interview with ricardo caballero

8/6/2019 Interview with Ricardo Caballero

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Ricardo Caballero

The recent financial crisis and subsequent recession have launched a thousand

theories from economists eager to explain how a relatively small shock in subprime

mortgages led to the most severe financial and economic collapse since the Great

Depression. With few exceptions, however, these theories have disregarded global

factors that fueled the crisis.

The insights of Ricardo Caballero stand in distinct contrast. Backed by

years of research on crises in emerging markets, the Chilean scholars recent work

illuminates how international capital markets with an insatiable hunger for safe

debt instruments led U.S. financial institutions to create assets that met technical

AAA risk standards but were highly sensitive to macroeconomic, systemic stress.

Global markets froze after the subprime implosion caused confusion at

first, and then a cascade of panic and withdrawal among investors who previously

believed they held safe assets. Knightian uncertainty, Caballero explains, in

which even the unknowns arent known, induces the financial equivalent of

cardiac arrest.

Other economists have developed related ideas, of course: global savings

gluts, shadow banking panics. But Caballero blends streams of research on inter-

national capital flows, debt markets and finance theory into a coherent theory of

systemic crisis.

This leads to policy tools that others overlook. While not dismissing

moral hazard concerns, higher capital reserves or better regulatory oversight,

Caballero contends that the most effective way to manage (and even prevent)

massive financial uncertainty is aggregate insurance provided by government

itself. Policy measures taken to date, he suggests, have not remedied the funda-

mental fragility of the worlds unappeased demand for safe assets.

As chair of one of the worlds leading economics departments, Caballero

is also a critical observer of his own field. Hes concerned that macroeconomists

today are reluctant to admit that their models ignore empirical realities, that they

too often embrace the beauty of theory rather than dealing with hard truths that

dont fit the dominant paradigm.

In professional journals, books and op-eds, and in the following interview,

Caballero lays out a provocative and engaging case for a broader, more powerful

approach to macroeconomic research and policy.

Photographs by Peter Tenzer


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ASSET SCARCITY ANDFINANCIAL CRISIS

Region: Id like to focus initially on thefinancial crisis. Youve written that the

heart of the crisis wasnt so much laxmonetary policy or a faulty regulatoryregime, but rather global asset scarcity,which led to the United States holding atoxic waste of highly risky assetsagreat phrase. Its an intriguing idea,somewhat novel to me. Could youexplain briefly what you mean?

Ricardo Caballero: Its a story in twosteps. The first, present at least since theAsian crisis, is that the world has experi-enced a shortage of assets to store value.

Emerging and commodity-producingeconomies have added an enormousdemand for assets that is not being metby their limited ability to produce theseassets. I believe this global asset shortageis one of the main forces behind the so-called global imbalances, the low equi-librium real interest rates that precededthe crisis, and the recurrent emergenceof bubbles. Contrary to the convention-al wisdom, I think these phenomena arenot the result of loose monetary policy,but rather the other way around:Monetary policy is loose because an

asset shortage environment would oth-erwise trigger strong deflationary forces.

This idea is related to Ben Bernankessavings glut story;1 he was working onthese things at the same time but from adifferent angle, emphasizing the behav-ior of savers rather than that of assetsupply. The models I developed withEmmanuel Farhi and Pierre-OlivierGourinchas clarified these differentmechanisms.2

Region: You wrote that the entire world

had an insatiable demand for safe debtinstruments.

Caballero: This is the second step, whichbegan in earnest after the Nasdaq crash,when foreign demand for U.S. assetswent back to its historical pattern of

being heavily concentrated on fixedincome (as illustrated by Gourinchas

and Rey in their classic paper on thetransformation of the United States intoa global venture capitalist)3 and espe-cially on highly rated instruments. Thisis the point, together with the naturalfragility that emerges from such bias,that I made with Arvind Krishnamurthy

at one of the AEA [American EconoAssociation] meetings.4

The enormous demand for assets, with a heavy bias toward Ainstruments, could not be satisfie

U.S. Treasuries and single-name corate bonds, and that imbalance gened huge incentives for the U.S. finasystem to produce more AAA asse

As a result, we saw both the goodthe bad sides of the most dynamic ficial system in the world, in full foSubprime loans became inputs financial vehicles, which by the lalarge numbers* and by the principltranching were able to create Ainstruments from those that were n

Region:You mean seemingly Aassets, right? Many contend that ra

agencies were too soft in their ratinthese senior tranches.

Caballero: Even if they were, that wathe main problem. A rating of AAAmeans that the probability of defauthat instrument is sufficiently lomeet this high standard, but it dosay when that instrument will defUnfortunately, by construction, Atranches generated from lower-quassets are fragile with respect to ma

economic and systemic shocks, wthe law of large numbers doesnt wThat is, this way of creating safe amay be able to create micro-AAA abut not macro-AAA assets. In owords, these assets were not resilient to macroeconomic shocks,though they might have technicallyAAA risk standards.

In principle, this was not a big ibut it became a huge one when hileveraged systemically important itutions began to keep these macro-

ile instruments in their balance sh(directly, or indirectly through spepurpose vehicles, or SPVs). This waccident waiting to happen; AIG aninvestment banks should have knbetter, but the low capital charges too hard to resist.

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The enormous demand for U.S. assets, witha heavy bias toward AAA instruments,

could not be satisfied by U.S. Treasuries

and single-name corporate bonds, and that

imbalance generated huge incentives for

the U.S. financial system to produce more

AAA assets.

