But just as there is evidence that increased financial intermediation is often a Good Thing, so there is also evidence from numerous past credit/asset price boom-bust episodes that a juxtaposition of rapid credit expansion and sharp asset price increases is often a harbinger of a painful bust to come. So everything hinges on whether the underlying developments are sustainable or not. The mistake of (most of) the economics profession, along with many others, was a failure to see what was really going on beneath the surface and to understand how disruptively things could unwind. But, as I shall explain, I believe that the standard tools of economic analysis, far from being proved redundant, can shed useful light on what went wrong. Macroeconomic antecedents The proximate causes of the present crisis undoubtedly lie within the financial markets. But it is worth dwelling briefly on the macroeconomic environment in the years preceding the crisis, which was conducive to the formation of what proved to be an unsustainable credit bubble. BIS Review 101/2009  3  The Great Moderation To begin with, this period was characterised by an unusually high degree of macroeconomic stability, with steady growth and low and stable inflation in most of the advanced economies; see for instance Fig. 4, which shows performance in the G5 countries before and after 1992 2 . There are three broad explanations for this “Great Moderation”. First, it could just have been a happy accident, if this was a period characterised by unusually small, or a benign sequence of, shocks.
BIS Review 101/2009  9  Asset Relief Program (see Taylor, 2009), raised the possibility in investors’ minds of the failure of a whole range of institutions that had previously been considered safe. That is evidenced in the simultaneous sharp spike upwards in the CDS spreads of a number of financial institutions after the collapse of Lehman’s (see Fig. 12). Moreover, the prospect of having to make significant default pay outs called into question the solvency of a key provider of that insurance, AIG. The bottom line of all this is that the information requirements for managing risk escalated rapidly at the same time as investors were waking up to the realisation that the distribution of prospective returns on a range of asset-backed securities was a great deal worse than they thought. Not surprisingly, there was a rush for the exits and a drying up of wholesale funding to institutions that were thought to be at all vulnerable. Moreover, attempts to cope with that by selling off assets ran into an adverse selection problem: if someone is selling an asset, then perhaps that indicates that they know it’s a “lemon”. And even the revelation of central bank support in its role as Lender of Last Resort, far from solving the problem, could be interpreted as a negative signal about an institution, as was so in the case of Northern Rock, for example.