The level of debt, in contrast, seems to matter much less as an indicator of a turn in the financial cycle, though it does seem to matter as an indicator of the extent of the correction and the consequent damage to the economy.24 We also have a wide range of other economic and financial indicators, such as asset prices and credit conditions. We can estimate how far these are above or below an equilibrium value to help us make an assessment of where we are in the financial cycle. And, of course, macroprudential policy makers need to apply their judgment. The Financial Policy Committee of the Bank of England uses all of these approaches to make its assessment of the level of risk or, to put it another way, where we are in the financial cycle. And we use that assessment to inform our stress test of the core banking system so that the test becomes more severe, with higher losses and greater stress, when we judge the risks in the financial system are getting higher. But we would, in my view, benefit greatly in this area from a better understanding of how the expectations of the future that inform financial sector risk-taking are formed, the ability to use that understanding in modelling the financial cycle and better real-time information on the evolution of expectations.
That is, that we know the range of outcomes that might happen and how the economy works and, insofar as is possible, given uncertainty, that we correctly analyse the available information to weight the probability of those. A famous corollary of this is the efficient markets hypothesis – that it is not possible to systematically ‘beat the market’. The stronger form of the hypothesis posits that market prices fully reflect all available information – that the price reflects the likely future revenue streams. But even if the price does deviate from that fundamental level, it may be rational for investors to remain in the market – as Chuck Prince famously put it, to keep dancing so long as the music is playing. The rewards of the game may be worth the risk of being stuck without a proverbial chair at the end. And even if they are not, sitting on the sidelines may not be a winning career move if promotions and funding flow to those with a reputation for high returns. It may be rational to stay with the herd, as Keynes said “it is better for reputation to fail conventionally”.11 Rational expectations do not mean that the future matches expectations and corrections are avoided – when new information arises, agents react to that. If the information is material for a financial asset, for example a change in Roman property ownership laws in AD 33, the adjustment can be large.