holders ought to neutralise fully any effect of increased leverage on the value of the firm. provided anglo - continental guano works v bell ( surveyor of taxes ) ( 1894 ) 3 tc 239. farmer ( surveyor of taxes ) v scottish north american trust, ltd ( 1912 ), ac 118. for example, the introduction of a separate corporate tax schedule in the uk in 1965 led for a time to the double taxation of equity. these investors account for perhaps half of the us equity market and two - thirds of the uk equity market. bis central bankers ’ speeches shareholders maximise firm value, and the world behaves according to mm, debtor discipline ought to defuse completely incentives to gear - up. figure 3 illustrates the point diagrammatically, showing payoffs to debt and equity. they are a mirror - image. the downside risk avoided by equity is assumed by debt and vice - versa for upside returns. in principle, then, combining debt and equity would lead to offsetting payoffs, neutralising risk - taking incentives. during the 19th century, debt appears to have played just this role. depositor flight and bank runs came thick and fast, operating as an effective disciplining device on shareholders and managers. that is why unlimited liability remained a prize asset until the end of the 19th century. this quasi - disciplining role of debt persisted up to the great depression. calomiris and mason ( 1997 ) find that debt and equity prices did a reasonable job of distinguishing good and bad banks during the chicago banking panic of 1932. indeed, they signalled distress fully six months prior to banks ’ failure. as the 20th century progressed, however, evidence of debt disciplining became patchier. studies in the 1980s typically failed to find balance sheet risk having a significant impact on banks ’ subordinated debt spreads ( gorton and santomero ( 1990 ) ). evidence from the 1990s was more encouraging ( flannery and sorescu ( 1996 ), morgan and stiroh ( 1999 ) ). but even then the link was weaker among larger banks, with little evidence of market prices influencing banks ’ risk decisions ( bliss and flannery ( 2002 ) ). nowhere was the ineffectiveness of debtor discipline better illustrated than in the run - up to the recent financial crisis. chart 6 plots cds premia for a sample of 33 large international banks over the period 2002 to 2011. it partitions the sample into “ crisis ” and “ no crisis ” banks, where the

s policy response to the crisis. the funding for lending scheme ; the liberalisation of our liquidity insurance to the banking system – through the extended collateral term repo scheme and the liberalised discount window facility ; and the financial policy committee ’ s related recommendation to the prudential regulation authority to relax liquidity requirements on banks – all these fell under the same broad heading. “ keynesian ” because we are supporting demand in order to help smooth the adjustment the economy is going through. but a central bank ’ s monetary and liquidity interventions cannot remove the need for adjustment. the uk economy entered the crisis with too much debt in banking, in the household sector, in government and, for the nation as a whole, externally. and the uk entered the crisis with the composition of demand imbalanced – too much public and private consumption, too little net trade. indeed, aggregate demand had been unbalanced for so long that the economy ’ s productive capacity was ( and probably still is ) unbalanced, investment in capital having followed the pattern of demand. for prosperity to be put on a secure footing for the longer term, adjustment is still needed. with one vital exception, engineering structural change in the economy is not the responsibility of the central bank. the exception of course is the safety and soundness of the banking system, which is a precondition for broader monetary stability. an undercapitalised banking system would not be able smoothly to supply sufficient credit to aid recovery as demand picks up, enabling investment in innovations and efficiency. nor has it been able to do so as much as needed to help capital shift to firms and sectors that are beneficiaries of the new pattern of global and domestic demand. in my view, that may explain some of the weaknesses in productivity growth. 9 the financial policy committee required recapitalisation of the uk ’ s big banks and building societies not simply because that is needed to underpin stability, which it is, but also because a resilient banking system is a precondition for sustained and better balanced recovery. new entrant banks can do a bit, but the big incumbent banks need to be healthy too. their repair is now underway. that has required, and will continue to require, realism about asset values, expected losses and risks – not pretending, taking the medicine. in that sense, it is a policy in the spirit of hayek. 10 so the overall policy package has combined keynes and hayek. conclusion in