The fifth and final lesson that I would take from the events of recent years is that there is significant value to having a diversified system of financial intermediation. Historically, most countries have relied heavily on the banking system as the principal source of intermediation. As we know, troubles in the banking system can weaken the intermediation process, with severe macroeconomic consequences. When intermediation is more broadly based, however, with capital markets as well as banks, the resulting system may be more stable and robust in times of crisis.

Thus, the question emerges; can the Federal Reserve respond to "financial crises" in the same way that it responded to "banking crises" in the past?

My own view is that the Federal Reserve now has less flexibility in responding to crises as this relates to its operation of the discount window. Historically, the discount window has been the Federal Reserve’s principal facility for providing liquidity in times of crisis. Indeed, going back to the 1980s and early 1990s, the Federal Reserve provided extensive lending through its extended credit program to banks experiencing prolonged liquidity problems. Going forward, however, the discount window is less likely to be used for several reasons.

First, use of the window is now circumscribed by the provisions of FDICIA designed to minimize FDIC exposure if the Federal Reserve lends to institutions that ultimately fail. Second, banks have become reluctant to use the window in normal times and so may not be willing to approach the window in difficult times for fear of signaling changes in their condition. Third, to the extent that crises now originate outside the banking system, nonbank institutions do not have direct access to the discount window to meet their liquidity needs.

Furthermore, joint distributions estimated over periods that do not include panics will underestimate correlations between asset returns during panics. Under these circumstances, fear and hence disengagement on the part of investors holding net long positions often lead to simultaneous declines in the values of private obligations, as investors no longer materially differentiate among degrees of risk and liquidity, and to increases in the values of riskless government securities. Consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account.

... At a minimum, risk managers need to stress test the assumptions underlying their models and consider portfolio dynamics under a variety of alternative scenarios. The outcome of this process may well be the recommendation to set aside somewhat higher contingency resources--reserves or capital--to cover the losses that will inevitably emerge from time to time when investors suffer a loss of confidence. These reserves will appear almost all the time to be a suboptimal use of capital, but so do fire insurance premiums--until there is a fire.

Is price stability really what we are after or are we after financial stability? Even more generally, going back over time we have tended to argue, I think correctly, that the objective of monetary policy is to create maximum sustainable economic growth, and we have argued, again I think quite correctly, that price stability is a necessary condition to reach that goal. But price stability may indeed be a proxy for something else, which I suspect is financial stability...It is by no means clear exactly how we should measure price stability, given the prospect that it will become increasingly difficult over time to define what constitutes output and prices...When we move into the 21st century, what we will try to stabilize may in effect be the purchasing power of money, however that is measured...While I am not saying that these involve issues that we need to  resolve today, I suspect that we will start to confront them in 5 years or certainly within 10 years, and they may very well affect our projections going out to, say, the year 2006. I also suspect that by around the year 2006, this very tricky question may involve what we are endeavoring to stabilize and may be the focus of our policy actions. My own guess is that we are going to be dealing with asset prices, the question of nominal long-term interest rates, and probably the outlook for nominal GDP as well.

History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset-price inflation that can feed through into markets for goods and services. Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as they can amplify the upswing.