order to address exceptional problems in nancial markets Without
these moves, the costs to our nancial infrastructure and real economy would have soared far beyond those we are
experiencing today But these necessary actions also have the unfortunate consequence of distorting incentives for future
behavior Unchecked, they could lead to costly future problems in the functioning of markets
Some might say that incurring such future costs would simply be reaping what is being sown today by ignoring the lessons of
the "rules v discretion" literature Although I don't subscribe to this view, it does cause me some concern But, I think the
current environment is also one in which we have to worry about the evil agent in Hansen and Sargent's robust control
analyses Recall that the "evil agent" is a parable for how we might end up in states of the world that fall outside of our typical
probability distributions and entail huge downside costs to the economy Robust policy guards against these outcomes, and I
interpret the Fed's aggressive and innovative lending programs to be "robust responses" to probability distortions caused by a
particularly evil agent
But, of course, I'm not here to speak simply as an economic researcher so let me give you my perspective as a Fed president
instead As always, these are my own views and not necessarily those of my colleagues in the Federal Reserve System
Today, the U S economic and nancial systems are facing their greatest challenges since World War II Turmoil in the housing
market accelerated in the summer of 2007 We have experienced large-scale disruptions to nancial intermediation and the
1
destruction of something on the order of ten trillion dollars of U S household wealth We are now a full year into a recession:
Many non- nancial industries are facing substantial risks of long-term structural impairment; and according to most economic
forecasts, the unemployment rate will likely exceed 8 percent this year
Beyond these serious immediate concerns, the U S economy is facing a number of diverse and di cult longer-term challenges
First, signi cant weaknesses have been revealed in our system of nancial regulation Market discipline did not prevent
excessively leveraged portfolios and inadequate risk-management, and a patchwork of regulatory authorities failed to curb
excessive risk-taking or detect systemic vulnerabilities These failures call for a reassessment of the roles of market discipline
and our regulatory structures in supporting the e cient functioning of nancial markets
Second, the Federal Reserve has undertaken policy actions of historic proportion We have aggressively cut the federal funds
rate, our traditional policy lever We have also created multiple new lending facilities and transformed the asset side of our
balance sheet And, going forward, we will be expanding nontraditional policies now that the fed funds rate is approximately
zero Accordingly, we are faced with the challenge of calibrating these unfamiliar policies and, in the future, determining the
appropriate time and methods for winding them down
Third, public policy responses have increasingly moved toward scal interventions To date, these have mostly been aimed at
improving market functioning: the Treasury's TARP program, FDIC guarantees, and the Hope for Homeowners Act, and other
programs to re-work mortgages Looking ahead, we expect large amounts of more traditional types of scal stimulus to
increase aggregate demand I believe a big stimulus is appropriate But it is also sobering to be deploying large amounts of tax-
payer funds at a time when our scal balance sheet is already coming under signi cant stress: The federal debt held by the
public is 38 percent of GDP, states have large unfunded liabilities, and growing numbers of retiring baby-boomers will further
pressure the unfunded liabilities for Social Security and Medicare Furthermore—especially in light of current economic
di culties—many taxpayers already consider their tax burdens to be very high
Finally, the monetary and scal policy interventions have been fast-moving and complex responses to extraordinary events As
such, they are di cult to communicate succinctly, require periodic re-calibrations as events change, and are often
misunderstood—even by well-informed segments of the public There is a great need for e ective communications and
transparency in policy-making This extends beyond communications with nancial market participants E orts to enhance the
general public's understanding of economic and nancial issues are essential In a democracy, an informed public is critical if
government o cials are to carry out policies for the public good So it is important that policy makers and informed private
citizens—like you in the NABE—continue to enhance communication e orts
Although each of these topics is worthy of an extensive discussion, time will allow me to make only a few modest observations
on these long-term challenges
The Future of Market Discipline and Regulation
Market discipline plays a vital role in testing and validating corporate strategies and business execution In most cases during
normal times, nancial markets can assimilate the relevant information to provide these important signals to investors They
then serve as a restraint on individual institutions taking undue risks
But I think we've learned from recent events that the force of market discipline can fail in unexpected ways The mechanisms
are not fully clear, but it seems that in the quiescent period before the current crisis, market prices indicated a high value for
residential housing and housing-related investments, such as MBSs and CDOs, with little perceived risk Markets responded to
these signals by increasing their provision of these investments, but with little attention paid to risk management Then, after
the crisis hit, market prices swiftly reversed Now, they signaled what were arguably extremely low values for these same
housing-related securities It's likely that the true value of these securities lies somewhere between the euphoria of 2005 and
the pessimism of 2008, but one could not infer this from market signals Rather, it seems that these abrupt swings in market
valuations were due at least in part to equally abrupt changes in market liquidity conditions I don't claim to fully understand
these changes in liquidity conditions But the high prices earlier this decade may have been associated with the ood of
liquidity into U S capital markets from abroad And the current low valuations may derive in part from reduced liquidity due
to balance sheet constraints and counterparty concerns surrounding nancial institutions that have su ered signi cant losses
In any case, it appears that at least in extreme cases, market-liquidity distortions can defeat price transparency This, in turn
can inhibit the e ect of market discipline on individual rm behavior
