Leveraged: The New Economics of Debt and Financial Fragility

Leveraged

Leveraged

The New Economics of Debt and Financial Fragility

EDITED BY MORITZ SCHULARICK

The University of Chicago Press

Chicago and London

The University of Chicago Press, Chicago 60637

The University of Chicago Press, Ltd., London

© 2022 by The University of Chicago

All rights reserved. No part of this book may be used or reproduced in any manner whatsoever without written permission, except in the case of brief quotations in critical articles and reviews. For more information, contact the University of Chicago Press, 1427 E. 60th St., Chicago, IL 60637.

Published 2022

Printed in the United States of America

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ISBN-13: 978-0-226-81693-7 (cloth)

ISBN-13: 978-0-226-81694-4 (e-book)

DOI: https://doi.org/10.7208/chicago/9780226816944.001.0001

Library of Congress Cataloging-in-Publication Data

Names: Schularick, Moritz, 1975– editor.

Title: Leveraged : the new economics of debt and financial fragility / edited by Moritz Schularick.

Other titles: New economics of debt and financial fragility

Description: Chicago ; London : The University of Chicago Press, 2022. | Includes bibliographical references and index.

Identifiers: LCCN 2022012491 | ISBN 9780226816937 (cloth) | ISBN 9780226816944 (ebook)

Subjects: LCSH: Finance. | Capital market. | Debt. | Risk. | Financial crises. | BISAC: BUSINESS & ECONOMICS / Economics / Macroeconomics | BUSINESS & ECONOMICS / Economic Conditions

Classification: LCC HG173 .L4835 2022 | DDC 332—dc23/eng/20220511

LC record available at https://lccn.loc.gov/2022012491

This paper meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper).

Contents

Foreword by Richard Vague

Introduction: The New Economics of Debt and Financial Fragility

Moritz Schularick

PART I  Finance Unbound: The Rise of Finance and the Economy

1  How to Think about Finance

Atif Mian

Comment by Karen Dynan

2  Reconsidering the Costs and Benefits of Debt Booms for the Economy

Emil Verner

Comment by Holger Mueller

PART II  Risk-Taking: Incentives, Investors, Institutions

3  Are Bank CEOs to Blame?

Rüdiger Fahlenbrach

Comment by Samuel G. Hanson

4  A New Narrative of Investors, Subprime Lending, and the 2008 Crisis

Stefania Albanesi

Comment by Fernando Ferreira

5  Bank Capital before and after Financial Crises

Òscar Jordà, Björn Richter, Moritz Schularick, and Alan M. Taylor

Comment by Anna Kovner

PART III  Mispricing Risks: Credit Booms and Risk Premia

6  Beliefs and Risk-Taking

Alessia De Stefani and Kaspar Zimmermann

Comment by Yueran Ma

7  A New Approach to Measuring Banks’ Risk Exposure

Juliane Begenau

Comment by Nina Boyarchenko

8  Is Risk Mispriced in Credit Booms?

Tyler Muir

PART IV  Financial Crises: Reconsidering the Origins and Consequences

9  Historical Banking Crises: A New Database and a Reassessment of Their Incidence and Severity

Matthew Baron and Daniel Dieckelmann

Comment by Mark Carlson

10  Was the U.S. Great Depression a Credit Boom Gone Wrong?

Natacha Postel-Vinay

Comment by Eugene N. White

11  Sectoral Credit Booms and Financial Stability

Karsten Müller

Comment by Orsola Costantini

Index

Footnotes

Foreword

In June 2019, the Private Debt Initiative of the Institute for New Economic Thinking (INET) convened an extraordinary group of economists for a conference on expanding the boundaries of economic thinking on credit cycles, private sector debt, and financial stability. Since they were from among a new generation of economists whose thinking was shaped strongly by the 2008 financial crisis, the conference was titled, appropriately, NextGen.

This book presents the new economic thinking discussed at this groundbreaking conference. It offers a synthesis of the new ideas that have emerged over the past decade along with an examination of questions that have yet to be addressed. I hope you will find the work presented on these pages as challenging and rewarding as those of us in attendance at the conference did.

