, the 1990s provided many illustrations of similar events. the discussion about financial cycles is far from new. one example is the major debate of the 1920s and 1930s between the austrians ( hayek, etc. ) on the one hand, and keynes on the other. keynes was focusing on the demand side and on how to get out of the bust, whereas hayek was focusing on the supply side and on how an economy got into the bust in the first place. while a great deal has been done to understand the reasons behind financial instability, many questions remain unsolved. so the discussion continues and when it comes to crises prevention, two conventional pieces of policy advice seem to emerge. the first line of defense is moral suasion. the central bank could warn market participants in various ways that they are becoming overly optimistic in their expectations about future cash flows, if we are talking for instance about stocks or real estate. the problem with moral suasion is that it is difficult to calm down a market that is rushing to new highs. talk rather than action is often not enough. still, if a bubble is starting to build up, it may be worth a try. this is one reason why several central banks have began to publish financial stability reports. in this way one can perhaps broaden the public discussion about what is happening. the second line of defense is prudential regulation. however, the way prudential regulation is done in practice raises two, interrelated problems. the first has to do with the fact that most financial crises stem not from individual banks getting into difficulties and affecting others by contagion. rather, in most cases, many institutions act more or less similarly, encouraged by overoptimistic expectations that macroeconomic conditions can be extrapolated uncritically into the future. the second problem with prudential regulation is that the tools are themselves often based on perceptions of risk which are not independent of the credit and asset price cycle itself. on the one hand, underlying actual risk builds up as expansion and leverage continue and the financial cycle proceeds on the other hand, apparent risk declines with the rise in collateral values. this causes difficulties for supervisors who tend to concentrate on individual institutions and treat risks as exogenous. this is not to deny that by improving prudential regulation, setting international standards ( for example basle ii ) etc, the risk of financial instability can be significantly reduced. supervisors are also recognizing the shortcomings i just mentioned and are

increasingly focusing on developments that generate systemic macroeconomic risks and on constructing built - in mechanisms to dampen the financial amplification of the business cycle. for example, supervisors are trying to encourage stress - testing by private sector risk managers to enable them to better see through asset market misalignments. another way is to make provisioning practices more forward - looking than at present and to adopt more conservative, less cyclically sensitive measures of value. the idea is to build capital cushions in good times that can be used in bad times. hence financial cycles could be milder. whether improved prudential regulations, supervisory practices and risk management techniques will suffice to avoid financial cycles in the future remains to be seen. our experience so far does, however, leave some doubts about this. this brings us to a possible third line of defense that could at least in principle be used to prevent large financial cycles. i am of course thinking about monetary policy the argument is that since we live in a fiat money system, there is no exogenous constraint on the supply of credit except through monetary authorities. if those reactions are geared exclusively to controlling inflation, then the monetary anchor may not counter a build - up of credit that does not immediately lead to inflation in the price of current output. hence, there is little to prevent the emergence of cycles in the prices of real and financial assets that are not included in the measure of inflation. in addition, experience has taught us that price stability is not, by itself, sufficient to ensure financial stability. so why don ’ t central banks simply change the way they conduct monetary policy and also try to prevent financial cycles? well, the conventional view is that they should not. there are some very powerful arguments against a central bank trying to respond to credit expansion and “ misalignments ” in asset prices that do not lead to inflation in goods and services. first, how do we know that a bubble is a bubble and not a reflection of fundamental values? second, even if the central bank does recognize the emerging bubble and wants to prevent it from building up, by the time it could form a judgement about this, it would be to late. third, if a central bank is fortunate with both the recognition and the timing, there is still a risk that it will cause an economic recession. to have any effect on excessive optimism about future returns on financial assets, the monetary response might have to be. nevertheless, the costs of financial cycles are sufficiently large to warrant