Unfortunately, by construction, AAA

tranches generated from lower-quality

assets are fragile with respect to

macroeconomic and systemic shocks.

In principle, this was not a big issue, but it

became a huge one when highly leveraged

systemically important institutions began

to keep these macro-fragile instruments in

their balance sheets. This was an

accident waiting to happen.

*Words in blue are defined in a glossary on

page 40.


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Region: So you do favor higher capitalrequirements ?

Caballero: I dont believe that increasingcapital requirements for banks across

the board is the right reaction to the cri-sis itself, but I do think that capitalcharges for systemically fragile instru-ments should be very high. From a sys-temic point of view, it is not the same fora bank to hold a single-name AAA cor-porate bond as a piece from a collateral-ized debt obligations AAA tranche. Thelatter is much riskier for the system.

UNCERTAINTY VERSUS RISK

Region: In several papers, you empha-

size the difference between Knightianuncertainty and risk, and describe apolicy in which financial institutionswould purchase aggregate insurancefrom the government to deal withuncertainty.

Could you explain this distinctionbetween uncertainty and risk, and elab-orate on the idea of aggregate insurance?

Caballero: Well, in a very different con-text, Donald Rumsfeld made this distinc-tion very clear for us all when he talkedabout the difference between known

unknowns and unknown unknowns.The former is risk; the latter is uncertain-ty. Risk has a more or less well-definedset of outcomes and probabilities associ-ated with them. Uncertainty does notthings are much less clear.

Financial institutions (and humanbeings in general) behave very differentlywhen they dont understand the risksinvolved than when they do. In the lattercasestraightforward riskthey canadjust their portfolios marginally toaccommodate any change in risk profiles.

But with uncertainty, when institu-tions or people dont truly understandwhat the risks are, they know or feelsomething is wrong but dont knowwhat and how likely it is, or how it willimpact them. In this context, the naturalinstinct is simply to withdraw rather

than to fine-tune. Such abrupt behaviorcan wreak havoc in a financial system

since, all of a sudden, the maturitytransformationthe vital role financialsystems provide in converting short-term liabilities into long-term assetshas to be undone. But this simply cantbe done when everybody wants to do itat the same timebank runs are anobvious example of this impossibilityand that further fuels the uncertainty,leading to more panic and fire sales. Thefinancial system is very good at manag-ing risk, but it is awful at handling(Knightian) uncertainty.

Region: It seems that unknown unknownsare happening frequently these days.What can be done to reduce their cost?

Caballero: Obviously, it starts by requir-ing banks to have solid buffers to man-

age deep recessions and even extridiosyncratic events. But it would bcostly to have the financial syhoard capital sufficient to deal withpanic component of crises. Ne

banks individually nor the financialtem as a whole should be required tpreparedin terms of capital reservfor another Lehman/AIG-like evThat would require freezing an emous amount of capital. It woulvery wasteful.

There is a point in a panic whengovernment has to say: Just holdNinety percent of the problem is nowpanic. Its not a real phenomenon,we just get rid of the panic, were do

Region: Like Roosevelts The only twe have to fear is fear itself.

Caballero: Exactly. But, of course,saying this wont do much; it needs backed up by a commitment to supthe system, and there are alwaysthings to fix as well.

There are several proposals out tto reduce the cost of the buffer by ing capital be contingentthat is,ing capital available not at all timesonly when events justify it. This is ain the right direction, and the

thing to do for idiosyncratic shocknormal recessions.

But contingent capital isnt an quate tool for fighting the kind of pathat arise from Knightian uncertaIts still too expensive as a mechanfor dealing with that level of panicsuch situations, the system doesnt capital but rather insurance or a guatee that the system will survive. Anis reduced by cutting off the tail odistribution of possible outcowhich is poorly understood and fr

ening, and mostly made of self-fulfiscenarios.The advantage of a cheaper arra

ment is not that it makes bankers easier, but that it allows the systehave a much larger weapon agthese events. Banks should pay a fe

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With uncertainty, when institutions orpeople dont truly understand what the

risks are the natural instinct is simply

to withdraw rather than to fine-tune.

Such abrupt behavior can wreak havoc in

a financial system. The financial system

is very good at managing risk, but it is

awful at handling (Knightian) uncertainty.


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advance for this insurance, and the feeshould be proportional to the systemicrisk of their balance sheets. Since the feeis much cheaper than the cost of actualcapital, they should be required to buy a

lot of insurance.

Region: And this aggregate insuranceshould be provided by government?

Caballero: Yes. It is the most efficientway because only the government hasenough credibility not to have to postcollateral in advance.

Region: Would this really be less costlyoverall, for the entire banking system,than higher capital requirements?

Doesnt it imply that the governmentwould put in its own resources, in theevent of a systemic crisis?

Caballero: The private sector should berequired to provision capital for actuallosses caused by bad loans and evennormal recessions, but it should not beasked to freeze capital for panic events.These do not require capital but justguarantees against extreme events thatare highly unlikely to occur but that eco-nomic agents in panic mode are all toowilling to imagine and exaggerate. The

government is the only agent that doesnot need to freeze capital to providecredible guarantees.

