Together, these two studies suggest that a drop of between 9 and 10 percentage points of real GDP in the US and between 11.5 and 20.0 percentage points in the UK would have been necessary to totally erase the two countries real estate bubbles. These results highlight the unfavourable tradeoff between financial stability and output growth when “leaning against the wind” is the only instrument available to address the former. They also strongly suggest that, even if central banks had optimally followed the “inflation-targeting” principles (or the “Taylor rule”) ahead of the crisis, the higher interest rates that would have resulted would not have been sufficient to prevent the emergence of a bubble and the ensuing financial crisis. IV. How might systemic risk be reduced? The unfavourable trade-off I have just highlighted provides a powerful incentive to explore the potential of alternative instruments. This is where “macro-prudential tools” come into play. These tools focus on directly addressing the vulnerabilities to which the financial system as a whole is exposed. Their strength is that they target the problem directly at the root. Slide 7 summarizes the two main dimensions of systemic risk: the “structural” dimension, which covers the possible risks associated with individual institutions whose failure would endanger the entire system; the “cyclical” dimension refers to systemic risks which are not directly linked to an individual institution, but which stem from financial institutions’ collective responses to business or financial fluctuations and adverse shocks. “Structural tools” strive to reduce the impact of institutional failure by strengthening individual institutions.

Perhaps a society has to undergo a learning process on a broad front so that earlier mistakes yield new insights. Economic policy decision-makers like myself are, of course, no exception here. But as financial turbulence does not inevitably lead to a serious crisis in the real economy, we need to ask why it is that in certain cases output and employment do suffer severe setbacks and the attendant deflation. Much will have been gained if we can learn to tell whether or not an extensive share price fall, for example, besides being troublesome enough for many people, is likely to result in a situation with general deflation, rapidly falling output and rising unemployment. An answer to that question was suggested in the summer of 1999 by the Federal Reserve chairman, Alan Greenspan: While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan’s current economic problems. Likewise, while the stock market crash of 1929 was destabilising, most analysts attribute the Great Depression to the ensuing failures of Policy. Most things indicate that when banks run into trouble on account of financial turbulence, the supply of credit may dry up and the payment system cease to function.