As in the case of many historic crises, the underlying problem was that credit losses in the financial sector turned out to be much larger than anticipated. However, as the crisis has evolved over the last one and half years, the problems have come to be less about credit risks and more about the adverse consequences of a global financial industry experiencing a quite substantial deleveraging process. The huge credit expansion and financial asset growth that preceded the crisis was facilitated by that many financial institutions were assuming high levels of debt, in many cases obviously at unsustainable levels. These institutions are now trying to decrease their leverage either by injecting more capital – or if that is not possible – by shrinking in size. To shrink institutions simply must sell off assets. This is currently being done on a huge scale by institutions all over the world and explains why financial markets are so strained at the moment. On the supply side there are a lot of sellers trying to get rid of assets, but on the demand side – due to low credit supply and high risk aversion – there are hardly any buyers. As a result, pricing is disrupted and liquidity drastically decreased, which in turn implies falling asset values and further losses in the financial industry. The fact that the problems to a large extent have been driven by financial markets breaking down, rather than by individual institutions credit risk exposures, explains the unprecedented international impact of the crisis.
In that case, unemployment is likely to fall faster as demand grows, meaning that unemployment will reach the 7% threshold sooner. Then it will be appropriate to tighten policy sooner in this case, as potential output will be lower. The only case where the linkage of policy to unemployment is potentially problematic is where there is scope for productivity to increase as demand recovers, but for some reason firms take on extra labour before the increase in productivity takes place. But this seems rather unlikely to me. In any case, it is important to realise that the 7% threshold does not constitute a trigger for the MPC to raise Bank Rate. Rather it represents a prompt for the Committee to undertake a  1  See Bell, D N F and Blanchflower, D G (2013) ‘Underemployment in the UK revisited’, National Institute Economic Review, No. 224. BIS central bankers’ speeches  3  broad assessment of the prospects for demand, supply and inflation. If it appears that there is still a substantial degree of slack in the economy which can be absorbed without threatening the achievement of the 2% inflation target in the medium term, then there will be scope to maintain the existing stance of monetary policy longer, perhaps re-setting the unemployment threshold to a new lower level at the same time.