Ricardo Caballero

The recent financial crisis and subsequent recession have launched a thousandtheories from economists eager to explain how a relatively small shock in subprimemortgages led to the most severe financial and economic collapse since the GreatDepression. With few exceptions, however, these theories have disregarded globalfactors that fueled the crisis.

The insights of Ricardo Caballero stand in distinct contrast. Backed byyears of research on crises in emerging markets, the Chilean scholar’s recent workilluminates how international capital markets with “an insatiable hunger for safedebt instruments” led U.S. financial institutions to create assets that met technicalAAA risk standards but were highly sensitive to macroeconomic, systemic stress.

Global markets froze after the subprime implosion caused confusion atfirst, and then a cascade of panic and withdrawal among investors who previouslybelieved they held safe assets. “Knightian uncertainty,” Caballero explains, inwhich even the unknowns aren’t known, induces the financial equivalent ofcardiac arrest.

Other economists have developed related ideas, of course: global savingsgluts, shadow banking panics. But Caballero blends streams of research on inter-national capital flows, debt markets and finance theory into a coherent theory ofsystemic crisis.

This leads to policy tools that others overlook. While not dismissingmoral 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 governmentitself. Policy measures taken to date, he suggests, have not remedied the funda-mental fragility of the world’s unappeased demand for safe assets.

As chair of one of the world’s leading economics departments, Caballerois also a critical observer of his own field. He’s concerned that macroeconomiststoday are reluctant to admit that their models ignore empirical realities, that theytoo often embrace the beauty of theory rather than dealing with hard truths thatdon’t 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 powerfulapproach to macroeconomic research and policy.

Photographs by Peter Tenzer

ASSET SCARCITY ANDFINANCIAL CRISIS

Region: I’d like to focus initially on thefinancial crisis. You’ve written that theheart of the crisis wasn’t so much laxmonetary policy or a faulty regulatoryregime, but rather global asset scarcity,which led to the United States holding a“toxic waste” of highly risky assets—agreat phrase. It’s an intriguing idea,somewhat novel to me. Could youexplain briefly what you mean?

Ricardo Caballero: It’s 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 anasset shortage environment would oth-erwise trigger strong deflationary forces.

This idea is related to Ben Bernanke’ssavings 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 worldhad “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 Gourinchasand 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 EconomicAssociation] meetings.4

The enormous demand for U.S.assets, with a heavy bias toward “AAA”instruments, could not be satisfied byU.S. Treasuries and single-name corpo-rate bonds, and that imbalance generat-ed huge incentives for the U.S. financialsystem to produce more “AAA” assets.

As a result, we saw both the good andthe bad sides of the most dynamic finan-cial system in the world, in full force.Subprime loans became inputs intofinancial vehicles, which by the law oflarge numbers* and by the principles oftranching were able to create “AAA”instruments from those that were not.

Region: You mean “seemingly” AAAassets, right? Many contend that ratingagencies were too soft in their ratings ofthese senior tranches.

Caballero: Even if they were, that was notthe main problem. A rating of AAA onlymeans that the probability of default ofthat instrument is sufficiently low tomeet this high standard, but it doesn’tsay when that instrument will default.Unfortunately, by construction, AAAtranches generated from lower-qualityassets are fragile with respect to macro-economic and systemic shocks, whenthe law of large numbers doesn’t work.That is, this way of creating safe assetsmay be able to create micro-AAA assetsbut not macro-AAA assets. In otherwords, these assets were not veryresilient to macroeconomic shocks, eventhough they might have technically metAAA risk standards.

In principle, this was not a big issue,but it became a huge one when highlyleveraged systemically important insti-tutions began to keep these macro-frag-ile instruments in their balance sheets(directly, or indirectly through special-purpose vehicles, or SPVs). This was anaccident waiting to happen; AIG and theinvestment banks should have knownbetter, but the low capital charges weretoo hard to resist.

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The enormous demand for U.S. assets, with

a 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 onpage 40.

Region: So you do favor higher capitalrequirements ?

Caballero: I don’t believe that increasingcapital requirements for banks acrossthe 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 obligation’s 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 knownunknowns 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 not—things are much less clear.

Financial institutions (and humanbeings in general) behave very differentlywhen they don’t understand the risksinvolved than when they do. In the lattercase—straightforward risk—they canadjust their portfolios marginally toaccommodate any change in risk profiles.