Private debt and credit cycles have not received their due in economic scholarship, which helps explain why mainstream economists missed the mountainous ascent of U.S. debt that led to the 2008 crisis. Though public debt has drawn much more academic attention than private debt, there is far more private debt than government debt across the world, and it is more directly linked to economic outcomes and financial crises. In 2020, the fragility of an economy with high private debts became apparent again. Only extraordinary policy intervention could stabilize an ever more fragile macroeconomy.

INET’s private debt team led by Matthew Sware was instrumental for the success of the conference. Thanks also go to Chad Zimmerman and Christine Schwab at the University of Chicago Press for their guidance, and to Zach Gajewski for help with editing. Special thanks go to Rob Johnson and INET, an organization founded in the wake of the 2008 financial crisis in large part because of mainstream economists’ failure to anticipate that crisis. INET stands out in its commitment to developing and sharing the ideas that can repair our broken economy and create a more equal, prosperous, and just society.

Richard Vague, INET board member

May 2022

INTRODUCTION

The New Economics of Debt and Financial Fragility

MORITZ SCHULARICK

Moritz Schularick is professor of economics at Sciences Po and the University of Bonn, and a fellow at the Institute for New Economic Thinking.

Nobel Prize–winning economist James Tobin once called debt the Achilles heel of capitalism. Though written in the late eighties, it was a prescient statement that has continued to resonate. When the COVID-19 pandemic struck in 2020, global debt stood at record highs. In advanced economies, households and companies were so deep in debt, levels were roughly equal in value to three years of economic output. Companies around the world had used a decade of low interest rates after the 2008 crisis to leverage up and boost their returns on equity. In the pandemic, these debts turned into a massive risk, threatening not only the survival of businesses but also the integrity of the financial system.

In an effort to stem the further spread of the COVID-19 virus, mass shutdowns began, spooking financial markets. Concerns over how many of these debts would be repaid, which companies would be able to withstand this new crisis, and how big the damage would be for lenders, especially banks, quickly came into focus. Within a week in March 2020, equity markets lost one third of their value, the prices of corporate bonds fell dramatically, bank share prices collapsed, and even the market for U.S. government debt—usually one of the most liquid financial markets in the world—froze.

The policy response followed a now well-known playbook, the same used during the Great Recession. Talk of bailouts was back in the news. Policy makers rushed to contain the financial fallout with emergency lending, asset purchases, and liquidity injections. Central banks’ balance sheets provided the backstop for the financial system and were expanded at unprecedented speed.

Some of the lessons of the last crisis were learned. With the banking sector having more capital than it had in 2008, it was able to withstand the first shock caused by the pandemic. Yet without the actions taken by governments, another financial crisis was a real possibility.

And herein lies the problem. Clearly, 2008 and 2020 represent different types of crisis. The first came from a credit-fueled bubble in the housing market, the second was triggered by a virus. But both exposed the fragility of a system built on high leverage and debt. Though the 2008 crisis taught us a lot about banks, the Great Recession should have been a wake-up call to how fragile the entire financial system has become, due, in a large part, to our leveraged existence. The more leveraged we are, the harder it becomes to withstand repeated shocks to the economy. As these shocks continue to occur—no matter where they come from—their effects could become increasingly worse unless we take the time now to concentrate on the issues that have made our system vulnerable in the first place. Instead of maintaining a shoddy roof guaranteed to spring a new leak even though an old hole is patched, it is time to go beyond short-term fixes and consider building a stronger, more resilient roof.

With higher leverage, it has become ever more difficult to stabilize the economy. The legacy of the COVID-19 recession will be even more debt, and the overhang could cloud the economic outlook for years to come. In the future, the economy will be even more fragile. Echoing the proverbial hair of the dog that bit us, we are drinking to get over the hangover, but the more booze we glug down, the more severe our long-term drinking problem becomes.

When financial liberalization started in the late 1970s and early 1980s, on both sides of the Atlantic, this outcome was not what the cheerleaders of free financial markets then envisaged. On the contrary, freeing up and deregulating the financial sector came with the promise of more opportunity, higher growth, and better risk-sharing through more complete markets. Put simply, the prevailing school of thought said that bigger was better—and it looks like it was wrong.

