“ The Great Moderation , the Great Panic and the Great Contraction ” by Charles Bean

at the causes of the financial crisis and subsequent recession. He argues that much of what went wrong can be analysed using standard economic tools. The Great Moderation was a period of unusually stable macroeconomic activity in advanced economies. This was partly thanks to good luck, including the integration of emerging market countries into the global economy, and partly a dividend from structural economic changes and better policy frameworks. The longer this stability persisted, the more markets became convinced of its permanence and risk premia became extremely low. Real short and long term interest rates were also low due to a combination of loose monetary policy, particularly in the US, and strong savings rates in a number of surplus countries. Low interest rates and low apparent risk created strong incentives for financial institutions to become highly geared. Unfortunately much of this leverage occurred off-balance sheet in order to avoid on-balance sheet capital charges. The innovative financial instruments developed to achieve this were highly complex. This complexity did not seem to matter when markets were steady and defaults low but was fatal once conditions deteriorated, as it became impossible to understand and price these instruments objectively. Leveraged institutions were trapped; as their assets sank in value and funding dried up, buyers became wary – a classic lemons problem. As losses moved inexorably towards institutions at the heart of the financial system, the complexity of the inter-bank network created enormous uncertainty about the extent of counterparty risk. Uncertainties in the financial system were transmitted to the real economy after the collapse of Lehman Brothers as expectations of future credit tightening, higher precautionary savings and the postponement of investment took a sudden and widespread toll on global demand. This made the task of deleveraging in the financial system even more difficult and the tightening of credit more severe. Central banks responded aggressively with sharp cuts in policy rates. To affect the yield curve over the medium run, central banks have made explicit commitments to keep rates low for a significant period of time or engaged in purchases of financial assets. Policy makers are also considering the benefits of developing additional macroprudential instruments which can be used to respond to rapid credit growth and rising asset prices. These new instruments should directly target the incentives to extend excessive credit. But there are a number of practical questions to answer before they can be implemented. …