But with uncertainty, when institu-tions or people don’t truly understandwhat the risks are, they know or feelsomething is wrong but don’t 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 systemsince, all of a sudden, the maturitytransformation—the vital role financialsystems provide in converting short-term liabilities into long-term assets—has to be undone. But this simply can’tbe done when everybody wants to do itat the same time—bank runs are anobvious example of this impossibility—and 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 extremeidiosyncratic events. But it would be toocostly to have the financial systemhoard capital sufficient to deal with thepanic component of crises. Neitherbanks individually nor the financial sys-tem as a whole should be required to beprepared—in terms of capital reserves—for another Lehman/AIG-like event.That would require freezing an enor-mous amount of capital. It would bevery wasteful.

There is a point in a panic when thegovernment has to say: “Just hold on.Ninety percent of the problem is now thepanic. It’s not a real phenomenon, so ifwe just get rid of the panic, we’re done.”

Region: Like Roosevelt’s “The only thingwe have to fear is fear itself.”

Caballero: Exactly. But, of course, justsaying this won’t do much; it needs to bebacked up by a commitment to supportthe system, and there are always realthings to fix as well.

There are several proposals out thereto reduce the cost of the buffer by hav-ing capital be “contingent”—that is, hav-ing capital available not at all times butonly when events justify it. This is a stepin the right direction, and the rightthing to do for idiosyncratic shocks ornormal recessions.

But contingent capital isn’t an ade-quate tool for fighting the kind of panicsthat arise from Knightian uncertainty.It’s still too expensive as a mechanismfor dealing with that level of panic. Forsuch situations, the system doesn’t needcapital but rather insurance or a guaran-tee that the system will survive. Anxietyis reduced by cutting off the tail of thedistribution of possible outcomes,which is poorly understood and fright-ening, and mostly made of self-fulfillingscenarios.

The advantage of a cheaper arrange-ment is not that it makes bankers’ liveseasier, but that it allows the system tohave a much larger weapon againstthese events. Banks should pay a fee in

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With uncertainty, when institutions or

people don’t 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.

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 alot 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?Doesn’t 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. Thegovernment 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 Ireland’s government providedthe guarantees after the crisis began, andhence didn’t charge banks for the insur-ance premium in advance. The structureof these premia is important to providethe right incentives to banks. Still, weshouldn’t be so naïve 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 normalevents, 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, you’re talking about the potentialfor moral hazard. You’ve 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. You’vewritten, 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 don’t 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 to thepolitical pressures stemming from thisview. What timing! The systemicproblem of moral hazard is that peopletake too much risk relative to what issocially optimal. But during a crisis—especially one that is triggered byuncertainty and panic—the problem isexactly the opposite: People are takingtoo little risk. That’s what flight toquality is all about. The most effectivepolicies at that point are those thatinduce people to reload on risk.

I wrote many op-eds at all stages ofthe crisis trying to remind policymakersthat punishing institutions, and trying toprovide long-term lessons in the middleof the crisis, was likely to add fuel to theuncertainty fire.5 Unfortunately, peopleneed to see in order to believe—a verycostly attitude during crises that areinherently very nonlinear phenomena.

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The systemic problem of moral hazard is

that people take too much risk relative to

what is socially optimal. But during a

crisis—especially one that is triggered by

uncertainty and panic—the problem is

exactly the opposite: People are taking too

little risk. … The most effective policies at

that point are those that induce people to

reload on risk.

Region: You’ve made an analogy, Ibelieve, that providing such lessons islike teaching people to eat right whenthey’re 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 thatit’s very important to have a good dietand good exercise in order to preventcardiac arrest. But once you’re in aseizure, that’s a totally secondaryissue. You’re not going to solve the cri-sis by improving the diet of thepatient. You don’t have time for that.You need a financial defibrillator, nota lecture.

Region: And you’ve also suggested,haven’t 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, it’s ludicrous to sug-gest that anticipation of support (a“bailout”) in an extreme systemic eventis one of the most significant sources ofmoral hazard.

With very few exceptions—perhapsFannie 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.Nothing is further from theseinvestors’ 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 onebelieves 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 fromthe wrong diagnosis.

The main dogma behind the greatresistance 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 theplacement 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. Surelythere 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 inreal life.

Region: But then it seems you’re giving abreak to the bankers, by not providingtangible—that is to say, financially puni-tive—lessons about the danger of theirexcessive risk-taking.

