Financial crashes ought to be occasions of great learning and introspection. Crashes occur as a result of being largely unanticipated. Those who had warned of an unsustainable boom had long before been ridiculed or beaten into submission.¹ However, crises appear to be such multifaceted and complex affairs that all and sundry can point to an aspect of the crisis they had predicted. Positions can become entrenched rather than open to reassessment. Authority figures who had dismissed the warning signs characterize the root causes as unknowable and suggest the crisis merits fundamental changes to our understanding of economics, institutional arrangements, and legal regimes. When banks are bailed out to the tune of trillions and social security nets are cut back in response, the regulatory debate, traditionally carried out in dimly lit corridors, is suddenly bathed in the bright light of political intrigue. Politics sends the debate down a parochial and partisan chute that produces recycled proposals often harbored for decades by one side or the other. The aftermath of financial crises creates a situation of numerous solutions in search of a problem.

Solutions in Search of a Problem

Lasting solutions require a clear understanding of the underlying issues we are trying to resolve. To assess the validity of either the risk-sensitive capital adequacy approach at the heart of the Basel II Accord on Banking Supervision, or the introduction of new leverage and liquidity ratios in the postcrash “Revised Basel II,” we need to consider how these approaches could have avoided the problems at hand.

The authorities are relatively good at containing idiosyncratic bank failures. Between 2008 and 2012, the US Federal Deposit Insurance Corporation (FDIC) closed 465 failed banks without fuss and similar bodies elsewhere have notched up reasonable successes in this regard. That’s not the problem over which we are still searching for a solution. Day-to-day protection of consumers, outside of widespread bank failures, is a large area in which regulation could do better. We address consumer protection in greater detail in Chapter 7. While the line between providing too much protection and too little customer choice will be continuously redrawn as society evolves, we do at least have the tools or means to effect better balance. Managing systemic risk in the financial sector to avoid or moderate the cycle of boom-bust is the major problem that continues to elude a solution.

This chapter focuses on understanding the causes of financial busts and considers financial regulation from the perspective of how it addresses them. A vital challenge of this task is to penetrate the political obfuscation. The politics of financial crises run deeper than party politics. Financial crises and their preceding booms lead to shifts in power between slices of society such as creditors versus debtors, financiers versus producers, home owners versus tenants, as well as the private sector versus public sectors. Power is nothing but political.

Is reducing systemic risk too broad or ambitious a goal? Isn’t trying to identify the causes of financial crises opening a hornet’s nest that regulators should best leave alone? Perhaps. But the cost of failure to limit crises is so great that we need to try, and, as will be argued in this book, we can do better than we have done recently. We also have a wealth of history and experience of banking crises to draw on. While crises may differ in instruments and institutions, the broad, underlying currents are similar.² It should also be remembered that banks have not always been regarded as systemically fragile as they appear to be today.³ When my father began investing in the stock market, banks were considered boring, defensive stocks that faithfully delivered an attractive dividend, but not much else.⁴

The Politicization of Financial Crashes

The economic, financial, and social costs of financial crises are enormous, and often the initial response is to boot the politicians out of office. Between early 2007 and the reelection in the US of President Barack Obama in November 2012, almost every country deeply affected by the Global Financial Crisis (GFC) failed to reelect the incumbent government. Public anger at the bailout of banks, followed by severe public expenditure cuts and revenue-raising measures to finance the rescues, brought down governments in Britain, Denmark, France, Ireland, Italy, Japan, Spain, and Greece. Arguably, President Obama’s first election in November 2008 benefitted from the backlash against the Republican Party unleashed by a crisis that erupted during the Republican presidency of George W. Bush.⁵

The contagion of financial crisis to political crisis is not new. The Asian Financial Crisis of 1997 to 1999 lit many political fires. Estimates suggest that over a thousand people died in a series of ugly riots in Indonesia during May 1998, and the crisis eventually forced the resignation of President Suharto. Bankers had achieved in less than two years what human rights campaigners had been trying to do for thirty-one. The 1994/95 Mexico Peso Crisis laid the ground for the first electoral defeat of the PRI party in 70 years. In the UK, Sterling’s ejection from the European Exchange Rate Mechanism on September 15, 1992, ended the Conservative Party’s long-established reputation for economic stewardship, condemning them to the opposition benches for over a decade. The Spanish peseta’s devaluation during the EMS crisis had a similarly devastating effect on Prime Minister Gonzalez’s PSOE party.