Deeper and larger financial markets have not made our economies safer or more stable. Instead, we have seen growing financial fragility. The past forty years have witnessed a dramatic rise in the frequency of financial crises and more correlated risk-taking, with increasing economic and political damage. Policy interventions by governments and central banks have grown bolder and more frequent as well; central banks’ balance sheets are already bigger than annual GDP in many countries. The invisible hand of the market has needed an outsized helping hand to assist it.

Whether the promise of higher growth has been fulfilled remains an open question; it is difficult to know what would have happened otherwise. But on first inspection, growth has slowed down—not accelerated—in the United States and elsewhere since the 1980s. What we know for sure is that with financial sectors and outstanding debt many times larger than the real economy, we now live in an age of latent financial fragility, kept together by government backstops that have come to play a crucial role in stabilizing an inherently fragile credit system. Paraphrasing the words of Hyman Minsky, we have gotten used to stabilizing an ever more unstable economy.

An Unstable, Fragile System

Today, we must consider if, at the heart of our economies, there stands a sector that has grown tremendously in size but whose benefits are hard to pin down and whose workings are hard to explain with standard economic models. If so—how big would we want such a sector to be and how many safeguards would we want to put in place? How many bets on the future do we want this sector to make?

This book brings together a new generation of economists, from different fields of the discipline, to address these questions. Among them are scholars working in the areas of macroeconomics, banking and finance, asset pricing, and financial history. What unites them is that the financial instability experienced in 2008 was a watershed event for their economic thinking that has only been reinforced by the pandemic. Their academic careers began around the time of the financial crash and the crisis shaped their research agendas for the following decade. For them, as for many others, the crisis demonstrated the shortcomings of mainstream economics’ treatment of financial markets, credit cycles, and asset prices. Fresh economic thinking was clearly needed.

Questioning established wisdom in economics curricula, the researchers in this volume have made groundbreaking contributions to the discipline and are now working at the world’s leading academic institutions. They form the core of a renaissance of thinkers shaping research agendas. Their work may well become the new canon. The Institute for New Economic Thinking’s Private Debt Initiative brought them together to take stock of what we have learned about the causes and costs of financial fragility and how we can apply this knowledge to today’s circumstances, and to those in the future.

These new voices come with a new message that, though nuanced and varied, forms the intellectual core of this book: financial instability is endemic to modern economies, and the origins of this instability reach deeper than the dry, technical debates about banking regulation, countercyclical capital buffers, or living wills for financial institutions.

They argue that the growth of debt has to do with structural processes, such as shifts in the income distribution, that can bring about changes in the supply of credit, triggering waves of lending and borrowing. Such credit booms are often linked to asset price booms—with stock and house prices going through the roof—and waves of optimism that influence the expectations of bankers and households alike. Overoptimism, neglected crash risks, and bad beliefs about risk and returns more generally have all emerged as important explanations of recurring credit booms that can pose grave financial stability risks.

This argument marks a clear break with past economic orthodoxy. Until recently, most economists agreed that high debt may increase vulnerability to bad events. For example, financial stability reports produced by central banks are typically full of discussions of potential vulnerabilities to changes in interest rates, inflation, or economic growth. But economists have hardly discussed financial markets themselves as the source of instability. Today, we are not so sure anymore about the inherent stability of financial markets. New economic thinking suggests that the financial sector itself could, in fact, be the source of instability, a result of overoptimism and neglected tail risks in good times and possibly overly bearish expectations in bad times. New approaches assembled in this book aim to understand precisely the risks stemming from animal spirits governing risk-taking in financial markets.

Many contributions put the repeating patterns of financial boom and bust, originating in excessive private borrowing, at the heart of crisis dynamics: Why do credit booms happen if they predictably increase the risk of financial crises? Why do markets, time and again, convince themselves that this time is different—as Carmen Reinhart and Kenneth Rogoff (2009) put it—and repeat the same old mistakes? Why are boom and bust phases in lending and risk appetite so frequent and often hard—and sometimes even impossible—to square with basic financial logic? Arguably, no other subfield in the discipline of economics is so full of puzzles and phenomena that are often difficult to explain from the point of view of rational human behavior.

