That spiral defined the pre-crisis arms race in financial returns. It generated an equilibrium of synchronously high returns and pay, as banks unilaterally militarised as defence against their competitors. But as in military arms races, the resulting outcome was a sub-optimally risky one. High equity returns came through risky leverage. And high pay, especially in equity-based forms, further encouraged risk-taking.17 The resulting high-leverage equilibrium sowed the seeds of the financial crisis. With hindsight, it was easy to spot this market failure, the co-ordination problem. Banks and the financial system as a whole would have been better off had there been a benign, enlightened regulatory planner, able to co-ordinate banks on a lower return equilibrium. Unfortunately, there was not. ************ Over the past decade, trading in financial markets has undergone a technological revolution.18 The frontier of this revolution is defined by speed. A decade ago, trade execution times were measured in seconds. A few years ago, they were measured in milliseconds. Today, they are measured in microseconds. Tomorrow, it will be nano-seconds or pico-seconds. For technologists, this is a “race to zero” – the promised land of zero  12  Haldane (2011a). 13  Haldane (2011a). 14  Gabaix and Landier (2008). 15  Aikman, Haldane and Nelson (2010) provide a formal, multiple equilibrium model of this phenomenon. 16  McLean and Nocera (2010). 17  Cheng et al (2010), Fahlenbrach and Stulz (2009). 18  See, for example, Foresight (2011).
Ruin is the destination to which all men rush, each pursuing his own best interest in a society that believes in the freedom of the  1  Byatt et al (2001). 2  Science News (1983). 3  Frank (2011). 4  Ridley (1993). BIS central bankers’ speeches  1  commons”.5 Therein lies the tragedy, the market failure. This situation is made more, not less, tragic by unbridled competition. The tragedy of the commons is one example of an age-old problem of military arms races. The incentives of individual players, and outcomes for society, are much the same as in commons tragedies. Individual country incentives are to increase military might, to leapfrog opponents to improve national security. But this game of leapfrog is a Red Queen Race. The quest for national safety results in a steady rise in military spending and a steady fall in both societal and national security. The common good is jeopardised. These arms-race dynamics, and commons tragedies, have a history in economics too. It is not just plumage that is conspicuous. As Thorstein Veblen set out at the end of the 19th century, so too is consumption.6 Some goods serve as a signal of social standing: they are positional. Not everyone can have the apartment which is closest to the sea. As in other arms races, the equilibrium is a sub-optimal one – a competitive shopping war in which everyone conspicuously over-spends. And so it is with economic behaviour more generally.