##ly adjusting to equate the demand for labour with its supply, periods of deficient labour demand can persist, sustaining mass unemployment and joblessness. yet efficient market forces “ should ” eliminate these disequilibria by having wages adjust to ensure full employment always and forever. monetary policy is not only a response to these rigidities ; it is made effective by them. in capital markets, there is ‘ momentum everywhere ’. from bonds to equities to currencies and commodities, past winners seem to enjoy further winning streaks, while past losers persist in trailing behind. 4 yet efficient market forces ‘ should ’ eliminate these predictable movements before they become apparent. * * * the belief that markets always clear had two dangerous consequences. 5 first, if markets always clear, they can be assumed to be in equilibrium ; or said differently “ to be always right. ” if the received wisdom is that the market is efficient, then bubbles can neither be identified nor their potential causes addressed. such thinking dominated the ( non ) reaction to us subprime and housing booms. consider that many market participants find it more profitable to anticipate each other ’ s behaviour than to divine the fundamentals. for a review of this broader phenomenon, see padoa - schioppa, t ( 2010 ), “ markets and government before, during and after the 2007 - 20xx crisis ”, the per jacobsson lecture, june. asness, c, moscowitz, t and pedersen, l ( 2013 ), “ value and momentum everywhere ”, journal of finance, lxviii, no. 3, june. see also turner, a ( 2010 ), “ market efficiency and rationality : why financial markets are different ”, lionel robbins memorial lectures, london school of economics. bis central bankers ’ speeches the game of guessing what everyone else is guessing ( everyone else is guessing … ) was familiar to keynes who observed that too often investors “ devote [ their ] intelligences to anticipating what average opinion expects the average opinion to be ”. 6 this disconnect between decisions and fundamentals feeds market volatility and capital misallocation. such “ beauty contest ” dynamics afflict not only sophisticated investors, but also many mortgage lenders and homebuyers, particularly during a “ new era ”. if house prices can only go up, it ’ s possible to borrow large multiples and pay off future obligations with the capital gains that will almost surely follow. such “ rational ”

years. by requiring banks to hoard capital in the upswing, regulators make it more expensive for banks to lend money. and by dampening the credit cycle policy could help stabilise spending in the real economy. protecting the cycle from the banks in my view there is a case for taking this further and adopting the more ambitious goal to use regulatory requirements to smooth out the credit cycle. in other words, preventing the imbalances within financial markets destabilising the real economy. this would involve varying the regulatory requirements to stabilise the supply of credit and the terms on which it was granted – for example by requiring banks to hold more capital when they would otherwise be loosening credit conditions, and allowing banks to run down capital when they would otherwise by restricting access to credit. this approach could offset to some degree not just a domestic credit cycle but the impact of developments elsewhere in the global economy which affect the terms on which banks are able to raise funds in financial markets or the he value of their assets. to a limited degree this would allow the authorities to make the banking system a shock absorber. policymakers would be raising capital requirements to preventing shocks that occur outside the banking system from destabilising the real economy. but i would limit the goal to smoothing the credit cycle and would not be inclined to go further and use it as a general stabiliser of the economy. weapons in the arsenal so what is the choice of instruments? i see great attractions in “ dynamic provisioning ”, in other words amending the accounting system to recognise likely future losses. that seems to produce a better guide to the real financial strength of banks and to be properly conservative in not recognising profit before it is earned. i am aware that this runs counter to a powerful school of accounting theology but i have been encouraged by proposals circulated recently by paul boyle at the frc for cyclical reserving and i hope that will be pursued. an alternative approach would be to vary regulatory capital floors with the cycle and require banks to hold undistributed reserves in the upswing which could be drawn on in the downswing. this is a second best because the reserves are taken after profit is struck, with all the signals that sends investors and staff. but it could have much the same effect as dynamic provisioning and may be capable of implementation rather earlier. but capital requirements are not the only approach. counter cyclical limits could be introduced on the liquidity position of a bank.