Prudent Risk Management Approach to Monetary Policy - Comments by Larry Summers

hello everyone welcome back to our Memory Lane Series where we explore remarks from renowned economists the better policy project in collaboration with the Central Bank of Armenia and the National Bank of Georgia wishes to express profound gratitude to all advisers particularly highlighting the contributions of Central Banking expert Larry summers in this video Summers discussed The Prudent risk management in monetary policy at a symposium in the diligent research and Training Center the emphasized es the importance of scenario planning adversarial processes and humility in macroeconomic policy Summers highlights the need for central banks to consider multiple scenarios and avoid overreliance on single models He suggests these strategies could improve responses to financial crisis and inflation Summers concludes with Reflections on the unpredictable nature of economics and the value of learning from past mistakes check out the full video for more insights from is speech good morning good morning great to see you how are you I am very well my friend how are you doing well thank you very much so let let us start uh so hello everyone again uh it is my distinct privilege today to introduce our final keynote session for this Symposium featuring an individual who has served as an important in inspiration for us at the Central Bank of Armenia on this journey to develop a prudent risk management approach to price stability this individual of course is Larry Summers who doesn't need any introduction so I will only say a few words so Larry suus is a Charles W Elliot Professor University professor and the president ameritus of Harvard University and will director of mos Safar rman Center for business and government at the camp the school during the past three decades he has served in a series of senior policy positions in Washington DC including the 71st Secretary of Treasury for President Clinton director of the National Economic Council for President Obama and vice president of development economics and chief Economist of the World Bank Larry I'd like to express my thanks for inspiring us over the past several years to reflect deeply on what constitutes a s a sensible and prudent approach to monetary policy amid heightened uncertainty and significant risk in particular we are grateful for the feedback you provided us back in July which have helped guide our development and journey since then later in this session my colleagues Armen ran and Douglas luxon will respond to two questions that you asked us in July which related one was about open economy considerations in the new framework and the second one was how a scenario based approach might have worked in a period where downside risks were more serious such as Global financial crisis and after recovery period after that before handing it over to you i' would like to very briefly provide a bit of content for our audience about our Noel framework for prudent risk management approach of monetary policy which we refer as F PassMark 2 the framework represents an attempt to address in a structured and systematic way what we believe to be the greatest policy imperative of our time appropriately dealing with the elevated role of risk and uncertainty in policymaking this is achieved in two ways first instead of trying to develop expert forecasts of the most likely future we transparently focus on understanding and communicating the key sources of risk and uncertainty moving forward and the second we pay particular attention to uncertainties particularly for those nonlinearities that could push economy into dark corners of price or macroeconomic instability to turn to the substance of our discussions as you have noted extensively in your interviews and writings the covid crisis and its aftermath have placed enormous stress on existing Central Bank Frameworks in terms of both analytics and communication if you have read our main framework paper or our forthcoming framework book you may have noticed that your voice features prominently in it first we were heavily inspired by the language you used in the past interview for barents where you stated that forward guidance is the vast majority of time fly we interpreted that as a challenge we see the Folly in forward guidance as being interl with a Reliance on a single Baseline forecast the other issue of course is the often uncritical Reliance on linear models to produce these baselines we also adopted the notion of adversarial collaboration within our own institutional framework so our framework typically includes two illustrative case scenarios that build the best argument for why policy path should be higher than what is currently priced in the financial market and we call it this case a and the opposite case for why the policy rate should be lower than the market expectations which is called po caseb finally we provide an example in the paper in the book on how the new framework would Engage The transitory versus persistent inflation debate of 2021 we argue that using a scenario based approach could have perhaps allowed Advanced economy central banks to have more quickly responded to inflationary forces and minimized some of the adverse impacts of welfare and credibility Larry I would like uh now to give the floor to you and provide you with an open-ended opportunity to reflect on the recent experience of past several years and in your view how have these recent experiences changed how central banks