At the same time, the authors here embrace a much more refined view of the benefits of financial liberalization and the blessings of more finance a.k.a. financial deepening. They dispense with the certainty of simple assumptions and instead point to repeated boom and bust patterns that often seem to cause substantial damage to the economy. This new economic thinking is empirically oriented, open to insights from economic history and behavioral economics.

The original insights about the deeper causes of financial instability assembled in this book have important implications for economic policy. Without a better understanding of the true drivers of financial instability, the reforms introduced during the previous crises may never make the next crisis any less likely. As long as we do not understand the deeper causes, our current financial system is not much safer than it was in the early 2000s, and policy makers will continue to fly blind. Without taking new thinking into account, other important lessons of 2008 will remain unlearned.

Where We’ve Been and Where We’re Going

The structure of the book is meant to encourage debate and critique. Contributions are followed by responses from other scholars of equal reputation and standing. These responses may make important additional points that support the arguments laid out in the main contribution. Yet sometimes they may also underscore open issues, put the finger on a missing link in the argument, or highlight evidence pointing in other directions.

This book intentionally preserves the spirit of critical comment and plurality of opinion that has slowly permeated economics in the last decade. Above all, every contributor shares a vision of economics that is question-driven, not method-driven, allowing for a fruitful conversation arising from different angles and perspectives on important questions.

The topics discussed here are broken up into four thematic parts, covering the dramatic increase of financialization and its real economic effects, the actors behind excessive risk-taking, the mispricing of risks, and the origins and consequences of past financial crises. To better understand the scope of the work and the issues the authors tackle, both individually and collectively, let’s take a closer look at each theme.

The Rise of Finance

Until the 2008 crisis, most macroeconomists believed the financial position of a household could be sufficiently described by a single number: net wealth. It did not matter whether a household had, say, $100,000 in cash versus assets of $1.1 million and debt of $1 million. As the net wealth number was the same, both were assumed to be identical for all practical purposes. Today, there is a consensus among financial economists that balance-sheet positions and leverage make a big difference for real economic outcomes, particularly if asset prices, such as house values, fluctuate excessively. We now understand the aggregate demand effects of changes in borrowing constraints (Eggertsson and Krugman 2012; Mian and Sufi 2011, 2014a) and the importance of debt overhang for slow recoveries from financial crises (Jordà, Schularick, and Taylor 2013).

Before the 2008 crisis, if economists worried about debt, they mistakenly worried about public debt, not private debt. Spain’s public debt, for example, reached 35% of GDP in 2007, and the budget was solidly in surplus. The situation looked even better in Ireland. Two years later, both countries’ financial systems had imploded, their unemployment was up sharply, and Madrid and Dublin were forced to seek bailouts from the EU. There was next to nothing in key indicators of public debt that hinted at the imminent catastrophe. Private sector borrowing, however, would have sounded the alarm—it was the epicenter of the crisis, and private credit growth, real estate lending in particular, would have given the correct early warning signal. Throughout history, financial stability risks in advanced economies have almost exclusively come from private sector debt growth, not from the public sector (Jordà, Schularick, and Taylor 2016b). Public debt increases after a crisis, not before one, as governments step in to stabilize a weak postcrisis economy (Reinhart and Rogoff 2009; Laeven and Valencia 2012; Schularick 2012).

Since much of precrisis macroeconomics had put theory ahead of empirical data, the discipline missed the extraordinary buildup of private debt in the second half of the twentieth century. It was not until long-run data were finally compiled that the extent to which private debt had grown faster than incomes in industrial countries became clear. The break with the past has been particularly evident since the 1970s, when private debt began to skyrocket. Today, the indebtedness of households in the United States and elsewhere is a much-debated phenomenon. The numbers are eye-catching—between 1950 and the 2008 financial crisis, American household debt has grown fourfold relative to income. In 2010, the household debt-to-income ratio peaked at 120%, up from 30% on the eve of World War II.

