The following article deals with the topic “The Future of Central Banking: Inflation Targeting vs. Financial Stability,” which will be discussed at the Global Economic Symposium in Rio this October. The author intends to enrich the discussion at the symposium with his personal stories and ideas.

In September 1998, following the financial collapse of Russia, a hedge fund went belly up. It wasn’t an ordinary hedge fund: among its board members were two economics Nobel laureates, and its failure triggered a coordinated bailout orchestrated by the Federal Reserve Bank of New York. Almost all of the major investment banks operating in the United States at that time were involved, with contributions totaling $3.6 billion.

1997 economics Nobel laureate Myron Scholes, of Black-Scholes model fame, and one of the partners of LTCM | Photo by Magnus Manske on Wikimedia Commons, CC BY 2.0

The story of Long Term Capital Management (LTCM) became, at the hands of journalist Roger Lowenstein, a best-selling book ingeniously titled When Genius Failed. Some of the several possible lessons implied from the book are: no single player is bigger than the market, extreme outcomes are incredibly hard to predict, and hubris can take a financial system down. In sum, even geniuses sometimes fail spectacularly; it’s part of the game we used to call capitalism. Capital unwisely invested is punished and changes hands to more efficient players, who are only as good as their last investment decision. Harsh as it may sound, this grand scheme of organizing society helped take mankind to levels of prosperity that were unimaginable before it emerged.

Ten years after the failure of LTCM, Lehman Brothers filed for bankruptcy, and global markets entered a destructive spiral, only interrupted after the largest injection of public money in financial institutions ever seen. In the minds of many economists and policymakers, one fact was directly linked to the other: Lehman’s failure triggered chaos in financial markets, so we should avoid large bank failures at any cost. This is one of the main pillars of what is now being called “financial stability.”

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