The way standard models deal with [financial instability] is, I think, incorrect. A lot of macroeconomists think in terms of an amplification mechanism. So you imagine that a shock hits the economy. The question is: What magnifies that shock and makes it have a bigger effect than it would otherwise have? That way of thinking would suggest that we live in an economy where shocks hit regularly and they’re always amplified, but every once in a while, there’s a big enough shock … So, in this way of thinking, it’s the size of the shock that’s important. A “crisis” is a “big shock.”This one, on how some people "understand" the financial crisis, is good:
I don’t think that’s what we observe in the world. We don’t see lots and lots of shocks being amplified. We see a few really big events in history: the recent crisis, the Great Depression, the panics of the 19th century. Those are more than a shock being amplified. There’s something else going on. I’d say it’s a regime switch—a dramatic change in the way the financial system is operating.
This notion of a kind of regime switch, which happens when you go from debt that is information-insensitive to information-sensitive is different conceptually than an amplification mechanism. So there’s a problem. Conceptually, the notion of adding things to existing models—a friction or an amplification mechanism—retains this overall paradigm in which financial intermediation generally has no role. I don’t think that is going to work.
After the fact, things always look clearer, don’t they? Monday morning. People make statements like, “Obviously, there was too much leverage.” That’s like saying the patient died because his heart stopped beating or inflation is caused by prices going up. Obviously, there was leverage. That’s why I said before that you need a theory of debt; you need to explain why there’s this debt and what is the purpose of having this debt. Does that security, which is optimal, have consequences that are socially suboptimal or not? What’s the problem? To make progress, we need to say more rather than just repeating these things.The interview is a nice summary of Gary's work, and you can read more about it if you follow the references. His regulatory reform proposal for "narrow-funding banks," is particularly interesting.