Caballero: If you think that calling themshortsighted and irrational is givingthem a break, then I guess I’m doingthat [laughter] ...

By the way, CEOs, equity owners andeven debt holders of banks go throughmiserable times during these crises, asdo politicians and countries that areeventually “bailed out” by the IMF[International Monetary Fund]. So theidea that they did what they did becausethey anticipated the bailout is reallystrange, to say the least.

I am not defending their investmentdecisions. I agree that they were thewrong ones. But the reason they madethese decisions was not their anticipationof a bailout. So why pay the enormouscost of not having a good antipanicmechanism in place if its absence is not asignificant source of better behavior?

FIRE SALES AND COMPLEXITY

Region: Would you tell us about yourrecent work with Alp Simsek on firesales, complexity and externalities?7

Caballero: I think that the essence ofmany of our problems in macroeco-nomics as a field stems from theassumption that we, as researchers andpolicymakers, and the economic agentswe model understand things much,much better than is actually the case.

The economy is an incredibly com-plex object—and I mean “complex” inthe sense of very hard to understand.This complexity is not something wecan just get rid of in the process ofwriting simple models, for it is centralto economic behavior during crises.My work with Alp is an attempt to cap-ture a small part of this complexityproblem and its role during financialcrises.

The basic idea is that the economy is avery complicated network of connections,but most of the time economic agents cango about their daily activities withoutworrying about those complications. Tosucceed, you—or financial institutions in

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our model—just 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 anindirect 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, acomplexity 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 neighbor’s 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 size—say, for example, a bank’sdecision not to use its liquidity to pur-chase distressed assets—has 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 you dis-cuss some of those? Also, economistssometimes propose that externalities betaxed. Is there any role for taxation?

Caballero: Yes, there’s a role, althoughthey come in mixtures. For example, abailout of distressed institutions fundedby small lump-sum taxes on all the banksmay lead to Pareto improvements.Without such a policy, our model’s equi-librium fails to replicate this redistribu-tion—that is, the financial system won’tprovide this solution if left to its owndevices—because each bank fails to inter-nalize that its contribution to a bailoutwill reduce payoff uncertainty of allbanks. My sense is that the many effortsby Treasury and the Fed during the crisisto find and “persuade” the main banks tobuy distressed assets were of this kind.

But also, once the system is in the firesales equilibrium, policies that supportasset prices become very effective bycoordinating agents closer to a fair-priceequilibrium. Many of the most success-ful policies implemented during the cri-sis were of this kind—for example, thesupport for the commercial paper mar-ket and the backup liquidity facility formoney markets. Unfortunately, thepolitical process often delayed thesepolicies to a point where much of thedamage had already been done.

Region: You advocated the latter kind ofpolicy in your 2008 paper with ArvindKrishnamurthy,8 and then in JacksonHole in your 2009 paper with PabloKurlat.9

Caballero: Yes. I began to work onKnightian uncertainty and its policyconclusion with Arvind well before thecrisis. We argued that a lender-of-last-resort facility would be particularlyeffective in dealing with panics of thiskind even if the policymaker is lessinformed than the private banks aboutthe allocation of distress. When we firstwrote that paper, not many peoplenoticed it, but then the crisis came and

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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.

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 buyex 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 doesn’t have the right speedto deal with a panic-driven crisis. Weneed to be prepared in advance. That’swhere 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? GaryGorton’s work on shadow banking pan-ics, for instance.10 Princeton’s MarkusBrunnermeier’s research also comes tomind;11 as well as the work of Adrianand Shin at the New York Fed,12 and theNYU-Stern Business School folks13—these economists and others have beenstudying financial crises, with a focuson this past one.

Would you describe how your ideasare 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, linkagesgone 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 of the AAA asset demand I’ve beentalking about, although I have highlight-ed more the role of sovereign investorsthan that of the repo market. Also, hiswork with Bengt Holmström pointingout the importance of the information-insensitiveness of debt contracts for thefunctioning of repo markets, and how allhell breaks loose once debt becomesinformation-sensitive, resembles thecomplexity threshold mechanism of mywork with Alp.

Relative to most economists, Garyand I tend—for severe systemicevents—to place blame less on incentivefailures and more on accidents that arise

from the very nature of what financialintermediaries do. As such, it is not sur-prising that our policy emphasis is onhow to prevent and deal with these acci-dents rather than—or not as much—onhow to constrain the financial system soit doesn’t misbehave.