Of course, credibility is itself a vari-able. Solid fiscal health of the govern-ment is key for this mechanism to workwell, and the level of guarantee has to becommensurate with what the govern-ment can handle. The recent financialcrisis in Ireland has provided clear evi-dence of the limits of public guarantees.Having said this, it is important to real-ize that Irelands government provided

the guarantees after the crisis began, andhence didnt charge banks for the insur-ance premium in advance. The structureof these premia is important to providethe right incentives to banks. Still, weshouldnt be so nave as to think that thegovernment or banks will be able to

fully understand ex ante all the risksgenerated by their activities.

It is important to insist that govern-ment-provided insurance be only forvery extreme events. For more normal

events, insurance and hedging arrange-ments should be an entirely private sec-tor business.

By the way, we already have in thelender of last resort a facility of the kindI am advocating. We just need to extendit to, in effect, a balance sheet insurer oflast resort that would be activated dur-ing systemic, not bank-specific, events,so that the implosion in asset prices thatfollows panics does not destroy the bal-ance sheets of the financial sector.

MORAL HAZARD

Region: When you talk about the gov-ernment backing that kind of risk-tak-ing, youre talking about the potentialfor moral hazard. Youve developedmodels of financial crises that distin-guish between liquidation shocks anduncertainty shocks, and said those typesof shocks differ considerably withregard to moral hazard and the conse-quences of government bailouts. Youvewritten, for example, The moral hazardissue is less important for uncertainty-

driven crises.Would you elaborate?

Caballero: Let me first step back a bit andtalk about moral hazard. I dont want tobe perceived as someone who totally dis-regards moral hazard. It is an importantphenomenon and a very important ele-ment of financial intermediation. Thereare many, many agency problems withinfinancial intermediaries.

But I think people focus on a kind ofmoral hazard that it is really secondary,

and they do so at the wrong time.Let me begin with the timing prob-lem. I still recall politicians and econ-omists calling for the need to teachlessons (in a punitive sense) to thefinancial system in the middle of thecrisis. In fact, I think Lehman hap-

pened to a large extent due topolitical pressures stemming from

view. What timing! The systproblem of moral hazard is that petake too much risk relative to whsocially optimal. But during a criespecially one that is triggereduncertainty and panicthe probleexactly the opposite: People are tatoo little risk. Thats what flighquality is all about. The most effepolicies at that point are those induce people to reload on risk.

I wrote many op-eds at all stagthe crisis trying to remind policyma

that punishing institutions, and tryinprovide long-term lessons in the miof the crisis, was likely to add fuel touncertainty fire.5 Unfortunately, peneed to see in order to believea costly attitude during crises thatinherently very nonlinear phenome

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The systemic problem of moral hazard

that people take too much risk relativewhat is socially optimal. But during a

crisisespecially one that is triggered

uncertainty and panicthe problem is

exactly the opposite: People are taking

little risk. The most effective policie

that point are those that induce peopl

reload on risk.


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Region: Youve made an analogy, Ibelieve, that providing such lessons islike teaching people to eat right whentheyre in the middle of cardiac arrest.

Caballero: Yes, exactly. In my SuddenFinancial Arrest paper, I draw ananalogy between panics and suddencardiac arrest.6 We all understand thatits very important to have a good dietand good exercise in order to preventcardiac arrest. But once youre in aseizure, thats a totally secondaryissue. Youre not going to solve the cri-sis by improving the diet of thepatient. You dont have time for that.You need a financial defibrillator, nota lecture.

Region: And youve also suggested,havent you, that people focus on a sec-ondary type of moral hazard?

Caballero: Yes. There are many incentiveproblems within the financial system,and hence there is a strong need for reg-ulation. However, its ludicrous to sug-gest that anticipation of support (abailout) in an extreme systemic eventis one of the most significant sources ofmoral hazard.

With very few exceptionsperhaps

Fannie Mae and Freddie Mac?finan-cial institutions and investors (when inbullish mode) make portfolio decisionsthat are driven by dreams of exorbitantreturns, not by distant marginal subsi-dies built into financial defibrillators.Not hing i s f urther f rom t heseinvestors minds than the possibility of(financial) death, and hence they couldnot ascribe meaningful value to an aidthat, in their mind, is meant for some-one else.

Logical coherence dictates that if one

believes in the undervaluation of thepossibility of a future crisis that charac-terizes the booms that precede crises,then one must also believe in the near-irrelevance of anticipated subsidies dur-ing distress for private actions duringthe boom.

Region: So there is a logical contradic-tion to the idea of moral hazard drivingrisk-taking behavior?

Caballero: Yes. And it also comes from

the wrong diagnosis.The main dogma behind the great

resistance in the policy world to institu-tionalize a public insurance provision isthe idea that if the financial defibrillatorwere to be implanted in an economy,banks and their creditors would aban-don all forms of a healthy financiallifestyle and would thus dramaticallyincrease the chances of a sudden finan-cial arrest episode.

This moral hazard perspective isthe equivalent of discouraging the

placement of defibrillators in publicplaces out of concern that, upon see-ing them, people would have a suddenurge to consume cheeseburgersbecause they would realize that theirchances of surviving sudden cardiacarrest had risen as a result of the readyaccess to defibrillators.

But actual behavior is less forward-looking and rational than is implied bythat logic. People indeed consume morecheeseburgers than they should, but thisis more or less independent of whetheror not defibrillators are visible. Surely

there is a need for advocating healthyhabits, but no one in their right mindwould propose doing so by making allavailable defibrillators inaccessible.Such a policy would be both ineffectiveas an incentive mechanism and ahuman tragedy when an episode of sud-den cardiac arrest occurs.

