This bias is prevalent in complex and opaque situations which are surely predominant in the modern financial system. Turning to the indebtedness of sovereigns, we cannot put the blame for excessive indebtedness on financial incentives. But the overweighting of current benefits and the overdiscounting of future costs can easily be attributed to electoral considerations and the finite career of elected politicians, careers which become shorter when they cannot “seduce” their electorates. At a cognitive level, I would also put the blame on another factor that could be called a “Keynesian bias”. Here, I refer to the conviction that countercyclical policies should be activated in downturns to mitigate the social cost of output and employment losses, but that they need not be reversed in upturns. This conviction is based on the view that there is no natural, theoretical or even apparent practical limit to state indebtedness, at least for developed economies. This cognitive bias is, in my view, a major explanation for the observed structural deficits in government accounts leading to an ever-rising debt to GDP ratio. In the OECD as a whole, for instance, the public debt to GDP ratio has increased from 70% in 2000 to 103% today! While we can dispute the precise diagnosis, we cannot disagree with the fact that the present crisis should and will serve as a wake-up call. Sovereigns, like banks, need to build up a buffer ahead of potential unfavourable economic developments.
How can we ensure that financial liberalisation does not lead to excesses that can endanger financial stability? How can we make sure that finance in advanced countries is conductive to the public good? Again, the answer is most evident in the case of the banking sector. Excessive leverage is the result of a faulty system design. Hence, we must improve the system design. This is what Basel III and the TBTF work programme are about. On the one hand, it aims at removing the main incentive distortion – the implicit state guarantee. The critical element here is to make sure that it will be possible to allow a big complex institution to fail, which means resolving it in an orderly manner. On the other hand, increased capital and liquidity requirements as well as a leverage ratio serve as stronger safeguards in the event that incentives cannot be fully corrected, and also because externalities are present in the case of large and complex institutions. In my view we are on the right track, but we have not yet reached our destination. It is important that we stay on this path, and do not get caught in the “disaster myopia trap” which means, as the crisis fades in our memory, forgetting progressively the dismal consequences of the identified faults in the system and – as a consequence – losing our determination to correct them.