Similarly, I share with Gary the viewthat most of the regulatory changes thatwe hear about are really not addressingthe fundamental problem: There was andstill is a very large demand for collateraland AAA assets which markets are notable to satisfy. Who knows what kind ofsubstitute the private sector will come upwith? And, even worse, what kind offragilities will emerge from the fact thatpolicymakers have not focused their ener-gy on helping to shape this solution butinstead chose to fight the wars of the past?

LESSONS FROM EMERGINGMARKETS

Region: I’d like to ask you about yourearlier work on emerging markets, espe-cially some of your research on suddenstops and sterilization efforts. Whatlessons can we learn about dealing withrecessions or the recent financial crisisfrom the experience of emerging mar-kets and their crises? What lessons areor are not pertinent?

Caballero: I think the main distinction isthat for emerging markets and mosteconomies around the world, there is abig difference between domestic and for-eign funding. There is a domestic and aninternational liquidity. Most of my workwith Arvind is about this distinction andhow the largest crises are the result ofshortages of international liquidity thatarise during the so-called sudden stops.Consequently, my work on contingentarrangements for emerging markets, pri-marily with Stavros Panageas, is aboutoptimal insurance arrangements againstthese sudden stops.14

In contrast, for the United States, thedistinction between domestic and inter-national liquidity doesn’t make much

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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.

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 financialsystem—not 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 itdoesn’t 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 wasa 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 thatinvestors suddenly discovered that the safeassets the financial system was sellingweren’t macro-safe. In that sense, it was ashortage ofmacro-safe assets that behavedlike a shortage of international liquidity.

However, there was another keyscarcity during the crisis: a politicalshortage. The subprime crisis wasminute relative to the wealth of theUnited States, but that’s 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 isa 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 they’reunder stress—before they enter full-blown cardiac arrest—by helping todevelop hedging and insurance instru-ments, collateralized debt obligations(CDOs) of contingent bonds.15 Thissounds very much like your proposalabout aggregate insurance sold by thegovernment. Could you elaborate onyour contingent bond idea?

Caballero: First, I should clarify that Ididn’t 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 pri-vate sector facilities designed to sell

insurance to these countries. As anexample, I imagined that countriescould sell contingent debt instrumentsto a (mostly) privately funded CDO.The IMF would play a prequalificationrole by determining which countriescould sell contingent debt to the CDOs,and it would also put its money whereits mouth is by investing in a juniortranche of the CDO.

Come to think of it, this arrangementis not too different from the facilitiesthat the Europeans and IMF have creat-ed recently to help the euro zone’speriphery economies—Greece, Irelandand Portugal, in particular—during theongoing 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

weren’t 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 don’t think they are

leveraging their resources much by

involving the private sector. They need to

engage in joint ventures, not only with

governments but also with the private

sector. Since these would be systemically

fragile instruments, we don’t want the

highly leveraged players to be holding the

tranches without significant capital charges.

Region: Has the IMF taken any steps inthat direction vis-à-vis emerging mar-kets? And have your thoughts about therole and relevance of the IMF or otherinternational financial institutionschanged since 2003, particularly in lightof the financial crisis?

Caballero: Yes, definitely. The IMF hasbeen refining and significantly enlarg-ing its contingent facilities. However, Idon’t 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 thesewould be systemically fragile instru-ments, we don’t 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 you’ve lookedat some of the obstacles to restructur-ing, from labor market rigidities tozombie 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 specificnations—the United States or in Europe,for instance—that 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 higherlevel of structural unemployment?

Caballero: That’s 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 theirfindings 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 mean thatreallocation increases during recessions,since this would also require that cre-ation increases. Steve and John hadalready documented that job creationactually falls at impact. We exploredwhether the initial spike in destructiontranslated into abnormally high cre-ation during the recovery phase of thecycle, which would be a dynamic ver-sion of the countercyclical reallocationstory. Not only did we not find thisincrease in creation during the recovery,but we found that job creation was actu-ally below normal levels. That is, cumu-lative restructuring is procyclical, notcountercyclical.

We then went on to show that amodel where financial constraints tight-en as a result of the recession couldexplain such patterns. I think this is theconnection with the current recovery.This was a recession which severelydamaged the financial sector; hence, itis not surprising that hiring is so muted.

Of course, we need to add to this thatwe still have a recession in the residentialconstruction sector, which will keepunemployment high for quite some time.