I think this is one of the manyinstances when economists and politi-cians choose to solve a second-orderproblem they understand rather thanfocusing on what actually happens in

real life.

Region: But then it seems youre giving abreak to the bankers, by not providingtangiblethat is to say, financially puni-tivelessons about the danger of theirexcessive risk-taking.

Caballero: If you think that calling tshortsighted and irrational is githem a break, then I guess Im dthat [laughter] ...

By the way, CEOs, equity owners

even debt holders of banks go thromiserable times during these crisedo politicians and countries thateventually bailed out by the [International Monetary Fund]. Soidea that they did what they did becthey anticipated the bailout is rstrange, to say the least.

I am not defending their investmdecisions. I agree that they werewrong ones. But the reason they mthese decisions was not their anticipaof a bailout. So why pay the enorm

cost of not having a good antipmechanism in place if its absence is nsignificant source of better behavior

FIRE SALES AND COMPLEXITY

Region: Would you tell us about yrecent work with Alp Simsek onsales, complexity and externalities?

Caballero: I think that the essencmany of our problems in macronomics as a field stems fromassumption that we, as researchers

policymakers, and the economic agwe model understand things mmuch better than is actually the cas

The economy is an incredibly cplex objectand I mean complexthe sense of very hard to understThis complexity is not somethincan just get rid of in the proceswriting simple models, for it is ceto economic behavior during crMy work with Alp is an attempt to ture a small part of this complproblem and its role during finan

crises.The basic idea is that the economvery complicated network of connectbut most of the time economic agentgo about their daily activities witworrying about those complicationsucceed, youor financial institutio

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our modeljust need to be good atunderstanding your local environment.

However, as crises cross a certainthreshold, all of a sudden it is no longerenough to understand the local environ-

ment. You begin to worry about indirecthits through the network. So what was arelatively simple optimization problemquickly becomes an immensely complexone. At that point, we have moved froma world of more or less well-definedrisks to one of (Knightian) uncertaintyand, as we discussed earlier, decisionmakers then become ultraconservative.And the most attractive individual deci-sion is simply to withdraw.

Region: Which triggers a fire sale?

Caballero: Indeed, fire sales are a centralaspect of crises. However, one of thepoints we make in that paper is that iffinancial markets are sufficiently liquid(in a precise sense that we define in thepaper), it is very, very hard to start a firesale. There are always enough asset buy-ers to absorb and bid for the assets of thedistressed financial institutions.

This changes, however, when we crossthe complexity threshold I mentionedearlier. At that point, all potential buyersbecome concerned with being hit by an

indirect shock, so they opt for hoardingtheir liquidity rather than bidding for thenow discounted assets of the distressedinstitutions. Naturally, this leads to allsorts of perverse feedback effects.

Region: Fire sales involve externalities.But your mechanism also incorporates aseparate externality, true?

Caballero: Yes, we have the standard firesale externalities, but we have an addi-tional and novel source of externality, a

complexity externality. The main physi-cal contagion mechanism in our modelis through network cascades. These net-work cascades get compounded manytimes by the behavioral reaction offinancial institutions to the increase incomplexity of the problem they need to

solve once the cascades become suffi-ciently long. Not only do they have toworry about their neighbors financialcondition, and the financial condition ofthe neighbors of their neighbor, but,increasingly, about the financial situa-tions of the neighbors of the neighborsof their neighbor. A tremendously com-plex cascade!

So any action that lengthens the cas-cade sizesay, for example, a banksdecision not to use its liquidity to pur-chase distressed assetshas the poten-

tial to generate powerful externalitiesonce the system is near the critical com-plexity threshold.

Region: Policy was not an explicit focus ofthat paper, but you do mention a numberof policy alternatives: bailouts, liquidity

provisions, stress testing. Would youcuss some of those? Also, econosometimes propose that externalititaxed. Is there any role for taxation?

Caballero: Yes, theres a role, alththey come in mixtures. For exampbailout of distressed institutions fuby small lump-sum taxes on all the bmay lead to Pareto improvemWithout such a policy, our models elibrium fails to replicate this redistrtionthat is, the financial system wprovide this solution if left to its devicesbecause each bank fails to inalize that its contribution to a bawill reduce payoff uncertainty obanks. My sense is that the many ef

by Treasury and the Fed during the cto find and persuade the main banbuy distressed assets were of this kin

But also, once the system is in thsales equilibrium, policies that supasset prices become very effectivcoordinating agents closer to a fair-equilibrium. Many of the most sucful policies implemented during thsis were of this kindfor examplesupport for the commercial paper ket and the backup liquidity facilitmoney markets. Unfortunately,political process often delayed t

policies to a point where much odamage had already been done.

Region: You advocated the latter kinpolicy in your 2008 paper with ArKrishnamurthy,8 and then in JacHole in your 2009 paper with PKurlat.9

Caballero: Yes. I began to workKnightian uncertainty and its pconclusion with Arvind well beforcrisis. We argued that a lender-of-

resort facility would be particueffective in dealing with panics ofkind even if the policymaker isinformed than the private banks athe allocation of distress. When wewrote that paper, not many penoticed it, but then the crisis came

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As crises cross a certain threshold

you begin to worry about indirect hits

through the network. The most

attractive individual decision is simply to

withdraw. When we cross the

complexity threshold potential buyers

become concerned with being hit by an

indirect shock, so they opt for hoarding

their liquidity. Naturally, this leads to all

sorts of perverse feedback effects.


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we ended up getting the Smith BreedenPrize for it [laughter].

