Examples include the extrapolation of past growth rates of incomes or asset prices into the future when in fact they reflect an adjustment of the level of income or asset price to a new equilibrium. At the time, the MPC argued that the rise in the ratio of house prices to incomes in the years leading up to 2007 reflected a fall in long-term real interest rates – in other words, an adjustment to a new equilibrium house price to income ratio. But if households extrapolated past increases in house prices into the future, then they may have mistakenly inferred that future incomes too would be higher, and so spending and borrowing more than could be sustained. Similar arguments could be made about the reaction of businesses and households to the rise in the sterling effective exchange rate in the late 1990s, and I shall return to this later. Since long-term interest rates in financial markets are, if anything, even lower today the question of sustainability has not yet been resolved. Misperceptions mean that unsustainable levels of spending, and associated levels of debt, can build up over many years. When those misperceptions are eventually corrected, they lead to sudden large changes in asset values, a synchronised de-leveraging of balance sheets, a large downward correction to spending and  14  Caballero (2010). BIS central bankers’ speeches  5  output, and defaults.

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