This paper was prepared for the NBER-CRIW Conference on
Wealth, Financial Intermediation and the Real Economy, November 12-13, 2010.
In recent times, we have benefitted from a wealth of interesting articles and research on the institutional changes and other innovations within the financial system that contributed to the 2008-09 crisis. Unfortunately, nearly all of that work postdates the crisis itself. It is disappointing and puzzling that so little evaluation of those changes was undertaken in earlier years. Our profession did not perform well in anticipating the risks created by many of the financial innovations. Yet, with the benefit of hindsight, many economists have written very lucid descriptions that suggest that the dangers were obvious. Many of us will comfort ourselves with the phrase, “If only I had known what they were doing …” Hence the topic of this conference on what can be done to provide a better flow of information to help prevent similar crises in the future.
However, the crisis was not so much a failure of information as it was an analytical failure to draw the appropriate conclusions. We knew what the individual agents were doing, but did not understand the linkages and the chain of reactions that would lead the system to spiral out of control. Policymakers became excessive advocates for financial innovation and placed far too much confidence in the incentives and discipline of private markets to restrain participants from excessive risk taking. Our ability with hindsight to identify the failures that led to the past crises can also create a false optimism about our ability to prevent future crises. In effect, the inability to conduct laboratory experiments to explore directly the implications of various reforms to the system leads to an over-emphasis on explaining the past rather than thinking about how various innovations might affect the future.
The focus of this conference is on designing a flexible and robust statistical framework that could monitor an evolving financial system and assist regulators in controlling the risks. While that is an important objective, let me begin with some doubts that a new regulatory process can reduce the risks to an acceptable level; perhaps we should also consider the alternative of moving further in the direction of a plain-vanilla financial system that forgoes some of the gains from financial innovation in return for reduced risk. James Tobin was fond of observing that “It takes a heap of Harberger triangles to fill one Okun Gap.” (Tobin 1977, p.468). His perspective seems particularly appropriate in the present context when we try to balance the gains from financial innovations in the U.S. and Europe against the costs of a mistake to an even wider global economy. Our neighbor, Canada, is an example of that alternative: while the menu of financial products is more restricted and the prices for some services are higher, Canada did avoid the direct effects of the financial crisis. It suffered only through the channel of reduced trade and its position as a major trading partner of the United States.
For too long, the financial sector has been a poor cousin within the statistical system. Just as the national accounts provide the macroeconomic framework for a variety of real sector analyses, the flow of funds should be the starting point for analysis of financial developments. Traditionally, the Federal Reserve has had the major responsibility for the collection of financial statistics and construction of the flow of funds accounts; but for many years the flow-of-funds was a neglected element, and the Federal Reserve was reluctant to devote a significant amount of resources to developing the accounts. More recently, the Bureau of Economic Analysis and the Federal Reserve have made a major effort to expand the financial accounts and integrate them with the sector income and outlay statements of the national accounts. The integrated macroeconomic accounts bring the United States more in line with the international System of National Accounts (SNA) in which economic agents are organized into five major sectors (nonfinancial corporations, financial corporations, government, nonprofit institutions serving households and households). There is also a consistent set of accounts that flow from production, income and outlay, capital, financial, and ultimately a net balance sheet for each sector.
The flow of funds accounts played a more significant role in financial analysis during the 1960s and 1970s, relative to recent decades. In part, the reasons might reflect the more restricted nature of the earlier financial system where various interest-rate ceilings and other restrictions created some nonlinearities in the system that created a need to observe changes in different types of credit. As those restrictions were eliminated, financial markets seemed more homogeneous, and many credit instruments were viewed as highly substitutable for one another. Interest shifted away from the composition of credit toward a greater focus on aggregates on the price of credit. There may be some shift back toward an interest in the composition of credit because of the severity of the disruptions of the past few years and a realization that they did not impact on forms of credit equally.
The integrated accounts are an advance in providing an improved system-wide framework for analyzing macroeconomic flows and the links between the real and financial sectors, but it provides surprisingly little insight into the causes of financial crises. The traditional view of financial institutions emphasized their role in intermediating the flow of resources between savers and investors. While it is true that financial institutions continue to fulfill that function, a modern interpretation places greater emphasis on their activities in transforming financial claims in the dimensions of liquidity, maturity, and credit risk. These dimensions are not captured in the aggregate accounts because the accounts rely on purely deterministic measures of value and cannot reflect the accumulation and transmission of risk exposures. Thus, the system needs to be expanded to incorporate measures of the risk and volatility of key balance sheet items. There is also two little integration of prices and quantities in the financial accounts. At the same time, the emphasis on balance sheets at the sector level is highly desirable because it highlights the role of counterparty risk in a system in which the assets of one sector are the liabilities of others. As conventionally presented, however, the accounts are too deterministic and too aggregated to serve that goal.
The primary purpose of this paper is to review the need for new types of economic statistics in the light of the financial crisis. There has been–and will be even more–discussion of the need for an expanded reporting system to meet the needs of the financial regulators. The focus herein is more on the public side of the statistical system. It reflects a nervousness about relying on internal confidential channels of information between private firms and their regulators. While, there is a need to balance the needs for a public information flow and legitimate private concerns about confidential business strategies, the system also needs the analysis of outside scholars. They need the access to the kind of data that would permit the analysis and construction of indicators that will provide realistic evaluations of the consequences of future financial innovations. Part of the argument is that the statistical system of the federal government has not evolved at a pace that matches the changes in the economy and the new technologies that can be used to monitor it. It is most apparent with respect to the financial system where the reporting structure has remained largely frozen in time despite a drastic change of financial structure. The later portions of the paper also examine the effects of financial crises on the real economy and whether there are major gaps in the reporting system outside of the financial accounts.