We have other models in which the probability of such distress may be related to various characteristics of banks, such as whether they are comfortably within thresholds for capital adequacy – the argument being that as they get closer to the threshold, depositors become less confident about the stability of each other’s behaviour. 26 And we have models in which bank capital is affected by macroeconomic developments; and models in which, through financial accelerator-like mechanisms, impaired bank capital affects the supply of credit, 27 and so potentially macroeconomic variables. But we don’t yet have models in which the determinants of the probability of banking system distress are influenced by the macro environment; and in which such distress can, really, occur and affect the macro environment. That seems to call for somehow embedding gametheoretic strategic interactions within dynamic macro models. 28  23  See Allen, F, and Gale, D, (2007) “Understanding Financial Crises”, Oxford University Press. 24  Commenting on a recent paper by Michael Woodford, Charles Goodhart (pointed out that the model incorporated credit risk premia but not default. Everyone is hoping that Woodford picks up the challenge. (See Goodhard, C, comments on “Credit Frictions and Optimal Monetary Policy” by Curdia and Woodford (2008). These were given at the 7th BIS Annual Conference. 25  See Diamond DW, Dybvig PH, (1983) “Bank runs, deposit insurance, and liquidity” Journal of Political Economy 91, pp401-19.
First, while papers are still produced in the tradition that “macroeconomists can safely go on ignoring finance”, we – policymakers – are having to make sense of a macro environment in which the supply of credit has been interrupted by problems sourced in part to swings in risk premia, and quite possibly swings in risk aversion. Models incorporating risk premia – and, indeed, embracing bubbles – might just help us with that. But it is striking that, so far, the progress in finance hardly features in the macro models used around the world for forecasting. Indeed, such models barely recognise the existence of financial instruments beyond risk-free bonds and equities. 19 In modern DSGE models, asset prices (and so risk premia) merely reflect economic developments; they are not “actors” in any way. Even if we were to accept that risk premia are not “actors”, for policymakers they might serve as useful diagnostics of what is going on in the economy – of the nature of the underlying shocks – given that asset price changes are typically apparent some time before the associated real economy adjustments. On that view, we need research that will help us read the “risk premia” tea leaves. For example, an increase in premia that could be traced to an increase in the correlation between consumption and investment returns, might point to a prospective increase in households’ precautionary saving.