should conduct and communicate monetary policy let me um thank you very much for including me uh in uh this Symposium Express uh my gratitude to you for the chance to provide you some input as you worked on this important document share a strong fence that the work you do is immensely important for uh your country because sound well financed money um and finance can not um make a country rich but mismanaged Finance can make a country uh poor and so in some ways it is the lot of uh Central Bankers to be like anesthesiologists when I go for my surgery there's no such thing as a great administration of anesthesia but if the anesthesiologist be becomes highly prominent it's not probably because something good as uh happened but it's because of something unfortunate that has happened nonetheless the development of better anesthe anesthesiological practice contributes greatly to the preservation of human health and in the same way more robust more reliable Central Bank Frameworks seem to me to be very important I'm also very much aware of um the dangerous part of the world in which you live and your ability to step apart from the immediate and political to do so serious a piece of work seems uh to me to be something that is highly commendable and it is my hope that both the substance of your framework will generate substantial discussion with other central banks in other places and that the seriousness and the thoughtfulness of the process you undertook will be a model as uh other countries uh set their approach uh going uh forward I am uh struck as a general uh Theme by um an epistemological uh point which is that all of us in thinking about macroeconomic policy need to operate with enormous uh humility there are different uh words uh for it um one can uh think in terms of uh unknown unknowns one can think [Music] about uh shock uncertainty parameter uncertainty model uncertainty as all being elements of uh the system one can think in terms of Frank nights celebrated distinction between uh risk and uncertainty all of it is to one can think of Nasim talb and many others emphasis on F tales and the non-normality of uh distributions all of it is in common service of the broad idea of epistemic humility we don't know and we don't fully know all that uh we don't know this is brought home to me by one of the many mistakes I have made uh in life I remember being of the view in um the 1980s that uh the liquidity trap was some kind of historical curiosity of primary interest to uh economic historians and without future relevance and then Japan uh happened and then the financial crisis and the zero lower bound uh happened I remember being of the view in the aftermath of the Clinton Administration that high inflation was like small poox a disease that had been eradicated in major countries and that proved uh to uh be wrong so I think the broad Challenge and I'm really very impressed by the ways in which your Central Bank um has um has uh re has reacted um is uh on several is on several levels um that there is a desire on the one hand to be analytic and rigorous and statistical and econometric and formal in one's approach but that doing all of those things drives very much towards choosing a model manipulating that model and operating uh that model and yet no model is capable of capturing an inherently unstable uh world and indeed there is the extra aspect um that some would call recursion that some would call reflexivity that uh represents a profound difference between economic and physical uh systems it is the essence of the celebrated Lucas uh critique the um laws of gravity are unaffected by the work of Engineers the laws of Economics are affected by economic policies Economic Policy choices and how they influence uh expect how they influence the behavior and uh the formation of uh expectations and so it is the challenge it seems to me to respond to those realities and yet not throw oneself back simply on the idea that there will be wise people who will scratch their beards and then say what is to be done um because no model or framework can work and so I think of the task that you have been engaged in as recognizing this profound need for humility while at the same while at the same time um still having method framework and uh formality from that perspective I'm impressed by three aspects of your work as I understand it that correspond with things that I have always tried to do as a uh decision uh maker though I think you have brought a degree of uh formality uh to uh the exercise that goes beyond uh things that I have ever been able uh to uh do I think that you are very right and important in your emphasis on scenario uh planning we don't know we don't know what is going to happen we don't even know what the distribution of um possible outcomes are the systematic use of multiple scenarios and the desire to formulate policies that are robust against all scenarios seems to me to be something that is uh very important it is not the same thing as the point about tals but it is related to the point about tals and it is of course connected to um wisdom about private sector uh Financial uh practice there is the old story about uh the guy who has a strategy he goes to the casino with $10,000 and he plays until he either has $1,000 or has Zer and he reports back to his wife that he has played he has used his strategy five times and each time he has won $1,000 and he concludes that he has a foolproof strategy for for making $1,000 that he has empirical evidence of a Sharp ratio of infinity