In a recent quarterly review, the Bank for International settlements observed:

How best to address financial cycles is a broader policy question that the specific analysis in this article obviously cannot answer. As discussed in detail elsewhere (see eg Borio (2014a,b)), there is a case that policy should first and foremost constrain the build-up of financial booms – especially in the form of strong joint credit and property price increases – as these are the main cause of the subsequent bust. And once the financial bust occurs, after the financial system is stabilised, the priority should be to address the nexus of debt and poor asset quality head-on, rather than relying on overly aggressive and prolonged macroeconomic accommodation through traditional policies. This would pave the way for a sustainable recovery. The idea would be to have macroeconomic policies that are more symmetrical across financial booms and busts so as to avoid a persistent bias that could, over time, entrench instability and chronic economic weakness as well as exhaust the policy room for manoeuvre.

As I discuss at length in Transparency Games, our financial system was redesigned during the Great Depression to address financial cycles. During the build-up to a financial boom, the combination of transparency and caveat emptor constrains the boom. Since investors know they are responsible for all losses on transparent investments, they exercise self-discipline and limit any investment to what they can afford to lose. During the bust, the nexus of debt and poor asset quality is addressed head-on by making the investors recognize their losses. This paves the way for a sustainable recovery. By design, there is no need to rely on overly aggressive and prolonged macroeconomic accommodation through traditional policies.

Of course, our financial system can only address financial cycles if the policymakers are willing to let the system operate as it is designed. In our current crisis, policymakers were unwilling to require investors, including banks, to recognize their losses. Instead, they chose to rely on overly aggressive and prolonged macroeconomic accommodation through traditional policies.