Financial crises can be the death knell for any incumbent government whatever its complexion. From a safe distance, the spread of crisis from finance to politics could appear to have some benefits. Brutish regimes that seemed intractable being removed, and the arrival of fresh leaders able to disown past blunders, facilitates an early return of international capital.⁶

The Bad Apple Theory of Financial Crises

The scenario just described is hardly reassuring if you are the political incumbent when a financial crisis erupts. Any rescue of politicians’ political fortunes must involve them being seen as acting promptly and resolutely. This necessitates projection of a theory of how it all fell apart without too much scrutiny of their role in the buildup to the crisis. Consequently, many governments adopt what I term the “bad apple theory” of banking crises.⁷ The bad apple theory presents the crisis as one caused by bad bankers, knowingly selling bad products out of bad foreign jurisdictions to innocent voters. It is a narrative of bankers pulling out smoking weapons of financial mass destruction⁸ from their jacket pockets, hurling them into a crowd of bewildered consumers, and then sprinting away.

The bad apple theory allows governments to move decisively to prosecute the bankers, ban the financial products, and get tough with foreign jurisdictions.⁹ It allows them to personalize blame with the added bonus of being able to distance themselves from it. Above all, it allows governments to be seen as swiftly swinging into action. The press also loves the bad apple theory stories. Unashamed at providing little scrutiny of bankers earlier, and lapping up the advertising revenues that banks provided them, the press salivates at the prospect of a good chase and demolition of real-life “villains.” Even Hollywood finds the bad apple theory compelling as a wonderful morality play.¹⁰

In chasing their villains, the popular press often plunges deep into the well of xenophobia. Listening to a few elder statesmen in Europe during the European sovereign credit crisis of 2011-2013, their biggest disappointment was not the partly foreseen limitations of the original single-currency framework but rather how quickly member-state unity slid into grubby national finger-­pointing.¹¹ Many Greeks blamed their predicament on German bankers and publicly appealed to the specter of the German occupation 60 years earlier. French and German bankers in turn blamed “lazy Greeks” and scheming American and British hedge fund managers with their toxic derivatives. European governments blamed US credit rating agencies. UK Parliamentary watchdogs and US congressional committees demanded appearances of everyone for their 15 minutes of public shaming.

No one was interested in a narrative of the failure of the system of regulation. If it was the whole system of regulation that had collapsed, then who would the finger of blame be specifically pointed at? Who had responsibility for the regulatory system at the time? Less tangible villains make for less attractive press copy and the bad apple theory was secured.

Proponents of the bad apple theory also believe that the bankers were able to peddle bad products out of bad jurisdictions because banking regulation was not comprehensive enough across institutions, instruments, and jurisdictions. Cries of “global banks need global regulation” were oft repeated. There is some truth to this, but I hesitate to conclude that what was needed was to make the existing bad regulation more comprehensive than it was.

Fundamentally, any argument about too little or too much regulation misses the mark. We should be pinpointing good vs. bad regulation, as in poorly focused or wrongly conceived regulation. It is not that risky assets proved risky and the regulation did not capture them all, but that the safe ones, for which the system required little capital to be put aside, turned bad at the same time. If what we had was bad regulation, then doubling up on it was never going to make things better and could actually make them worse.¹² In fairness, many regulators recognize this even if politicians prefer simpler explanations of there being too little good and too much evil.

Incentives are critical. Precious little happened during the Global Financial Crisis that was not explicitly incentivized to happen either by the marketplace, regulation, or both. To effect behavioral changes the incentives have to be changed. “Originating” loans and then packaging them to redistribute as fast as possible, as opposed to holding onto them, was the proclaimed new ­business model of banks in the first decade of the 21st century. Was this because ­bankers were knaves and knew the loans they originated would blow up, or was it because holding loans required expensive regulatory capital? Meanwhile, originating and then redistributing loans allowed for significant up-front fees and much less capital, which boosted shareholder returns. The banking model was not in conflict with the regulatory model—it was a reflection of it.

