[W]ith the financial world in turmoil, Minsky’s work has become required reading. It is getting the recognition it richly deserves. The dramatic events of the past year and a half are a classic case of the kind of systemic breakdown that he—and relatively few others—envisioned.

[I]t seems plain that supervisory and regulatory policies could help prevent the kinds of problems we now face. Indeed, this was one of Minsky’s major prescriptions for mitigating financial instability. I am heartened that there is now widespread agreement among policymakers and in Congress on the need to overhaul our supervisory and regulatory system, and broad agreement on the basic elements of reform.

Some have argued, Hyman Minsky most prominently,(8) that monetary policy success breeds greater financial instability by encouraging investors to assume more risk, especially through greater leverage. Perhaps this contention is at the heart of the argument that recent Fed policy actions in response to the subprime mortgage mess will only increase financial risks in the future.

It is hard to figure out how to test the Minsky proposition, but my instinct is that it is not correct. As vexing as the current market situation is, it is important to remember that in the early 1980s the unwinding of the Great Inflation led to failure of many industrial firms, farmers, banks and eventually a large part of the savings and loan industry. The financial turmoil of 1998 seems mild by comparison with the early 1980s; of course, we do not yet know the full extent of the current turmoil in housing and housing finance.

It is a distinct pleasure to be invited to speak at this year’s Hyman Minsky conference. Throughout his career, Hy Minsky emphasized the importance of understanding the linkages between the institutional structure of the financial system and the macro economy. For many years, such an emphasis was, shall we say, out of fashion, both in macroeconomic modeling and in policy discussions. In recent years, however, dramatic changes in financial markets and a wave of financial crises around the world have brought renewed interest in the role that the financial system plays in economic growth and in macroeconomic stability.

It is useful to distinguish two broad classes of hard landings. The first involves the reversal of an imbalance between aggregate supply and aggregate demand. The classic example is the boom-bust scenario. The second class involves the unwinding of sector or market imbalances that either initiate a downturn in the economy or aggravate a downturn that would otherwise have occurred. A classic example of this genre is a stock market correction...I associate many of the second class of hard landing scenarios with the work of a former colleague and friend, Hyman Minsky, who died in 1996. He emphasized the development of financial vulnerabilities in expansions and their contribution to serious recessions. In his view, serious recessions are typically the result of a coincidence of adverse shocks on an already vulnerable economy. Minsky emphasized the role of vulnerabilities arising from financial imbalances, including excessive debt burdens or increases in the price of risky assets relative to safe assets.

CHAIRMAN GREENSPAN. If we are going to get anywhere, we can't have people literally talking at cross purposes. Janet, you did not even accept the premise with which Al is starting, that everyone agrees that we should seek price stability as a goal. If we are going to get anywhere, the question I have to ask first is whether you agree with Al that price stability is a goal we should seek. If you do not, this discussion then gets to the question of whether there is a consensus among the Committee members that price stability is something that should be our long-term goal, not how we get there. First, we have to agree on the goal.

MS. YELLEN. I would simply respond to that by saying that the Federal Reserve Act directs us to aim for both maximum employment and price stability. To the extent that there is no tradeoff at low inflation rates and there are benefits that outweigh the short-run costs, then price stability, literally zero inflation, is good and we should go for it. To the extent that there is a tradeoff, we have to weigh what to do, and I think I am pointing to the possibility of a tradeoff as we go to very low inflation rates.

CHAIRMAN GREENSPAN. So, you are discussing the issue of the transition, not the ultimate goal?

MS. YELLEN. No, I am discussing the issue of the ultimate objective. If we have to pay a permanent price at zero measured inflation in the form of permanently less employment and higher unemployment, I do not read the Federal Reserve Act as unambiguously telling us that we should choose price stability and forego maximum employment.

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CHAIRMAN GREENSPAN: … Let me see if we can establish some structure for our discussion. Can you give me three sentences in conclusion on how you view the question: Is long-term price stability an appropriate goal of the Federal Reserve System?

MS. YELLEN. Mr. Chairman, will you define "price stability" for me?

CHAIRMAN GREENSPAN. Price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions.

MS. YELLEN. Could you please put a number on that?

CHAIRMAN GREENSPAN. I would say the number is zero, if inflation is properly measured.

MS. YELLEN. Improperly measured, I believe that heading toward 2 percent inflation would be a good idea, and that we should do so in a slow fashion, looking at what happens along the way. My presumption based on the literature is, as Bob Parry summarized it, that given current inaccurate measurements, heading toward 2 percent is most likely to be beneficial.