The first lesson is to give financial markets a more central role in macroeconomic frameworks. The fact that frictions in financial markets can amplify business cycles has long been understood, but was not central in economic analysis until 2007. This has changed: there is a rich and growing literature on the impact of banks and financial intermediaries in macroeconomics, which now includes problems arising in the financial sector as well as debts from households in addition to firms.

Fiscal policy is also receiving renewed attention. The pre-crisis view (supported by data) was that government spending had little impact on economic activity. We now understand that fiscal policy effects are quite heterogeneous. In particular, it is more effective in crisis times when private demand is constrained. Of course, not all governments can engage in higher spending and research has developed measures of “fiscal space” to identify which countries can use this policy.

The third lesson is that central banks can rely on a range of tools even when the interest rate has been lowered all the way to zero. These include issuing large amounts of money (quantitative easing), communicating on future policy (forward guidance) and purchasing risky assets (credit easing). It now appears that these tools may have to be used quite regularly in the future and ongoing research assesses how this should be done.

The low-level of interest rates is not just the result of central banks’ actions but reflects more structural forces. These include the high demand for safe assets (assets that keep their value even during a major crisis), an object of active research. The world economy faces an imbalance between a high demand for such assets and limited sources of supply. We can then expect interest rates to remain persistently low, raising a broad range of questions such as how investors and pension funds should respond.

The fifth lesson is the need to pay attention to financial stability. Measures at the level of individual banks and investors (micro-prudential policy) need to be accompanied by policies that look at the entire system (macro-prudential policy). This is challenging as the financial sector keeps evolving, for instance with the rise of non-bank financial intermediaries that are not so well understood. The global nature of many financial firms also requires some coordinated efforts by policy makers.

Recent research has documented the presence of a global financial cycle, distinct from the usual business cycle. This financial cycle reflects the varying appetite of investors for risk and is influenced by policy in the world's major economies. Measuring this cycle and assessing its impact of capital flows and financial conditions of individual countries remains challenging and is also the object of active research. A point of debate is whether the cycle is so powerful that countries may not be able to shield themselves by adopting a flexible exchange rate. Still, economists recognise that new tools are required to prevent swings in capital flows from fueling asset price bubbles. These include limits on what borrowers can do (how much of a house can be financed by a mortgage) and restrictions on what lenders can do (how much equity banks must hold).

So where does this leave us? We now have a better understanding of how financial conditions affect the economy. Substantial efforts have been undertaken to make banks more resilient, but the financial sector keeps evolving and we’ll only know in the next recession whether this was enough. There are growing concerns that the world economy could enter a weak phase soon with the US business cycle losing momentum. Policy makers will face substantial challenges in responding as interest rates are still low and the room for fiscal policy is limited.

This paper was presented during the Bern Alumni Chapter’s 14th annual Alumni Reunion, held on 3 December 2018.