With Pablo, I proposed an automaticmechanism to deal with panics inwhich banks would be required to buy

ex ante a sort of contingent creditdefault swap (CDS) contract for theirsystemically risky assets. That is, theywould pay in advance for having theright to have their assets guaranteed inthe event of a systemic (not an idiosyn-cratic) crisis. As I said earlier, the polit-ical process doesnt have the right speedto deal with a panic-driven crisis. Weneed to be prepared in advance. Thatswhere the idea of a financial defibrilla-tor comes into play.

RELATION TO OTHER RESEARCH

Region: How do you view your work inrelation to research by others? GaryGortons work on shadow banking pan-ics, for instance.10 Princetons MarkusBrunnermeiers research also comes tomind;11 as well as the work of Adrianand Shin at the New York Fed,12 and theNYU-Stern Business School folks13these economists and others have beenstudying financial crises, with a focuson this past one.

Would you describe how your ideas

are similar to, or distinct from, theirs interms of shocks, transmission mecha-nisms and policy?

Caballero: All the names you mentionhave done important work in this area,and most of them have made multiplecontributions, so it is difficult to sum-marize. The main common element isthe emphasis on the endogenous andperverse feedbacks that arise when assetfire sales take place. We all talk aboutamplification mechanisms, linkages

gone wrong, and the connection andfeedback between volatility and thetightness of financial constraints.

Perhaps the closest in interpretation ofthe nature of the events and the structur-al factors behind the conditions that ledto the panic is the work of Gary Gorton.

He highlights the role of collateral in therepo market and how this structural fea-ture can naturally lead to runs. This is anaspect ofthe AAA asset demand Ive beentalking about, although I have highlight-ed more the role of sovereign investorsthan that of the repo market. Also, hiswork with Bengt Holmstrm pointingout the importance of the information-insensitiveness of debt contracts for thefunctioning of repo markets, and how allhell breaks loose once debt becomes

information-sensitive, resembles thecomplexity threshold mechanism of mywork with Alp.

Relative to most economists, Garyand I tendfor severe systemiceventsto place blame less on incentivefailures and more on accidents that arise

from the very nature of what finanintermediaries do. As such, it is notprising that our policy emphasis ihow to prevent and deal with these dents rather thanor not as much

how to constrain the financial systeit doesnt misbehave.

Similarly, I share with Gary the that most of the regulatory changeswe hear about are really not addresthe fundamental problem: There wasstill is a very large demand for collaand AAA assets which markets areable to satisfy. Who knows what kinsubstitute the private sector will comwith? And, even worse, what kinfragilities will emerge from the factpolicymakers have not focused their e

gy on helping to shape this solutioninstead chose to fight the wars of the

LESSONS FROM EMERGINGMARKETS

Region: Id like to ask you about earlier work on emerging markets, ecially some of your research on sudstops and sterilization efforts. Wlessons can we learn about dealing recessions or the recent financial cfrom the experience of emerging mkets and their crises? What lesson

or are not pertinent?

Caballero: I think the main distinctithat for emerging markets and economies around the world, therebig difference between domestic andeign funding. There is a domestic aninternational liquidity. Most of my wwith Arvind is about this distinctionhow the largest crises are the resushortages of international liquidityarise during the so-called sudden sConsequently, my work on contin

arrangements for emerging marketsmarily with Stavros Panageas, is aoptimal insurance arrangements agthese sudden stops.14

In contrast, for the United Statesdistinction between domestic and innational liquidity doesnt make m

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Most of the regulatory changes that we

hear about are really not addressing the

fundamental problem: There was and still

is a very large demand for collateral and

AAA assets which markets are not able to

satisfy. Who knows what kind of substitute

the private sector will come up with? And,

even worse, what kind of fragilities will

emerge from the fact that policymakers

have not focused their energy on helping

to shape this solution.


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sense, and thus the current accountitself is not a primary concern. I thinkthis view was vindicated during the cri-sis, which had the United States as theepicenter, but the dollar appreciatedduring the worst of it!

Having said this, there is an analogywithin the United States itself. The crisiswas a sudden stop to its private financialsystemnot from foreigners, but fromall investors. Not surprisingly, some ofthe contingent insurance arrangementsthat apply to sovereigns also apply to theU.S. financial system.

The other analogy is that externalcapital flows concentrated in particularkinds of instruments did strain the U.S.financial system and expose its regulato-ry weaknesses. A much less sophisticat-ed version of this (in the sense that itdoesnt include complex financialinstruments and innovation) is alsocommon in the financial system ofemerging markets when they are flood-ed by capital flows.

Region: So in the recent crisis, there was

a shortage, but of a different kind: nottoo little international liquidity, but ascarcity of safe assets.

Caballero: In a sense, yes. The globalscarcity of safe assets is what created pres-sure and distorted the incentives of the

U.S. financial system. The analogy is thatinvestorssuddenly discovered that the safeassets the financial system was sellingwerent macro-safe. In that sense, it was ashortage of macro-safe assets that behaved

like a shortage of international liquidity.However, there was another key

scarcity during the crisis: a politicalshortage. The subprime crisis wasminute relative to the wealth of theUnited States, but thats irrelevant dur-ing a crisis when the political systembecomes an obstacle to the much-need-ed reallocation. I completely underesti-mated how significant a constraint thepolitical process could be. It was verymuch like that faced at the aggregatelevel by emerging markets when there is

a shortage of international liquidity.

