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The Return of the Finance Threat?

Given recent history, policymakers would be unwise merely to hope for a best-case scenario in which a strong and quick economic recovery redeems the enormous run-up in debt, leverage, and asset valuations. Instead, they should now act now to moderate the finance sector’s excessive risk-taking.

CAMBRIDGE – After the 2008 global financial crisis, governments and central banks in advanced economies vowed that they would never again let the banking system hold policy hostage, let alone threaten economic and social well-being. Thirteen years later, they have only partly fulfilled this pledge. Another part of finance now risks spoiling what could be – in fact, must be – a durable, inclusive, and sustainable recovery from the horrid COVID-19 shock.

The story of the 2008 crisis has been told many times. Dazzled by how financial innovations, including securitization, enabled the slicing and dicing of risk, the public sector stepped back to give finance more room to work its magic. Some countries went even further than adopting a “light-touch” approach to bank regulation and supervision, and competed hard to become bigger global banking centers, irrespective of the size of their real economies.

Unnoticed in all this was that finance was in the grip of a dangerous overshoot dynamic previously evident with other major innovations such as the steam engine and fiber optics. In each case, easy and cheap access to activities that previously had been largely off-limits fueled an exuberant first round of overproduction and overconsumption.

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