But past evidence suggests that any recovery in risk appetite might take time – more time than fundamentals would imply. All of these behavioural elements have come together in today’s financial markets – disaster myopia, intrinsic uncertainty and deep trauma. This may help explain why risk-takers have their foot poised on both brake and accelerator, why risk capital is in stop-start mode. That implies a risk of heavy and persistent financial congestion in the period ahead. With hindsight, Roosevelt’s fear (of fear) in 1933 was well-founded, economically and psychologically. It may also be being repeated. The role of macro-prudential policy As long as aversion to risk-taking is causing financial congestion, growth (like traffic) will remain sluggish. The public policy question, then, is whether anything can be done to allay the fear factor, speed the repair of balance sheets and stimulate risk-taking. Experience during the Great Depression taught us a great deal about the role of fiscal and monetary policy in these situations. Indeed, in many respects the Great Depression was the birthplace of activist monetary and fiscal policy, today’s conventional arms of macro-economic policy. For different reasons, however, these arms are at present close to fully stretched. In countering the fear factor, that begs the question of what else might be done? With fortuitous timing, there is a new tool in the box, a third arm of macro-economic policy. This is so-called macro-prudential policy. As its name implies, this policy tool is intended to meet macro ends using prudential means.
The UK has recently put in place an explicit macro-prudential regime. In July of last year, the UK government announced a new Financial Policy Committee (FPC) to execute macro-prudential policy.7 The FPC is housed in the Bank of England and met for the first time in June this year. The FPC’s objective is to protect and enhance the resilience of the UK financial system against risks including “unsustainable levels of leverage, debt or credit growth”. Therein lies a key FPC challenge. There is evidence of unsustainably high levels of leverage in some sectors. But elsewhere, there is evidence of credit growth being unsustainably low. Some companies remain over-leveraged. Yet others are suffering a credit shortage, with bank lending to companies continuing to contract over the past 12 months. 5  For example, Graham and Narasimhan (2004), Malmendier and Nagel (2011). 6  For example, Cogley and Sargent (2008), Barro (2006). 7  HM Treasury (2010). BIS central bankers’ speeches  5  In framing macro-prudential policy today, both these factors need to be weighed: on the one hand, enhancements to the risk-bearing capacity of the financial system to repair balance sheets; on the other, encouragement for the risk-taking capacity of the system to boost credit supply. These factors can sometimes point in subtly different directions. The first might point to higher buffers to boost banks’ risk-bearing capacity, while the second might point to lower buffers to boost their risk-taking capacity.