THE ROLE OF THE IMF

Region: In 2003, you wrote an articleabout The Future of the IMF, and yousuggested that the InternationalMonetary Fund should do more to sup-port emerging markets when theyreunder stressbefore they enter full-blown cardiac arrestby helping todevelop hedging and insurance instru-ments, collateralized debt obligations(CDOs) of contingent bonds.15 This

sounds very much like your proposalabout aggregate insurance sold by thegovernment. Could you elaborate onyour contingent bond idea?

Caballero: First, I should clarify that Ididnt choose that title. It was anAmerican Economic Association ses-sion with a predetermined title. I neverfelt comfortable with it, so I redefinedthe IMF acronym in the first paragraphto mean International MarketFacilitator. The IMF does many things;

I just wanted to focus on the much nar-rower goal of facilitating private capitaldeployment to emerging markets dur-ing crises.

In that context, I thought the IMFcould play a dual role in supporting private sector facilities designed to sell

insurance to these countries. Aexample, I imagined that councould sell contingent debt instrumto a (mostly) privately funded CThe IMF would play a prequalificarole by determining which councould sell contingent debt to the CDand it would also put its money wits mouth is by investing in a jutranche of the CDO.

Come to think of it, this arrangemis not too different from the facithat the Europeans and IMF have ced recently to help the euro zperiphery economiesGreece, Ireand Portugal, in particulardurinongoing turmoil.

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The global scarcity of safe assets is what

created pressure and distorted the

incentives of the U.S. financial system.

Investors suddenly discovered that the

safe assets the financial system was selling

werent macro-safe. In that sense, it

behaved like a shortage of international

liquidity. However, there was another key

scarcity during the crisis: a political short-

age [which] becomes an obstacle to

the much-needed reallocation. I completely

underestimated how significant a

constraint the political process could be.

The IMF has been refining and

significantly enlarging its contingent

facilities. However, I dont think they ar

leveraging their resources much by

involving the private sector.They need

engage in joint ventures, not only with

governments but also with the private

sector. Since these would be systemical

fragile instruments, we dont want the

highly leveraged players to be holding ttranches without significant capital cha


10/14

Region: Has the IMF taken any steps inthat direction vis--vis emerging mar-kets? And have your thoughts about therole and relevance of the IMF or otherinternational financial institutions

changed since 2003, particularly in lightof the financial crisis?

Caballero: Yes, definitely. The IMF hasbeen refining and significantly enlarg-ing its contingent facilities. However, Idont think they are leveraging theirresources much by involving the privatesector. They need to engage in joint ven-tures, not only with governments butalso with the private sector.

The lesson of the current crisis forthese arrangements is that since these

would be systemically fragile instru-ments, we dont want the highly lever-aged players to be holding the trancheswithout significant capital charges.

RECESSIONS ANDRESTRUCTURING

Region: Some of your research in thepast has suggested that restructuringafter recessions is slower than manyeconomists believe, and youve lookedat some of the obstacles to restructur-ing, from labor market rigidities to

zombie lending. You emphasize theimportance of policies that enable cre-ative destruction to function moreswiftly, to restore microeconomic flexi-bility and better macro performance.

What do you see as current rigidities,either internationally or for specificnationsthe United States or in Europe,for instancethat are likely to impederecovery from the recent recession?

And should we be concerned aboutjobless recovery in the United States? Doyou think there might now be a higher

level of structural unemployment?

Caballero: Thats the gist of my workwith Mohamad Hammour from the1990s.16 This was a time when theimportant work of Steve Davis and JohnHaltiwanger in documenting the nature

of the process of job creation anddestruction in U.S. manufacturing led toan explosion of research trying toexplain this process.

One of the key features of their

findings was that recessions comewith sharp spikes in job destruction.Somehow, other researchers jumpedto the conclusion that this spike meantthat job reallocation was stronglycountercyclical. That is, that realloca-tion increased during recessions: asort of Schumpeterian cleansing.Many theories were written about thisphenomenon.

Mohamad and I made the ratherobvious observation that a spike in

destruction in itself does not meanreallocation increases during recesssince this would also require thatation increases. Steve and John already documented that job cre

actually falls at impact. We explwhether the initial spike in destructranslated into abnormally high ation during the recovery phase ocycle, which would be a dynamicsion of the countercyclical reallocastory. Not only did we not findincrease in creation during the recobut we found that job creation was aallybelow normal levels. That is, culative restructuring is procyclical,countercyclical.

We then went on to show th

model where financial constraints ten as a result of the recession cexplain such patterns. I think this iconnection with the current recovThis was a recession which sevdamaged the financial sector; henis not surprising that hiring is so mu

Of course, we need to add to thiswe still have a recession in the resideconstruction sector, which will unemployment high for quite some t

You also mention my workJapanese zombies with Anil KashyapTakeo Hoshi.17 There we documen

chronic version of the above phenonon. We showed how weak dombanks have depressed much-nerestructuring in post-bubble Japan.

THE PRETENSE-OF-KNOWLEDSYNDROME

Region: At the end of last year, you lished a rather biting critique of theboth academic and central bresearchers practice macroeconomYou warned that what you called

pretense-of-knowledge syndromdangerous for both methodologicapolicy reasons.

Would you briefly review thattique and elaborate on what you coner a silver liningthat by seeking and policies that are robust to the e

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37 JU

We explored whether the initial spike indestruction translated into abnormally

high creation during the recovery phase

of the cycle. We found that job creation

was actually belownormal levels. That is,

cumulative restructuring is procyclical, not

countercyclical. A model where financial

constraints tighten as a result of the

recession could explain such patterns.

