The banking crisis-death to rational expectations?

I am delighted to contribute this essay in honour of my friend Professor Yoshio Kurosaka. I was glad that he was able to visit Cardiff Economics during September-October 2008 when the storm from the Lehman bankruptcy had just broken. It was a fascinating time and the crisis gave rise to much discussion. Prof. Kurosaka brought to it the lessons from Japan’s ‘lost decade’ and that episode, together with the Great Depression, had a big influence on the policy response of the major countries. However, no episode is ever exactly the same as any other and in this paper I go into what I see as the particular features of this crisis. At the end I add a few remarks about what lessons are shared with the Japanese experience of banking crisis. The banking crisis of 2007–9 can probably be dated to August 2007, when the first bank casualties of the sub-prime collapse appeared and the interbank market closed up, claiming as its first victim the UK’s Northern Rock bank. However, many central banks took little offsetting action on their official lending rates, confining themselves to the provision of liquidity to the interbank market; the exception was the US central bank, the ‘Fed’, which was coping with the direct fall-out of the sub-prime collapse. For the others a dominant feature of 2008 was continued worldwide growth at rapid rates accompanied by a sharp boom in commodity prices which in turn fed into domestic prices. It