and that he now needs to go 10x on this uh strategy and increase the frequency with which he plays that illustrates the danger of failing to recognize nonlinearities of failing to uh recognize a full range of uh possible uh scenarios so I think your emphasis on scenario planning is uh something that I would uh very much salute a second aspect of uh your uh your framework that I would very much salute is uh the adversarial uh aspect um the attempt to probe a possible error there are many decisions that have the character of decisions as typically portrayed in decision analysis textbooks should I choose option A or should I choose option b should I undergo surgery should I not undergo surgery should we go to war should we not uh go to war should we initiate this program should we not initiate this program but there are also many many decisions in life that are best characterized as exercises in calibration where should we set a policy interest rate how much money should we devote to R&D spending or some other uh worthy uh pause how long should we allow ourselves to prepare a given report in all of these uh cases um one is seeking to optimize a variable that broadly speaking is uh continuous it is one of the most fundamental theorems of the calculus um that uh at a maximum the first derivative is zero or that um at the top of a hell whichever way you turn you go down that means that if the arguments for moving up are stronger than the arguments for moving down you are not at a maximum and so attempting to pose both the considerations for more and for less for higher for lower and to verify that they seem to be in equipoise as best one can make a judgment seems to me to be uh very much uh something uh that uh is appropriate and is a valuable contribution to uh the policy process the third thing I would say is and I think that your movement um is a uh is a cons is a construct is a constructive um one is that one needs to be very careful to protect one's credibility in an uncertain World by not pretending to know more than one actually can of course one needs to make and refine the best judgments that one uh possibly uh can but those judgments will be inherently uh flawed and therefore one needs to not express oneself with excess of confidence um in their favor my wise crack over time has been that uh Central Bankers used to but in too many cases no longer understand what the Oracles of Deli understood that uh if you are seen as omniscient and omnipotent but are in fact human and somewhat clueless it is best to keep your pronouncements vague oracular and unfalsified and that may be going too far but it is I think capturing some wisdom that is potentially quite uh important or to put it at its most uh cynical um forward guidance fails the market doesn't believe it when you give it and you feel Bound by it down the road and so it inhibits flexibility without enhancing uh credibility that may be an overstatement in a variety of uh contexts but it is I think a useful uh caution I would just conclude by describing an exercise that I have found useful in organizations of which I am a part which is to focus on working um history back from the future I like to ask organizations of which I'm a part two questions if we look back from five years from now and we are regretting our Collective failure what is the most plausible way in which that will have happened if we look back from five years from now and we are celebrating extraordinary success Beyond which anyone had hoped that we would achieve what is the most plausible scenario by which that had happened and that tends to force thinking about both the dark and the bright uh Corners the extreme end of the tales of distribution and I think therefore ironically has the effect of both increasing prudence and increasing uh creativity and is's I think a useful exercise for uh Committees of fallible uh humans and so those are some Reflections um on uh your uh framework and again I look forward to a bit of conversation and I'm grateful for the chance to have been included in your deliberations including today thank you very much thank you very much may I have just one small follow off question on that do you think that the developed country central banks used whatever you just described during this last couple of years and do you think that our framework could be useful for them in thinking about the problems I think that um they have um I think had a bit of a tendency to be overly slavish to um single internal models and uh consensus uh forecasts I uh something I got very right I think it's fair to say is the degree of inflation that the United States suffered in the aftermath of the massive fiscal stimulus and uh covid several years ago I think that central banks would have done a better job if they had perceived that risk in a more Salient way and I think if they had engaged in more adversarial process and they had put more emphasis on a multiplicity of scenarios that considered how their base case views would be wrong I think they would have been less prone to uh make that kind of error I think in a similar way with respect to financial stability the linear mechanical character of stress testing has tended to impart an excessive bias towards optimism with respect to the risk of uh financial crisis so I think the ideas that you introducing and the types of approaches you're recommending are useful in those regards

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Length: 30min 46sec (1846 seconds)

Published: Thu Jun 20 2024