This was a recession which severely dam-

aged the financial sector; hence, it is notsurprising that hiring is so muted.


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More About Ricardo J. Caballero

mous uncertainty to which we are con-fined, we can make some progress?Also, would you tell us how your col-leagues have responded to your critique?

Caballero: There is an enormous selec-tion bias in the reactions. Ive mostlyheard the positive ones, which havebeen plenty, but Im sure I didnt pleaseeveryonethere are many polite peoplein our profession [laughter].

Region: It occurs tome thatas head of thedepartment at MIT, you have real influ-

ence in terms of how economics is taughthere. Does it shape the way you teach andwhere you lead the department?

Caballero: Well, the assumption that a

department head has that kind of poweris quite a stretch [laughter]! Having saidthis, Im about to teach a course inwhich I will, in the introduction, talkbriefly about this methodological issue.But I still need to teach the basic models.That wont change.

In fact, I think it is very important toclarify that I am not antimodel. On the

contrary, the economy is so complexthere is little hope of understanding mwithout models. I just dont want tmodels to acquire a life that is indepent from the purpose they are ultim

designed to serve, which is to understhe functioning of real economies.

The critique part of the paperrefer to argued that the current comacroeconomics has become so merized with its own internal logicit begins to confuse the precision iachieved about its own world withprecision it has about the real one.

The Region

38JUNE 2011

Current Positions

Chair, Department of Economics, Massachusetts Institute of Technology,since 2008; Ford International Professor of Economics, since 2000;Co-director, World Economic Laboratory, since 2003; on MIT facultysince 1992

Previous Positions

Associate Professor of Economics, Columbia University, 199092;Assistant Professor, 198890

Visiting Scholar and Consultant: European Central Bank, Federal ReserveBoard of Governors, Inter-American Development Bank, InternationalMonetary Fund, World Bank and other central banks and government

institutions around the world on multiple occasions

Affiliations and Activities

Member, National Academy of Sciences Board on Mathematical Sciencesand Their Applications, since 2009

Associate Editor, Open-Assessment E-Journal, since 2006; Cuadernos deEconoma, since 1995; Revista de Anlisis Econmico, since 1992

Member, Editorial Board, MIT Press, since 2005-08; Journal ofRestructuring Finance, since 2003; Central Banking, Analysis andEconomic Policy Series, Central Bank of Chile

Member, International Scientific Committee, Revista di Politica Economica,since 2003

International Research Fellow, Kiel Institute of World Economics, since 2001

Member, Advisory Group, Brookings Panel on Economic Activity, since 1999

Member, Scientific Advisory Board, Centre de Recerca en EconomicaInternacional, Barcelona, since 1999

Research Associate, National Bureau of Economic Research, since 1994;NBER Faculty Fellow, 199194; NBER Olin Fellow, 199192

Research Fellow, Alfred P. Sloan Foundation, 199195

Honors and Awards

Fellow, American Academy of Arts and Sciences, since 2010

Emerald Management Review Citation of Excellence Award, 2008

Smith Breeden First Prize for Best Paper, Journal of Finance, 2008

Frisch Medal, Econometric Society, 2002

Chiles Economist of the Year, El Mercurio(Chilean newspaper), 2001

Fellow, Econometric Society, since 1998

Publications

Prolific author of journal articles, books, chapters, popular articles andop-eds on macroeconomics, international economics and finance. Currentresearch on global capital markets, financial bubbles, crisis preventionand dynamic restructuring. Policy work on aggregate risk managementfor emerging markets and developed economies.

Education

Massachusetts Institute of Technology, Ph.D. in economics, 1988

Pontificia Universidad Catlica de Chile, M.A. in economics, 1983Pontificia Universidad Catlica de Chile, B.S. in economics, 1982


12/14

There is absolutely nothing wrongwith building stylized structures as justone more tool to understand a piece ofthe complex problem. My problemswith this start when these structures

take on a life on their own, andresearchers choose to take the modelseriouslya statement that signals thetime to leave a seminar, for it is alwaysfollowed by a sequence of nave and sur-real claims.

The quantitative implications of thiscore approach, which are built on sup-posedly micro-founded calibrations ofkey parameters, are definitely on the sur-real side. Take, for example, the pre-ferred micro-foundation of the supplyof capital in the workhorse models of the

core approach. A key parameter to cali-brate in these models is the intertempo-ral substitution elasticity of a representa-tive agent, which is to be estimated frommicro-data. A whole literature developsaround this estimation, which narrowsthe parameter to certain values, whichare then to be used and honored by any-one wanting to say something aboutmodern macroeconomics.

This parameter may be a reasonableestimate for an individual agent facing aspecific micro decision, but what does ithave to do with the aggregate? What

happened with the role of Chinesebureaucrats, Gulf autocrats and the likein the supply of capital? A typicalanswer is not to worry about it, becausethis is all as if. But then, why do we callthis strategy micro-foundation ratherthan reduced-form?

My point is that by some strange herd-ing process, the core of macroeconomicsseems to transform things that may havebeen useful modeling short-cuts into apart of a new and artificial reality. Andnow suddenly everyone uses the same

language, which in the next iteration getsconfused with, and eventually replaces,reality. Along the way, this process ofmake-believe substitution raises our pre-sumption of knowledge about the work-ings of a complex economy and increasesthe risks of a pretense of knowledge

about which Hayek warned us in hisNobel Prize acceptance speech.