From an accounting perspective, the sharp increase of credit-to-GDP ratios in advanced economies in the twentieth century has been first and foremost a result of the rapid growth of loans secured on real estate, that is, mortgage and hypothecary lending. The share of mortgage loans in banks’ total lending portfolios has roughly doubled over the course of the past century, from about 30% in 1900 to about 60% today. To a large extent, the core business model of banks in advanced economies now resembles a real estate fund: banks are borrowing short-term from the public in the form of deposits and in capital markets to invest into long-term assets linked to real estate, placing the majority of their eggs into one basket. This Great Mortgaging has been driven by the rapid growth of mortgage lending to households. The intermediation of household savings for productive investment in the business sector—the standard textbook role of the financial sector—constitutes only a minor share of the business of banking today, even though it was a central part of that business in the nineteenth and early twentieth centuries.

The deeper drivers of the process of increasing private debt remain much debated. Rising income inequality is frequently invoked as a significant factor. Raghuram Rajan’s influential book Fault Lines (2010) popularized the view that growing income inequality and indebtedness were two sides of the same coin. The idea is that households with stagnant incomes increasingly relied on debt to finance consumption, be it out of sheer necessity to get by or to keep up with the Joneses, whose incomes were growing nicely.

This link between rising inequality and household borrowing features prominently in post-2008 research. In their important work, Mian and Sufi (2009) demonstrated that household borrowing in low-income regions of the United States increased strongly before the 2008 crisis, followed by substantial employment losses during the Great Recession. Kumhof, Rancière, and Winant (2015) have exposed the connection between inequality, debt accumulation, and financial instability. Economic historians have also shown that both major financial and economic crises in the twentieth and twenty-first centuries—the Great Depression and the Great Recession—were preceded by a sharp rise of income inequality and growing household indebtedness. Krippner (2012) has linked the debt buildup to growing socioeconomic pressures. In a similar spirit, historian Hyman (2012) tied the growth of household debt in America to widening income disparities.

A recent paper by Mian, Straub, and Sufi (2020) lays out a potential mechanism that ties inequality and increasing debt together. They argue that rising income concentration at the top brought about a savings glut of the rich that supplied the funds for increased borrowing by nonrich households. For every borrower, there must be a lender, and wealthy Americans provided the savings for the borrowing of the less fortunate. In his intervention in this book, Atif Mian discusses, in greater detail, the link between rising income and wealth inequality, excessive borrowing, and financial instability. He argues that the credit supply shock from the savings glut of the rich has predominantly financed the demand-side of the real economy. This increasing reliance on credit as demand raises serious policy and equity questions he exposes and examines. In her response, Karen Dynan concurs, but she is somewhat less concerned with the immediate risks for the U.S. economy, as recent credit growth largely came from the corporate and government sector.

In his intervention, Emil Verner addresses the question whether credit booms are beneficial for the real economy. A large literature in the 1990s supported the view that financial deepening—making markets larger and more complete—was unequivocally beneficial for economic development. This view now looks somewhat naive. Verner argues that credit supply expansions can finance either an expansion in demand or an increase in the economy’s productive capacity. Key patterns in the data indicate that private debt booms often boost demand instead of productive capacity. His conclusion is that debt booms and developmental credit deepening should be seen as fundamentally different phenomena that operate through different channels. In his response, Holger Mueller highlights that the policy implications of these findings might well be more complex. For example, how would economies evolve in the absence of credit booms? Mueller believes it is possible that a world without such periodic bursts of excessive risk-taking might still develop more slowly and exhibit lower rates of growth.

Excessive Risk-Taking

Evidence shows that crises and severe economic downturns can be predicted by buoyant conditions in credit markets, measured either by increases in the quantity of credit (Schularick and Taylor 2012, Mian et al. 2017) or by low expected returns on credit assets (Krishnamurty and Muir 2019). But why do economic agents borrow and lend so much if it predictably leads to a financially fragile economy? What explains the excessive risk-taking observed before crises? The interventions in the second part of the book present the important inroads that have been made in the past decade in answering these questions and in understanding the deeper causes of recurring excessive risk-taking.

