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Economists still aren’t talking about financial risk

The financial crisis left the economics profession soul-searching. The crisis surprised most everyone for its severity and the deep, prolonged recession it caused. Since then, traditional and inventive policy tools haven’t returned the economy and employment to capacity. It’s given economists a lot to think about; have they learned the right lessons?Some have and some haven’t.

This was on display at the recent International Monetary Fund conference, “Rethinking Macro Policy II: Early Steps and Lessons“—a follow up to a similar conference two years ago. Many notable macro economists were there, including three Nobel laureates and top policy makers. After the first conference I was hopeful—now I’m less optimistic: There was an acknowledgment that the financial crisis had a profound effect on the economy, with little progress made on how to deal with it.

Traditional macro economic models don’t usually include financial risk. Macroeconomics often focuses on predictable things and what policy makers can do to improve growth and unemployment. For example, fiscal policy: if you increase government spending the economy grows. Or monetary policy: if you lower interest rates it’s cheaper to invest, so firms will expand, which also increases growth. These relationships are fairly well understood and predictable, though the magnitudes are not—it’s still uncertain how much Y you’ll get if you do X.

In contrast, financial economics focuses on what’s uncertain—by attempting to quantify and price financial risk. So you’d think following a financial crisis, there would be some attempt to combine the two approaches. But that hasn’t happened. At the recent IMF conference, the only financial economist to present was Fed Board governor Jeremy Stein who spoke about bank regulation.

The importance of uncertainty and financial risk were brought up, but the discussion focused on what regulators can do to minimize financial risk to prevent another crisis. Better regulation is important, but it misses the point. By definition uncertainty is impossible to predict and hard to control. Relying on policy makers to keep the financial sector in check requires a degree of omniscience that no one has.

However, economists can better understand how the economy is impacted by financial risk, in particular, how monetary and fiscal policy work when there’s uncertainty. Some the IMF’s own economists, like Dale Grey (pdf), are doing path-breaking research to answer these very questions. Take the example of interest rates and economic growth. If there’s more risk, banks don’t lend as much; thus, monetary policy can be less effective in an uncertain environment. Low rates may even contribute to risk by propagating asset bubbles. Financial risk also impacts inflation, the exchange rate, and GDP, which can have implications for fiscal policy. It impacts the broader economy and vice versa. We need to understand these relationships better, especially which economic factors bring normal risk to crisis levels.

Economic models can’t predict every outcome, but they inform how different economic factors interact. Their purpose is to give policy markers a road map of how different factors in the economy relate to each other.  A map might not tell you everything that lies between New York and Washington DC. But it tells you Washington DC is south of New York and the most direct road there. As economies evolve and we learn more, the maps need to change. Given what we’ve learned in the last five years, it seems only sensible that financial risk should be on the map.

You can follow Allison on Twitter at @AllisonSchrager. We welcome your comments at ideas@qz.com.

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