In times of market stress, price movements are dominated by aggregate risk conditions, rather than the fundamental condition
of individual rms These movements can be driven by many factors Industries, rms, or nancial products which seem
unrelated may become unexpectedly interconnected due to deterioration, or simply the perception of deterioration, in the
health of one or more key nancial intermediaries or market-makers Separately, nancial investors may suddenly reassess the
relative risk return pro les of certain classes of nancial instruments and transactions, and may simply adopt a heightened
level of risk aversion
How might we mitigate some of the potentially adverse consequences of such interconnectedness? The futures and derivatives
industry is weighing whether privately negotiated derivatives contracts should be centrally cleared or remain collateralized
bilaterally among pairs of counterparties An increasing number of derivatives contracts are now being multilaterally netted by
central counterparties, or clearinghouses Central clearing of such contracts shifts exposures from particular counterparties'
balance sheets to the clearinghouse For example, a signi cant e ort is underway to begin central clearing of credit-default
swaps This e ort is a reaction to the lack of transparency that left market participants not knowing which of their
counterparties might be liable for large losses on credit-default swap positions Arguably, this uncertainty caused many market
participants to withdraw from trading a wide spectrum of nancial instruments in which counterparty performance might be
called into question Of course, centralized clearing does not eliminate performance risk; it simply concentrates it at the
clearinghouse This means the clearinghouse itself becomes a potential single point of failure Accordingly, adequate capital,
good risk-management and prudential oversight are essential for such clearing facilities
Although forecasting is usually a very di cult task, some forecasts are easier than others For example, it is not di cult now to
predict that nancial institutions will face more intense supervision and regulation Indeed, investment banks and other
nancial institutions have already agreed to added scrutiny by applying to become bank holding companies Presumably, the
enhanced supervision will take aim at some of the obvious culprits of the recent turmoil One objective would be to prevent a
reoccurrence of imprudent mortgage lending practices: in particular, lending decisions that were not properly based on a
borrower's underlying "ability to pay" but instead were viable only if housing prices continued to rise Another aim would be
more realistic assessments of rms' exposures to seemingly remote o -balance sheet assets
We have also seen that a range of rms and institutions can be systemically important for nancial stability So it seems likely
that the scope of nancial enterprises subject to "systemic" supervision might need to be expanded as well Here, too, the
regulatory decisions will be di cult Questions about changes in the treatment of clearing houses, exchanges, hedge funds, and
private equity investors must be studied carefully Furthermore, the types of nancial entities that are systemically important
may change over time Of course, tighter regulation carries with it risks that must be taken into consideration, including the
potential e ect on innovation, the higher nancing charges to recover the added costs of regulation, and the possibility that
riskier activities may simply shift to o -shore jurisdictions This latter risk highlights the need for international cooperation
and coordination on regulatory reforms
Discussions about systemic risks lead naturally to the topic of how to respond to asset price bubbles The rst issue in this
discussion must be how to identify asset price bubbles This was the famous question asked by Alan Greenspan in December
1996 It is important to get this right—I continue to be concerned that, as Chairman Greenspan pointed out, an aggressive
campaign to ght a perceived asset bubble could entail large downside costs if the assessment proves to be wrong That said,
we are currently bearing enormous downside costs from the fallout from large mortgage-related asset losses, and this fact
reinforces the need for changes in policy My view is that we should concentrate on designing macro-prudential regulatory
policies aimed at helping to prevent and protect against the consequences of asset price bubbles Strong systemic supervision
and enhanced market discipline will need to be a part of this design
Finally, strong supervision and market discipline will periodically determine that a nancial institution is no longer viable So a
high-priority issue is the need to design a more e cient and orderly process to resolve the insolvency of large complex non-
banking institutions Such a process should be aimed at reducing the systemic rami cations of an imminent insolvency on the
nancial system and the economy This raises a number of questions What functions and size thresholds should be used to
determine which institutions are covered? What are the appropriate triggers to invoke the insolvency resolution process? How
should the priority of creditors' claims be established? Should the process include the possibility of a bridge bank type
institution established by the regulatory authority? The answers to these questions must also confront the possibility that
systemic problems may arise before insolvency, as counterparties may be reluctant to trade with an institution that is in
distress
Fiscal Implications of Policy Actions
The second long-term issue that will in uence the future course of monetary and public policy is the quantity of government
debt The Federal Reserve has responded to the nancial crisis by establishing a number of lending facilities, which have altered
the composition and size of our balance sheet And the Federal Reserve System has begun outright purchases of GSE debt and
mortgage-backed securities to enhance liquidity in those markets and further reduce interest rates Aggressive scal policy
responses have also taken place during this recession: the initial tax cut stimulus, the Troubled-Asset Recovery Plan TARP ,
FDIC guarantees for senior bank debt, and several programs aimed at delivering relief for troubled homeowners And more
traditional stimulus packages will be coming soon
For me, the economic rationale is clear: Without these policy actions, the downturn—and its costs to society—would be even
more severe than what we are currently facing They hold open the promise of mitigating the losses in jobs and output during
the downturn And avoiding unnecessary realignments of nancial, physical, and human capital would reduce any permanent