There were and always are bad apples that should be pursued and prosecuted. Regulation must be tightened to close regulatory evasion. But we should have modest expectations of the impact this will have on reducing the incidences of banking crises. In Chapter 11, we discuss in more detail the relative merits of using criminal or civil law in pursuing the bad apples. But the bad apples did not so much cause a crisis as have their rogue behavior revealed by it. Warren Buffet put it most succinctly when he suggested, “(a)fter all, you only find out who is swimming naked when the tide goes out.”¹³ Even if all the bad apples were removed, the banking crisis would still have occurred. In truth, we were let down by a system of banking regulation that not only failed to prevent the crisis but actually amplified it.

What Causes Banking Crises?

Banking crashes are not random events. They almost always immediately follow the peak of financial booms. There is a financial cycle of boom and bust. Despite the spread of financial innovation and shadow banks, financial booms almost always take place in the form of a boom of credit growth and property prices. Famous booms that presaged notorious crashes include those during the Roaring ’20s in the United States and Europe, the Barber Boom of 1972–74 in Britain, the Tesobonos Boom of 1992–94 in Mexico, the Asian-Tigers Boom of 1995–97 in South East Asia, the dot-com bubble of 1998–2000 centered in the United States, and the Great Moderation, also in the United States from 2004 to 2006. The general rule is simple—the bigger the boom, the more colossal the crash.

Although financial cycles are influenced by the economic and policy cycles, the length of financial cycles is longer, which makes both statistical measurement and apportioning blame challenging.¹⁴ Financial booms are often a long sweep of moderately accelerated credit growth over six to seven years, reaching a sharp peak right at the end. However, despite the methodological and quantitative challenges, booming credit growth and property prices are not difficult to locate. Crashes, meanwhile, tend to have elements of both sharpness, especially in the early collapse of investment, and elements of lingering drag as the banking system remains fragile for a while.¹⁵

The cause and effect of boom-bust can be seen a little more clearly if we look at it in a tighter time frame than normal through a perverse set of banking and currency crises centered around the 1988 Basel 1 Accord on Banking Supervision, which contributed to its subsequent revision (Basel II). Under Basel 1, lending to an OECD government was considered not risky while lending to a non-OECD government was seen as being more so. This was always a slightly odd distinction, as the OECD was originally established in 1948 to run the US-financed Marshall Plan for a Europe ravaged by war and while its membership expanded in later years, it kept its predominantly Western European—plus American and Japanese—focus.

Membership in the OECD was never based on credit worthiness. This Western European, US, and Japanese bias was replicated in the composition of the Basel Committee. (Some argue that the failings of Basel I and II are an example of the financial consequences of membership bias.) The problem arose when an emerging-market economy joined the OECD, automatically switching its Basle rating from risky to not risky. Doing so allowed international banks to lend to borrowers in the country with much less capital than before. A surge in foreign currency lending almost always followed, more than the country could safely absorb and so lending would promptly succumb a year or two later into a banking and currency crisis. Mexico and Hungary joined the OECD in 1994. Their banks crashed in 1995. In Mexico, the crisis spread via the devaluation of the peso to neighbors, creating the so-called Tequila crisis. The Czech Republic joined the OECD in 1995 and suffered a banking and currency crisis in 1996. South Korea joined in 1996. By 1997 its banks and currency had crashed, fueling the Asian Financial Crisis.

While the identification of booms and busts is not simple, there is a wealth of statistical evidence for the financial cycle.¹⁶ The message is clear. If we want to tackle the problem of banking crashes, we have to attend to the problem of banking booms.

Addressing the Boom

It might seem that we should focus on eliminating the boom-bust credit cycle.But it is unlikely that this could be done. Moreover, even if it were possible, it is debatable whether it would be the right thing to do. We have written much about the misery of busts but the pride that precedes the fall is not without usefulness. Booms trigger the imagination, creating ambitious schemes that would never have otherwise materialized, or not have happened in a timely manner. Many of these schemes had lasting worth. Vast networks of canals, railways, electrification, fiber-optic cabling, and even the Internet were lugged on the back of financial booms.¹⁷ Our goal is not to eliminate the boom-bust cycle but to moderate it—to nurture sustainable economic progress that is not shaken to death by soaring booms and plunging busts or strangled to death by overly burdensome regulation.