Region: We mistake the model for truthitself.

Caballero: Yes. It is much more conven-ient to talk about things we understandthan about things we are struggling tounderstand. But at the end of the day,were supposed to explain the thingsthat are hard to understand, so we arespinning the wheels to help us feel busyrather than making actual progress.

Region: What should be done to improvethis state of affairs?

Caballero: I argue in the paper that thereare lots of useful insights being producedin the periphery of macroeconomics,and that perhaps a key step is to embracethe complexity of the environment andwhat it does to economic agents andtheir decisions, as well as to our conclu-

sions as researchers. I think the worrobust control by Hansen, Sargentothers is a step in the right directalthough it still assumes that policymers know too much.

But a big part of my point is thaone really knows with any certawhat we need to do next, and hencneed to allow for much more freedoexploration. We shouldnt specialimuch in one particular class of mobecause were not sufficiently close tabsolute truth to do that. Thats the mal thing to do when youre very

to the global maximum, which w

not. We should be a lot more toleraalternative approaches and never foour mission, which is to help unstand an overwhelmingly complex ity, not to replace it with one thmore convenient to us as researche

Region: Thank you very much.

Douglas ClemMarch 22,

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39 JU

It is very important to clarify that I am not

antimodel. On the contrary, the economy

is so complex that there is little hope ofunderstanding much without models.

The current core of macroeconomics has

become so mesmerized with its own inter-

nal logic that it begins to confuse the preci-

sion it has achieved about its own world

with the precision it has about the real one.

We need to allow for much more freedom

of exploration. We shouldnt specialize so

much in one particular class of models.

We should be a lot more tolerant of

alternative approaches and never forget our

mission, which is to help understand an

overwhelmingly complex reality, not to

replace it with one that is more convenient

to us as researchers.


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Endnotes

1 Bernanke, Ben S. 2005. The Global Saving Glut

and the U.S. Current Account Deficit. Remarks at

the Sandridge Lecture, Virginia Association of

Economists, Richmond, Va., March 10.2 Caballero, Ricardo J., Emmanuel Farhi and Pierre-

Olivier Gourinchas. 2008. An Equilibrium Model

of Global Imbalances and Low Interest Rates.

American Economic Review98 (1), 358-93.

3 Gourinchas, Pierre-Olivier, and Hlne Rey. 2007.

From World Banker to World Venture Capitalist:

U.S. External Adjustment and the Exorbitant

Privilege. In Current Account Imbalances:

Sustainability and Adjustment. Richard H. Clarida,

ed. University of Chicago Press, 11-66.

4 Caballero, Ricardo J., and Arvind Krishnamurthy.

2009. Global Imbalances and FinancialFragility.American Economic Review99 (2),

584-88.

5 See articles listed at

http://econ-www.mit.edu/faculty/caball/light.

6 Caballero, Ricardo, J. 2009. Sudden Financial

Arrest. Paper presented at the 10th Jacques

Polak Annual Research Conference, International

Monetary Fund, Washington, D.C., Nov. 5-6.

7 Caballero, Ricardo J., and Alp Simsek. 2011.

Fire Sales in a Model of Complexity.

8 Caballero, Ricardo J., and Arvind Krishnamurthy.

2008. Collective Risk management in a Flight to

Quality Episode. Journal of Finance63 (5),

2195-2230.

9 Caballero, Ricardo J., and Pablo D. Kurlat. 2009.

The Surprising Origin and Nature of Financial

Crises: A Macroeconomic Proposal. MIT

Department of Economics Working Paper 09-24.

10Interview. The Region. December 2010. Federal

Reserve Bank of Minneapolis.

11Go to http://www.princeton.edu/~markus/.

12See, for example, Federal Reserve Bank of New

York Staff Reports 346 and 382.13 Go to

http://whitepapers.stern.nyu.edu/home.html.

14 See, for example, NBER Working Papers 10786

and 11293.

15 Caballero, Ricardo J. 2003. The Future of the

IMF. American Economic Review93 (2), 31-38.

16 Caballero, Ricardo J., and Mohamad L.

Hammour. 2005. The Cost of Recessions

Revisited: A Reverse-Liquidationist View. Reviewof Economic Studies72, 313-41.

Caballero, Ricardo J., and Mohamad L. Hammour.

1999. Institutions, Restructuring, and

Macroeconomic Performance. Invited lecture,

12th World Congress of the International

Economic Association, Buenos Aires, Argentina,

August 25.

Caballero, Ricardo J., and Mohamad L. Hammour.1998. Jobless Growth: Appropriability, FactorSubstitution and Unemployment. Carnegie-Rochester Conference Series on Public Policy48(June), 51-94.

Caballero, Ricardo J., and Mohamad L. Hammour.1996. On the Ills of Adjustment. Journal ofDevelopment Economics51, 161-92.

Caballero, Ricardo J., and Mohamad L. Hammour.1996. On the Timing and Efficiency of CreativeDestruction. Quarterly Journal of Economics446(3), 805-52.

17 Caballero, Ricardo J.,Takeo Hoshi and Anil K.

Kashyap. 2008. Zombie Lending and Depressed

Restructuring in Japan. American Economic

Review98 (5), 1943-77.

18 Caballero, Ricardo J. 2010. Macroeconomics

after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome. MIT Department of

Economics Working Paper 10-16.

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interview with ricardo caballero

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