But the historical record is revealing. Historically, ratios in excess of 90–100% of GDP have been found to exert a lasting drag on growth, perhaps of around 1 percentage point.2 At these levels, government debt has in the past been growth-sapping – and fear-enhancing. That adds to pressures on debt sustainability, which depends importantly on the wedge between interest costs and GDP growth. Psychological scarring These balance sheet scars are real. But in financial markets, risk perceptions are as important as reality. Behavioural economics tells us that financial crashes can leave lasting psychological scars on risk-taking. These mean that perceptions of risk can be systematically over-stated – the fear of fear itself. One potent psychological factor is disaster myopia. Psychologists know from experimental evidence that, faced with uncertainty, people base their judgements on simple rules of thumb or heuristics.3 One such rule of thumb is the “availability heuristic”. This states that agents base probabilistic assessments on the ease with which an event can be brought to mind: how recently it has occurred, how severe are its effects and how personal is the experience. Car crashes are the classic example. These often arise from disaster myopia, as drivers systematically under-estimate the probability of a pile-up and drive too fast. The longer the period since the last crash, the greater the risk-taking. After a lengthy stretch of clear motorway, risk appetite may become too healthy, and risk-taking too great, relative to the true probability of disaster. In other words, drivers are disaster-myopic.

A second practical role for macro-prudential policy is to make recommendations for how regulation might contribute towards moderating the credit cycle. The Basel Committee has recently developed guidelines for one potential macro-prudential tool – banks’ counter-cyclical capital buffer. This guideline is based on deviations in the ratio of credit-to-GDP from its long-term trend. This has been shown to be a reliable early warning indicator of future crises across a wide range of countries. It is akin to a Taylor rule for macro-prudential policy. Chart 18 plots the path of the UK credit-to-GDP guide-path over recent years. Unsurprisingly, it suggests that UK banks’ capital ratios should have been tightened in the run-up to the crisis, with credit-to-GDP above its long-term trend by up to 10 percentage points. That disequilibrium has since been completely eliminated as credit growth has collapsed. Currently, the guide-path is close to cycle-neutral. Any further fall would put credit below its cycle-neutral level, implying a loosening to support risk-taking. Setting regulation to boost risk-taking may feel like a new and radical departure from the past. But in fact it is neither as radical nor as new as it might first appear. In 1938, the US was facing a double-dip recession. Criticism of banks’ unwillingness to lend to the real economy was rampant. Fear in financial markets was mounting. The situation was eerily reminiscent of today. At that point, Roosevelt turned macro-prudential. In the Uniform Agreement on Bank Supervisory Procedures, a relaxation of prudential and valuation standards was announced for US banks.