By reducing uncertainty, the lessened financial and economic volatility that would result could augment underlying growth. We need to cushion the desolation of crashes—often hardest on those who have least benefited from the boom. To moderate the amplitude of the boom-bust cycle requires either boom limitation measures, bust absorptive buffers, or both.

The distinction between the ending of boom-bust and the moderation of boom-bust is critical. The argument used by Chairman Greenspan and others against the Federal Reserve acting to moderate the boom in financial assets is that booms and busts are hard to define. If the object were the surgical removal of booms and busts, I would agree that we lack measurements that are calibrated in sufficient-enough detail and the instruments with which to do so. However, if the aim is to lean against the wind, to moderate persistently above-normal growth in credit, and to dampen otherwise-calamitous consequences, then we do have sufficient ability to measure when to do so.¹⁸ This is the essence of a countercyclical credit policy, which is one of the proposals we explore in Chapter 5.

Fools or Knaves?

What causes booms? In the last crisis, bankers pulled out of their jacket ­pockets smoking weapons of mass destruction that they threw into a crowd of bewildered consumers, and then they ran toward them, stuffing as many of these products as they could into their back pockets. Banks got themselves into trouble by originating and repackaging credit instruments and then not distributing them far enough. They established “special-purpose vehicles” so that they could hold on to them and create the financial leverage to increase their exposure. Bear Stearns, one of the first investment banks to come unstuck in the GFC, was very active in this sector as were Lehman Brothers and many others.

A host of people lost considerably in Lehman Brothers’ failure. However, few individuals suffered more personal losses than its 25,000 managers and staff. Why would Lehman managers press so close to these instruments if they knew they were going to blow up? Some have calculated that if you were to total up the previous decade of bonuses, the bankers were still ahead even after their firms closed and their stock awards had became worthless. But bygones are bygones. Past cash bonuses were banked and maybe even spent. Dick Fuld, Lehman’s CEO, personally lost $900 million as a result of the collapse of Lehman.¹⁹ From my own banking experience, I would suggest it unlikely that investment bankers thought it okay to lose fortunes of this magnitude on the grounds that they had made enough money before. Perspective, or even loyalty to firm or their products, has not been a defining feature of modern investment bankers. If the bankers expected these products to explode they would have bailed, implemented strategies that better insulated them, or at least a strategy that did not involve clinging onto these products so tightly with their own bonus pools. They were fools and they fooled themselves.

Generally, a few people doing things that they know are risky does not cause financial booms. Booms originate with many people believing their actions are safe—so safe that, as returns start shrinking because everyone is doing the same thing, they feel justified in “doubling up” their bets. Using derivatives or employing more borrowing are the ways greater leverage is intentionally achieved, justified on the grounds that a safer world requires bankers to employ more leverage if they are to generate the same returns as in to generate the same return as in the riskier past.²⁰ In the wonderful world of hindsight, we know that the belief that it is safe to “double up” is wishful thinking spurred by a contagion of greed. But this thinking is also often supported by the arrival of some new technological advance like railways, motor cars, or electricity that does objectively transform economic activity.

An essential point is that booms are characterized by mass euphoria that seeps through and is reinforced by aspects of life beyond financial markets. Booms are ages of technological advance and a belief that the white heat of technology will melt away our problems.²¹ TV pundits and popular historians paint a picture of linear progress and perpetual betterment.²² Movies reflect the optimism of the day, like Charlie Chaplin’s 1925 film The Gold Rush or the top-grossing movie of 2004, Shrek 2. Even economists appear less dismal as they discuss the increasing employment and growth opportunities of some new technology, while Nobel laureates expound the benefits of financial innovation. Governments claim to have solved major economic challenges. Financial booms are not a circumscribed conspiracy.

