Breaking the Boom-Bust-Bailout Cycle

By Simon Johnson, Bloomberg - November 12, 2011

At one level, all financial crises are the same. A relatively small group of people, typically bankers, find the opportunity to take very big risks. For a while, financiers show high profits, justifying rising stock prices for their companies and large bonuses for their top executives. But these profits are never properly adjusted for what will actually materialize over five to 10 years, meaning that they understate risk and overstate true earnings.

Greater short-term returns are often available if you take more risk; just look at the Icelandic banking system after 2003. Three banks were allowed to develop very large offshore businesses, building up a combined balance sheet that was 10 times the size of Iceland’s gross domestic product, mostly based on short-term funding. Iceland’s political leaders thought they had found a new road to prosperity. In October 2008 they discovered a perennial truth: Giant profits involve giant risks. Iceland’s banks collapsed, plunging the economy into a deep recession.

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