The central debate here concerns the role of incentives and institutions versus beliefs as the driver of excessive risk-taking. Incentives are often referred to as financial actors having skin in the game. In this line of thinking, low levels of equity play a central role in generating credit booms. Bankers have an incentive to take excessive risks because the payouts from their bets are asymmetrical. Heads they win, tails someone else loses. Financial regulation post-2008 has emphasized this incentive aspect, but various authors in this book make a strong case that misguided incentives might have less to do with excessive risk-taking than is commonly held. The true reasons for risk-taking could lie elsewhere, hence the risks for financial stability. Regulators, in other words, might be barking up the wrong tree.

In his intervention, Rüdiger Fahlenbrach looks at the incentives of bank CEOs before the 2008 crisis, studying a classic question in risk-taking literature: Are bank CEOs to blame for the recurrent bouts of excessive risk-taking we face in modern economies? He does not find much support for the idea that bad financial incentives have been a first-order contributing factor to excessive bank risk-taking. Instead, the evidence suggests that most bank executives believed that the risks they took were good for shareholders. Bank CEOs often lost substantial amounts of money when their stock packages became worthless, and in light of the considerable sums involved—sometimes hundreds of millions of dollars—it is difficult to argue that a lack of skin in the game explains why these CEOs pushed their banks to take risks that led to bankruptcy. Fahlenbrach concludes that all actors—households, banks, rating agencies, investors, and policy makers alike—failed to see the risks and believed in the upside potential of the U.S. housing market. By implication, regulating incentive structures alone might do little to mitigate socially excessive risk-taking.

In his response, Samuel Hanson agrees in principle, but he adds qualifications with regard to the interdependence of bad beliefs and bad incentives as explanations for excessive risk-taking during credit booms. Overoptimistic beliefs may well lead to problematic incentive structures on the bank level that aggravate the effects. On the other hand, monetary incentives may induce people to find ways to rationalize economic phenomena or dance as long as the music is playing, although they are aware of the risks.

Stefania Albanesi provides an important new perspective on the 2008 crisis itself. Based on meticulous data work, she demonstrates that real estate investors—borrowers with two or more first mortgages—played a prominent role in the 2007–2009 crisis, accounting for close to 50% of foreclosures at some point. This narrative is very different from the one prominent in the media, as Fernando Ferreira points out in his response. In fact, poor and minority subprime borrowers did not play a central role in the housing crisis and subsequent Great Recession. In terms of credit volumes, the 2008 crisis was mostly a middle-class affair. The narrative that places the blame on subprime borrowers has its origin in media coverage that, early on in the events, singled out certain parts of the population.

While many authors agree that incentives play a role for excessive risk-taking in credit booms, they are not the only factor. Imagine a market where actors have the right incentives because everyone is playing with their own money and has maximum skin in the game. Should we expect this market to be stable, and therefore avoid bubbles, excessive volatility, and spectacular crashes? A good part of the literature on incentive-driven financial stability would likely answer yes. As soon as people are not playing with others’ money, we would think the many puzzling phenomena we observe in credit markets would disappear. But if we look at a real-world market that fulfills these criteria of substantial incentives and low leverage—the equity market—we still encounter bubbles, manias, and crashes. Incentives, in short, are not the whole story.

In their intervention, Òscar Jordà et al. look at the risk-taking and incentives issue from a macroeconomic angle, ultimately coming to very similar conclusions. The authors ask if higher capital ratios—more bankers’ skin in the game—make financial systems safer. To address this question, they study financial crises in seventeen countries since 1870 and ask if changes in capital ratios are associated with risks of financial instability. The answer is resoundingly negative. They point out, however, that while capital apparently does very little to restrain endogenous risk-taking in financial markets, it helps absorb exogenous shocks and provides for speedier recoveries from crises. Anna Kovner’s thoughtful response stresses it will always be problematic to disprove microeconomic theories with macroeconomic time series; it is possible that changes in capital on an aggregate level do not reduce tail risk in aggregate, but higher bank capital may still lead to lower risk at individual banks and make the system more resilient to shocks.