Booms quickly blast off from their fundamental foundations and begin feeding upon themselves. Higher asset valuations lead to higher returns and stronger asset values, justifying higher borrowing and more spending, which creates even higher asset values justifying more borrowing. The wheels on the boom bus keep turning with valuations being propped up by less and less actual cash earnings.²³ The housing market is particularly prone to boom-bust cycles. In housing booms, lenders feel that their lending is safely collateralized against an apparently liquid security with rising valuations—so safely collateralized that they do not need to bother greatly with the income details of the name on the mortgage application form. The argument was that should a mortgage holder be unable to keep up with future repayments, their house could always be sold for a sum greater than the original loan. This optimistic thinking, powered more by greed than wonton neglect, lay behind the 2007/8 subprime mortgage debacle in the United States.

This scenario highlights a fundamental problem with bank risk management models. These models assume that when a bank wants to sell some security, they will be the only ones doing so which is a reasonable assumption during booms. But when the wheels of a boom stop spinning, many banks will be forced into the sale of similar assets at the same time as everyone else. This will depress valuations sharply, turning previously liquid assets into illiquid assets, only disposable at a deep discount of their previous or long-term valuation.²⁴

Today this is routinely characterized as a “black swan” event after Nassim Taleb’s 2007 book of the same name. It suggests a situation where the distribution of outcomes—an example would be the number of bank failures/rescues in the United States—is “fat tailed” and extreme outcomes are more likely than a “normal” distribution would imply. Bankers and regulators now routinely run black swan stress tests on their lending portfolios. However, this characterization critically misses the endogeneity and dynamic of the process,²⁵ where the bust is not an extreme random event but a corollary of the previous boom. The reality is probably better described as two separate distributions of outcomes. Imagine a histogram with bars showing the number of quarters in which there were no bank failures, one failure, two failures, three and so on. Of the two distributions we are talking about, the first is a normal distribution, with the highest bar representing the number of quarters where there have been, say, just a couple failures; the lower bars representing the number of quarters where there have been only one or three failures; and the lowest bar of all representing zero and more than four failures. This is a true reflection 75 percent of the time. However, during late boom and bust, this pattern dissolves into an entirely different distribution of outcomes closer to a U shape (a type of beta distribution) where there is a much longer period of no bank failures than normal (none occurred between June 2004 and February 2007) followed by an extremely high number (152 failures were recorded in 2010 alone).

The Failure of Risk-Based Capital to Safeguard the System

In the previous chapter we argued that outside of consumer protection, the primary reason we regulate banks is not to stop “one-off” bank failures. Since they have limited collateral damage, these one-off failures can be good lessons that everyone can learn from—as in the case of the 1995 collapse of Barings Bank. The main reason we regulate banks, or why we should be doing so, is to reduce the frequency or amplitude of systemic crashes in which good and bad alike fail. That invariably means moderating the previous boom. Booms are driven by a broad underestimation of risk, a cycle that is itself self-reinforcing. This is why risk-based capital adequacy requirements on their own can make the financial system less safe rather than more so—as observed during the last financial crash and explained in the following paragraph.

Credit mistakes are made primarily during the booms. As a boom progresses and lending expands rapidly, it is desirable that the banking system act conservatively, putting aside more capital as a cushion against an increasingly likely future crash. However, the boom is only happening because the perception and contemporaneous measurements of risk are low and falling. In a system where the amount of capital put aside is based on the current measurement of riskiness of the assets (the sum of risk-weighted assets), as the boom progresses, and measured risks fall, it appears that the banks have more capital as a percentage of their risk-based assets and are therefore able to lend more without more capital. As banks collectively expand their lending, prices of assets rise, giving the impression that risks have fallen further. The cycle intensifies.²⁶ Those banks in trouble post-2007, when the riskiness of their assets soared, were ones that appeared to have capital well in excess of regulatory minimums and historic levels prior to 2007.

