The problem of credit

During the Great Moderation investors became dependent on the signals emanating from central banks as up until 2007 the signals worked well in generating robust returns. The signals were of course predicated on the view that as long as inflation remained under control, the economy was not over-heating and thus assets could continue their growth in value. However, there is now a great deal of evidence that the Great Moderation was distinguished by a substantial growth in credit which drove asset prices higher, creating an unsustainable boom. This boom in asset prices was perceived by many market participants as being sustainable, because the underlying macroeconomic models assumed that credit markets were efficient and cleared. Any excess release of credit into the economy would naturally lead to higher inflation, thus causing interest rates to rise to choke off the excess expansion. According to this model, unsustainable credit booms could not exist. Credit was therefore largely ignored by the investment community as well as the central banks.