One of the striking things about the current financial crisis is the extent to which it was foreseen. Almost every major central bank, as well as the international financial institutions like the IMF, had been warning for some time about a serious underpricing of risk in the system. They pointed to low differentials between the financial returns paid on risky assets and safe assets and to increased levels of debt relative to underlying capital. In the face of very low interest rates, financial institutions were buying riskier assets to improve returns, often “leveraging” themselves several times over (by buying assets with borrowed money). Just before the crisis broke, in August 2007, the authorities were actually cautiously welcoming evidence that the underpricing of risk was being reversed.
How had this underpricing come about? In part it had resulted from the long period of low interest rates that had continued from the ending of the high-tech bubble in 2001, until central banks began to raise rates again in 2005. After the bubble burst, there was a fear of deflation in the US. Moreover, there appeared to be a world glut of savings. These two factors prompted expansionary monetary policies, with nominal interest rates at low levels and accelerating monetary growth in several countries.
This period of low interest rates did not lead to higher inflation. Indeed, these years saw a continuation of what is known as the “great moderation.” Ever since the early 1990s, the developed countries, with the partial exception of Japan, have enjoyed a golden age. Inflation has been low and growth steady with few, if any, cycles. This benign macro-economic picture led many to believe that financial conditions were less risk-prone than in the past.
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