Structural Risk Limits Are Better

Measured risks are procyclical. A risk-based regulatory system discourages putting aside capital when it is plentiful for some future time when it will be scarce. During a crash, this system also discourages lending when, in hindsight, collateral valuations are often at their lowest point. To avoid this procyclicality, we need a regulatory system that is less dependent on “statistical” measures of risk and more reliant on what I would call “structural” measures of risk, i.e. measures of risk detached from contemporaneous developments and perceptions. Structural measures of risk would measure, for instance, the size of mismatches between assets and liabilities by maturity, or currency, say, rather than current correlations between asset prices or frequency of recent price declines. The new 3 percent leverage ratio (of equity and equity-like assets to total assets—including those off the balance sheet) proposed in revised Basel II is a structural risk limit. While it is may seem crude, it does limit the amount of leverage that could be built on the belief that assets are currently safer than they will turn out to be in a crash.

The other “structural” risk limit introduced in the revised Basel II is the net stable funding ratio, which requires banks to hold enough guaranteed funding to enable them to withstand the closing of the money markets for as long as 12 months. Banks don’t like these structural limits and have mounted tough opposition to their early implementation. However, the leverage ratio and net stable funding ratio represent a subtle, important and fundamental departure from a risk-based system that has otherwise been more likely to amplify the boom-bust cycle than to moderate it. In Chapter 5, we discuss a more systematic way of building on these early initiatives.

___________________

¹In 1996, my friend Tony Dye, Chief Investment Officer of Phillips & Drew, warned that there was a “dot-com bubble” and began pulling client funds out of stocks. But the market continued to soar and after repeated underperformance, clients began to leave, in droves, pulling down the assets the firm managed from £60 billion to £35 billion. In March 2000, Tony, by then nicknamed Dr. Doom, was asked to take early retirement. Before the new manager could change the fund’s allocation, the dot-com bubble burst and the fund shot to the top of performance rankings. Tony was vindicated but the process had been grueling. He died in 2008 at the age of just 60.

²Charles Goodhart and P. J. R. Delargy “Financial Crises: Plus ça Change, plus c’est la Même Chose” (special paper 108, LSE Financial Markets Group, London, 1999).

³See Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009).

⁴This past boring banking period is sometimes attractively referred to in the United Kingdom as “Mainwaring banking” after Captain George Mainwaring in the popular British 1970s TV sitcom Dad’s Army. Captain Mainwaring was the pompous, blustering buffoon, a stickler for rules and order, who led the home guard of misfits rejected for serving in the war’s main front in the fictional seaside town of Walmington-on-Sea during World War II. He derived his sense of self-importance from being the town’s stingy bank manager.

⁵US Republicans may complain that the seeds of the crisis were sown in the deregulation of the US banking system under the previous Democrat Treasury team of Rob Rubin and Larry Summers. Democrats could retort that it was fuelled by the fiscally unsustainable combination of “Bush tax cuts” and the Iraq and Afghan wars. Because the financial cycle is longer than the political one, crises throw up many legitimate questions over their parenthood.

⁶Financiers threaten hell and damnation at the merest hint of a loan default, so the speed with which international capital returns following default is one of the mysteries of financial history. Several countries appear to have routinely devalued and defaulted. Argentina, Venezuela, Mexico, Turkey, Greece, Spain, and others have each defaulted over six times in less than six generations.

⁷Avinash D. Persaud, “Risk-Sensitive Regulation Failed to Stop the Crisis,” Financial Times, December 10, 2010.

⁸Warren Buffet famously referred to derivatives as financial weapons of mass destruction in his annual letter to shareholders in 2002. At the time, the world was engrossed in what turned out to be a charade around Iraq’s weapons of mass destruction.

⁹See Avinash Persaud, “Look for Onshore, Not Offshore Scapegoats,” Financial Times, March 4, 2009.

¹⁰The Global Financial Crisis has spawned a handful of movies including Inside Job (2010), narrated by Matt Damon; Margin Call (2011), starring Kevin Spacey, Jeremy Irons, Zachary Quinto, and Paul Bettany; and Too Big to Fail (2011), based on Ross Sorkin’s book.

¹¹I have heard this lament from two distinguished Europeans, economist, ECB Vice President and former Italian Finance Minister Tomaso Padoa-Schioppa (1940–2010) and economist, former European Commissioner and Italian Prime Minister, Mario Monti.

