This is the reason that banking was tightly regulated in many countries following the Great Depression. These regulations were removed in the 1980s and 90s under the mantra that markets know best.
It is worth exploring the theory used to justify the deregulation of finance and banking in many countries, including New Zealand.
Market theory states that the role of banks is to channel savings into productive investments. Banks and other lenders operate in competitive markets to ensure funds are allocated in the best interests of an economy.
Lenders are motivated by profit. They carefully scrutinise loan applications to ensure the applicant can service the debt.
Lenders model the systemic risk of bad debts using historical data assuming that past patterns will continue. These models pay scant attention to the possibility of asset bubbles or herd behaviour because such behaviour doesn't fit the model.
Any bank that was inept in its lending practices would be taken over by profitable competitors or forced to close. Market discipline would ensure efficiency.
Borrowers are also perfectly rational. When they take out a loan they carefully scrutinise how they will invest this money to ensure a profitable rate of return.
Economic theory states that borrowers have perfect information and are totally independent of others in their decision making.
All this perfectly rational and informed decision making means that governments should have no concern about the level of private debt in an economy.
This is because private debt is the outcome of millions of rational and independent borrowers and lenders who have perfect information about the future.
That is the theory. Here is an alternative and possibly more realistic view of how banking and finance works.
Many lenders are motivated by bonuses and commissions that relate to the quantity rather than the quality of their lending. Banks fight for market share.
Any banker or bank that failed to deliver in the race to increase lending and market share would be penalised in its share price.
There is no point standing on the sidelines when the economy is booming. Any banker with concerns about bad debts and asset bubbles risks having to find alternative employment.
As bankers compete to meet lending targets they have a tendency to oversupply the market for loans. As these funds flood an economy they usually end up financing asset bubbles. In the 1990s it was tech stocks. In the last decade in many countries it was housing. The availability of easy credit pumps up the asset price increasing the value of the collateral allowing further lending.
Young first home buyers become desperate to get on the housing ladder. They take on huge mortgages in the belief that house prices can only rise.
Their parents regale them with stories about how difficult it was when they first started out.
What these parents fail to acknowledge is that they almost had to beg their bank manager for their first mortgage.
Lending was tightly controlled therefore house prices were a much lower multiple of average incomes. The most insidious aspect of a debt-fuelled housing boom is that it destroys the fabric of a society. Unlike shares or gold, people need a house to live in.
The deregulation of finance, here and abroad, opened a Pandora's box that had been tightly closed since the Great Depression.
When bankers get it wrong, entire economies can collapse. When tomato growers get it wrong, puree becomes cheaper.
* Peter Lyons teaches economics at St Peter's College in Epsom and has authored several economics texts.