impairment to the economy's productive infrastructure Since most economic forecasters envision the current downturn as
rivaling the deep recessions of 1974–75 and 1981–85, I think these scal programs must be large in order to be e ective and
to instill badly needed con dence
No matter how necessary these actions may be, there are some devilishly di cult judgments involved Our profession needs
many constructive voices to remind us all of the e ects that these public policies may have on the nation's long-term nances
By historical standards, our current scal debt is not unusually large; but our expected future obligations are enormous The
war on terrorism continues generating great human cost and sacri ce, and mounting government debt The onset of the baby-
boomers' retirement will further pressure intergenerational insurance programs, such as Social Security and Medicare In
addition, many state pension plans are underfunded relative to future obligations So the value of prudent scal management is
high
Communications and Policy Risks
With much of my time used up, I now come to one of the most important challenges policymakers face: communications
While we at the Fed pride ourselves on always conducting extensive, thorough analyses of all economic issues, our e orts to
analyze the current situation and design appropriate policy initiatives are probably unprecedented in scope But policymakers
face another very important challenge: In a complex and dynamic environment, the public needs e ective and transparent
communications As our lending facilities and other policy responses continue to evolve, this is a daunting task
It would be nice if we could provide a simple summary of the country's nancial predicament I'll give it a try,—and, you will
quickly see that it is inadequate in many ways Here goes: Many investments and bets were placed on the assumption of ever
increasing housing values These positions were leveraged and ampli ed by innovative nancial engineering based on an overly
con dent belief that risks could be dispersed to the winds These beliefs became assurances that were too often accepted by
investors, credit agencies, and regulators All parties failed to see the possibility and extent of systemic vulnerabilities As the
bets turned sour and correlations among seemingly unrelated nancial returns increased, losses cascaded into large disruptions
to our nancial system These disruptions have negatively a ected real economic activity, causing further losses in the nancial
sector and worsening the disruption So, policy has responded in a number of new and targeted ways to these nancial
disruptions with the intention of mitigating the negative impact on economic activity
As a communications device for explaining why we have transformed and expanded the Fed's balance sheet, this summary is
simple but incomplete It leaves out many critical details and fails to capture three key issues: complexity, speed, and
uncertainty
My earlier comments on market discipline and nancial product structure have already touched on the complexity issue, but
here's another example Following the use of TARP funds to inject capital into the banking system, a notable public concern has
been the absence of any obligation for banks to lend in exchange for this new capital We have not done a good enough job in
communicating that even though analyses of previous banking crises suggest that capital injections are more likely to unlock
lending capacity at banks, it is not bene cial to substitute a policymaker's judgment over a banker's judgment with regard to
initiating individual loans We can productively insert judgment in some broad ways—such as on the supervisory side in
questioning risk-management practices—but not on the ex ante review of individual lending decisions
Turning to speed, it is sometimes necessary to address emerging distress with quick action; and the time between that action
and the communication of a full explanation of the events can seem uncomfortably long We have provided a good deal of
information to the public In the past 18 months, Chairman Bernanke and Secretary Paulson have testi ed before Congress
many times, and Federal Reserve o cials have given numerous speeches about our policies The minutes of our FOMC
meetings also provide further context for our actions And we now publish extended forecasts quarterly, with a commentary
describing the forces shaping these outlooks Still, we should strive to do more
Undoubtedly, the greatest challenge we face is the enormous uncertainty of this situation Yes, the irony between "undoubtedly"
and "uncertainty" is fully intended here I discussed the challenges earlier of assessing nancial risk from liquidity, credit,
solvency or agency sources
Those are surely large But I am also thinking of an important observation made by Robert Lucas long ago: As advice-giving
profession, we economists are in way over our heads At any time, this is a sobering and humbling thought to remember
Nevertheless, in the current environment, this reminds me that the pursuit of robust policies in the face of large uncertainties
is likely to be most e cacious A good Bayesian decision maker can't place all of his or her policy bets on a single hypothesized
diagnosis when the evidence is still ambiguous If Hansen and Sargent's evil agent is out there somewhere distorting probability
distributions, he is doing a devilishly good job
The need to act in the presence of ambiguity and such unusual events certainly adds to our policy and communications
challenges These challenges are further compounded by the fact that in order to restore the best balance between market
discipline and government intervention, it is important for all of us to recognize that the current situation is a once in a 100-
year event, not to be repeated in our lifetimes or at least not to be expected sooner
Consequently, I think the communications response must be to "never give up " We need to work very hard to explain the risks
that we are facing and the rationale for why we think our policy actions best address those risks As I alluded to earlier, much
digital ink has been spilled in these attempts so far More is on the way If ink were scal stimulus, we might see a more rapid
economic recovery in 2009
Note
1
This gure incorporates rough estimates of changes in household wealth since the end of the third quarter
Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily re ect the views of the
Federal Reserve Bank of Chicago or the Federal Reserve System
Cite this document
APA
Charles L. Evans (2009, January 2). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090103_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20090103_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2009},
month = {Jan},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20090103_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}