¹²Charles Goodhart and Avinash Persaud, “How to Avoid the Next Crash,” Financial

Times, January 30, 2008.

¹³Warren Buffet, “Letter to Shareholders” (Berkshire Hathaway, 2001).

¹⁴See Mathias Drehmann and Mikael Juselius, “Measuring Liquidity Constraints in the Economy: The Debt Service Ratio and Financial Crises,” BIS Quarterly Review (September 2012), pp. 21–35.

¹⁵See Avinash Persaud, “Hold Tight: A Bumpy Credit Ride Is Only Just Beginning,” Financial Times, August 16, 2007.

¹⁶See: 1) Moritz Schularick and Alan M. Taylor, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–2008,” (NBER Working Paper 15512, 2009), later published in American Economic Review 102, no. 2, pp. 1029–61 (2012); 2) Stijn Claessens, M. Ayhan Kose, and Marco E. Terrones, “Financial Cycles: What? How? When?” (IMF Working Paper 11/76, 2011a); and 3) International Monetary Fund, “When Bubbles Burst,” in World Economic Outlook: Growth and Institutions, Washington, DC: IMF, 2003.

¹⁷Carlota Perez has done some fascinating research suggesting that each technological revolution in the past has given rise to a paradigm shift and a “new economy.” She shows how these “opportunity explosions,” which are focused on specific industries, also lead to the recurrence of financial bubbles and crises. See Carlota Perez, Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages (Cheltenham, UK: Edward Elgar, 2003).

¹⁸See Claudio Borio, “The Financial Cycle And Macro-Economics: What Have We Learnt?” (BIS Working Papers 395, Basel, Switzerland, December 2012).

¹⁹See Geraldine Fabrikant and Erik Dash, “For Lehman Employees, the Collapse Is Personal,” New York Times, September 11, 2008.

²⁰Traditional finance theory suggests that investors’ return expectations relate to their perceptions and appetites for risk. The more risk, the more returns. Moreover, it has often been thought that different investors have different appetites for risk but that these did not change; what changed were their returns and expectations of returns. However, there is some evidence that investors have return expectations based on what was achieved in the past and that they regulate the amount of risk required to achieve those returns. When the world is a safer place and returns fall, they have to take on more risk (by increasing their risk appetite) to push returns back up. See Manmohan Kumar and Avinash D. Persaud, “Pure Contagion and Investors’ Shifting Risk Appetite: Analytical Issues and Empirical Evidence,” International Finance 5, no. 3 (November 2002), pp. 401–436.

²¹Harold Wilson, then leader of the British Labour Party, famously coined this phrase when he said, “A new Britain would need to be forged in the white heat of [this] scientific revolution.” (Speech to annual party conference, Scarborough, in September 1963.)

²²In What Is History? (New York: Vintage, 1967), Edward Hallett Carr speculates that our view of where we are in history relates to whether we are in a boom or bust. In a boom, we tend to view progress as linear: things are good now, they were less good before, and they will get even better tomorrow. In a bust, we adopt a cyclical view of where we are: things are bad now, they were good before, and one day they will be good again.

²³See Avinash D. Persaud, “Regulation, Valuation and Systemic Liquidity,” Financial Stability Review 12 (Banque de France, October 2008).

²⁴See Avinash Persaud, “Sending the Herd off the Cliff Edge: The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Practices” (BIS Papers 2, Washington: Institute of International Finance, 2000); reprinted on BIS Papers 2, http://www.bis.org/publ/bppdf/bispap02l.pdf. This essay won first prize in the Institute of International Finance’s Jacques de Larosière Awards in Global Finance 2000.

²⁵This endogeneity is something that Nassim Taleb, an insightful thinker, understands and writes about but that is not always understood by those using his terminology.

²⁶(1) Stephany Griffith-Jones and Avinash Persaud, “The Pro-Cyclical Impact of Basel II on Emerging Markets and Its Political Economy,” in Capital Market Liberalization and Development, ed. José Antonio Ocampo and Joseph E. Stigletz (New York: Oxford University Press, 2008); and (2) Charles Goodhart and Avinash Persaud, “A Party Pooper’s Guide to Financial Stability,” Financial Times, June 4, 2008.