You also mention my work onJapanese zombies with Anil Kashyap andTakeo Hoshi.17 There we documented achronic version of the above phenome-non. We showed how weak domesticbanks have depressed much-neededrestructuring in post-bubble Japan.

THE PRETENSE-OF-KNOWLEDGESYNDROME

Region: At the end of last year, you pub-lished a rather biting critique of the wayboth academic and central bankresearchers practice macroeconomics.18You warned that what you called the“pretense-of-knowledge syndrome” isdangerous for both methodological andpolicy reasons.

Would you briefly review that cri-tique and elaborate on what you consid-er a silver lining—that by seeking toolsand policies that are robust to the “enor-

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We explored whether the initial spike in

destruction translated into abnormally

high creation during the recovery phase

of the cycle. … We found that job creation

was actually below normal 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 not

surprising that hiring is so muted.

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. I’ve mostlyheard the positive ones, which havebeen plenty, but I’m sure I didn’t pleaseeveryone—there are many polite peoplein our profession [laughter].

Region: It occurs to me that as 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 adepartment head has that kind of poweris quite a stretch [laughter]! Having saidthis, I’m 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 won’t change.

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

contrary, the economy is so complex thatthere is little hope of understanding muchwithout models. I just don’t want thesemodels to acquire a life that is independ-ent from the purpose they are ultimatelydesigned to serve, which is to understandthe functioning of real economies.

The critique part of the paper yourefer to argued that the current core ofmacroeconomics has become so mes-merized with its own internal logic thatit begins to confuse the precision it hasachieved about its own world with theprecision it has about the real one.

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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, 1990–92;Assistant Professor, 1988–90

Visiting Scholar and Consultant: European Central Bank, Federal ReserveBoard of Governors, Inter-American Development Bank, InternationalMonetary Fund, World Bank and other central banks and governmentinstitutions 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 deEconomía, since 1995; Revista de Análisis Económico, 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, 1991–94; NBER Olin Fellow, 1991–92

Research Fellow, Alfred P. Sloan Foundation, 1991–95

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

Chile’s 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 Católica de Chile, M.A. in economics, 1983

Pontificia Universidad Católica de Chile, B.S. in economics, 1982

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 structurestake on a life on their own, andresearchers choose to “take the modelseriously”—a statement that signals thetime to leave a seminar, for it is alwaysfollowed by a sequence of naïve 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 thecore 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 about“modern” macroeconomics.

This parameter may be a reasonableestimate for an individual agent facing aspecific micro decision, but what does ithave to do with the aggregate? Whathappened 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 samelanguage, 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,we’re 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 work onrobust control by Hansen, Sargent andothers is a step in the right direction,although it still assumes that policymak-ers know too much.

But a big part of my point is that noone really knows with any certaintywhat we need to do next, and hence weneed to allow for much more freedom ofexploration. We shouldn’t specialize somuch in one particular class of modelsbecause we’re not sufficiently close to anabsolute truth to do that. That’s the opti-mal thing to do when you’re very close

to the global maximum, which we arenot. We should be a lot more tolerant ofalternative approaches and never forgetour mission, which is to help under-stand an overwhelmingly complex real-ity, not to replace it with one that ismore convenient to us as researchers.

Region: Thank you very much.

—Douglas ClementMarch 22, 2011

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39 JUNE 2011

It is very important to clarify that I am not

antimodel. On the contrary, the economy

is so complex that there is little hope of

understanding 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 shouldn’t 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.

Glossary

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AAA instrumentsA financial instrument with the highest credit rating givenby debt agencies such as Standard & Poors and Moody’s.

Capital requirementsA bank regulation setting specific levels and types of capitalto be held in reserve by the bank rather than invested orloaned to others.

Collateralized debt obligation (CDO)A type of security whose value and payments derive from aportfolio of fixed-income assets; in this case, those assetswould be contingent bonds.

Credit default swap (CDS)A type of insurance that protects the lender if the borrowerdefaults. If the loan defaults, its liability becomes a credit forpayment from the CDS issuer.

ExternalitiesIndirect effects of a consumption or production activity onagents other than the originator of such activity not reflect-ed in prices.

Knightian uncertaintyAfter economist Frank Knight, who distinguished betweenrisk and uncertainty in his 1921 book, Risk, Uncertainty,and Profit.