Mispricing Risks

If bad incentives are only half the story, and bad beliefs the other half, what exactly do we know about the repeated mistakes that economic agents make, and how frequent they are? To what extent do bad beliefs permeate financial markets and lead to boom-bust cycles? In their intervention, Alessia di Stefani and Kaspar Zimmermann review the evidence for misguided beliefs and assumptions—particularly related to borrowers’ and lenders’ overoptimism—as the driver of credit booms. Using survey data and bank balance-sheet information, they document how expectations of different economic agents can be systematically biased and how this bias often takes the form of extrapolating past fundamentals, consistently leading to similar results as those of the past. A consequence is that sentiment indicators are reliable predictors of reversals—so when sentiment is irrationally exuberant, we can be assured disappointment is lurking around the corner. Di Stefani and Zimmermann conclude that waves of optimism and neglect of crash-risk play an important role for credit booms and crisis dynamics.

Yueran Ma provides an informed and comprehensive discussion of the recent literature on the nexus of deviations from perfectly rational forecasts and credit cycles. She identifies a common theme in the data: economic agents overextrapolate recent events. When things are good, people expect them to get even better; in bad times, there is no light at the end of the tunnel and economic agents remain too cautious for too long. Put differently, when good things happen, they feed extrapolation and overoptimism and, if connected to the credit system, can lead to excessive credit growth. When the overoptimistic expectations disappoint and don’t pan out as hoped, excessive lending eventually turns into losses, the moment of truth comes, and financial panic sets in.

It is important to note that these recent advances in the understanding of behavioral credit cycles are reminiscent of older approaches associated with Hyman Minsky and Charles Kindleberger, but the new implications for economic policy today are profound. If periodic mispricings of risk caused by expectational errors is an inherent feature of unfettered financial markets, then market discipline—an underlying principle of financial regulation—has to be reconsidered. It’s possible that when market discipline is needed most—that is, in times of financial exuberance and excessive risk-taking—this discipline fails systematically.

In her contribution, Juliane Begenau proposes to advance beyond slow-moving balance-sheet indicators and measure banks’ risk exposure in real time. To do this, she invites us to think of a bank’s balance sheet as a portfolio of bonds of different maturities. The bank balance sheet’s risk can then be measured in exactly the same way as the bond portfolio’s risk. In a standard asset pricing framework, the return can be expressed as a combination of different factors. The opacity of a typical bank balance sheet then gives way to a combination of measurable risk factors that can be hedged. Nina Boyarchenko discusses the assumptions underlying this novel approach with regard to the nettability of the asset, the liability side of banks’ balance sheets, and the absence of limits to arbitrage. Possibly her most important criticism is that banks are often the marginal intermediaries in asset markets, so their leverage constraints influence prices. Risk premia and expected asset returns may be determined by the relative health of the very financial intermediary whose risk exposure we are trying to measure. Banks partly set the prices for the risks they face.

In his chapter, Tyler Muir studies the price of risk and asks if it is systematically too low during credit booms. He shows that credit booms typically occur when risk is low in asset markets even though the fact that a credit boom is underway means that future risks are high. Put differently, risk premiums fall in credit booms while the quantity of risk appears to rise. This situation suggests a low, possibly too low, price of risk in markets. An important insight from Muir’s intervention is that risk aversion in the economy appears very low in credit booms. This insight is fundamentally consistent with the idea that low risk in the past (e.g., low volatility of asset returns) leads agents to view the world as safe, causing them to be overoptimistic about risk going forward and inducing them to underprice risk and take on excessive leverage in a credit boom.

Reconsidering the Origins and Consequences of Crises

Financial history is back in vogue since the 2008 financial crisis. On the one hand, researchers turned to the past to better understand the events that unfolded. On the other hand, the 2008 crisis opened up new windows on past crises as researchers began to look for commonalities and dissimilarities, and they are now again being explored in light of the economic effects of the COVID-19 pandemic. By now, it is well understood that financial crises are not black swan events but regular occurrences in industrial and developing economies, whether the result of poor financial foresight or an internationally debilitating virus.

Matthew Baron and Daniel Dieckelmann make this point by proposing a new quantitative approach for reconstructing and analyzing the global history of banking crises. Importantly, this new quantitative chronology points to the overlooked phenomenon of quiet crises, situations characterized by large declines in bank stock prices that are somehow missed in narrative chronologies of financial instability. The effects of such quiet episodes of financial distress