Law of large numbersA probability theorem describing the result of performingthe same experiment many times. The average of resultsfrom a number of trials will become closer to the expectedvalue as more trials are performed.

Moral hazardWhen persons or institutions protected from risk are there-by encouraged to take on more risk than they would if notso protected.

Special-purpose vehicles, or SPVsLegal entities established for narrow and often temporaryobjectives related to regulation, taxation or risk. SPVs areset up by a sponsoring firm specifically to achieve thoseobjectives. An SPV is not an operating company in theusual sense, but rather a “robot” company—a set of ruleswithout employees or a physical location.

SterilizationAny form of monetary policy undertaken to maintaindomestic money supply in the face of international capitalflows. Often done to minimize currency appreciation andinflation due to such transfers.

Sudden stopsA sudden slowdown or reversal in a country’s capitalinflows.

TranchingDividing into portions, usually by level of risk.

Zombie lendingOtherwise known as “forbearance lending,” the term refersto the practice, prevalent in Japan in the early 1990s, ofbanks continuing to lend to otherwise insolvent firms(“zombies”).

Endnotes1Bernanke, Ben S. 2005. “The Global Saving Glutand the U.S. Current Account Deficit.” Remarks atthe Sandridge Lecture, Virginia Association ofEconomists, Richmond, Va., March 10.

2Caballero, Ricardo J., Emmanuel Farhi and Pierre-Olivier Gourinchas. 2008. “An Equilibrium Modelof ‘Global Imbalances’ and Low Interest Rates.”American Economic Review 98 (1), 358-93.

3Gourinchas, Pierre-Olivier, and Hélène Rey. 2007.“From World Banker to World Venture Capitalist:U.S. External Adjustment and the ExorbitantPrivilege.” In Current Account Imbalances:Sustainability and Adjustment. Richard H. Clarida,ed. University of Chicago Press, 11-66.

4Caballero, Ricardo J., and Arvind Krishnamurthy.2009. “Global Imbalances and FinancialFragility.”American Economic Review 99 (2),584-88.

5 See articles listed athttp://econ-www.mit.edu/faculty/caball/light.

6Caballero, Ricardo, J. 2009. “Sudden FinancialArrest.” Paper presented at the 10th JacquesPolak Annual Research Conference, InternationalMonetary Fund, Washington, D.C., Nov. 5-6.

7Caballero, Ricardo J., and Alp Simsek. 2011.“Fire Sales in a Model of Complexity.”

8Caballero, Ricardo J., and Arvind Krishnamurthy.2008. “Collective Risk management in a Flight toQuality Episode.” Journal of Finance 63 (5),2195-2230.

9Caballero, Ricardo J., and Pablo D. Kurlat. 2009.“The ‘Surprising’ Origin and Nature of FinancialCrises: A Macroeconomic Proposal.” MITDepartment of Economics Working Paper 09-24.

10 Interview. The Region. December 2010. FederalReserve Bank of Minneapolis.

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

12See, for example, Federal Reserve Bank of NewYork Staff Reports 346 and 382.

13Go tohttp://whitepapers.stern.nyu.edu/home.html.

14 See, for example, NBER Working Papers 10786and 11293.

15Caballero, Ricardo J. 2003. “The Future of theIMF.” American Economic Review 93 (2), 31-38.

16Caballero, Ricardo J., and Mohamad L.Hammour. 2005. “The Cost of RecessionsRevisited: A Reverse-Liquidationist View.” Reviewof Economic Studies 72, 313-41.

Caballero, Ricardo J., and Mohamad L. Hammour.1999. “Institutions, Restructuring, andMacroeconomic Performance.” Invited lecture,12th World Congress of the InternationalEconomic 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 Policy 48(June), 51-94.

Caballero, Ricardo J., and Mohamad L. Hammour.1996. “On the Ills of Adjustment.” Journal ofDevelopment Economics 51, 161-92.

Caballero, Ricardo J., and Mohamad L. Hammour.1996. “On the Timing and Efficiency of CreativeDestruction.” Quarterly Journal of Economics 446(3), 805-52.

17Caballero, Ricardo J., Takeo Hoshi and Anil K.Kashyap. 2008. “Zombie Lending and DepressedRestructuring in Japan.” American EconomicReview 98 (5), 1943-77.

18Caballero, Ricardo J. 2010. “Macroeconomicsafter the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome.” MIT Department ofEconomics Working Paper 10-16.

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