The Origin of Financial Crises by George Cooper (October 2008) – Executive Summary & Key Messages

Two main subjects:

  • Why markets for goods and services tend toward equilibrium, but financial markets do not.
  • Why central banks are useful and what they should do (which they currently don’t).

Breaking the 170 page book into nine chapters, Cooper first talks about the current conditions (late 2008), disparages the Efficient Market Hypothesis and waxes poetic about John Maynard Keynes.  At this point, if you disagree with Keynesian Economics or its current “bastardization” as Cooper puts it, you may be ready to put the book down.  This would be a mistake.   Having made his bias clearly visible, it is easier to remove his slanted opinion from some very good history and the information provided throughout the book.

The third chapter of the book is easily the most important and well written of the book.  If even half of the population could understand money, credit and debt creation, wealth creation and central banks as explained in the book, we may not have half of our current issues today.  An actual understanding of what fiat currency is would most certainly enrage most people.

The remaining chapters continue to explain why the central bank is a good tool if used correctly, linking it to a governor—a corrective tool to limit the excess velocity of a machine—as well as further beating up the Efficient Market Hypothesis, advocating a policy that connects non-contradictory ideas of capitalism in good times, and socialism in bad.  He often points out that the central bank has caused inflation, currency debauchment, and how these are points Lenin claimed essential to the socialist movement.  Pointing out the concept of moral hazard and how the Federal Reserve as the “bank of last resort” furthers this would make many conservatives happy.  His conclusion does, however , ooze the progressive mindset that we need smart people at the top to regulate the masses.

Summary of key statements:

Efficient Market Theory: Asset Prices are always and everywhere at the correct price.

By definition, an equilibrium-seeking system cannot internally generate destabilising forces able to push it away from equilibrium.  According to this financial theory, any asset price movement must be generated by external “shocks”.

The idea that markets are always correctly priced remains a key argument against central banks, attempting to prick asset price bubbles.  Strangely, however, when asset prices begin falling, the new lower prices are immediately recognised as being somehow wrong, requiring corrective action on the part of policy makers.

Each and every day, financial markets move in ways that simply cannot be explained by our theories of how these markets work.

Nevertheless, despite overwhelming evidence to the contrary, the Efficient Market Hypothesis remains the bedrock of how conventional wisdom views the financial system!

Fortunately, there is an alternative theory: Financial Instability Hypothesis developed by the American economist Hyman P. Minsky. “Minsky Moment” is a phrase describing the point at which a credit cycle suddenly turns from expansion to contraction.

The implications of Minsky’s suggestions are that financial markets are not self-optimising or stable and certainly do not lead toward a natural optimal resource allocation.

The existence of bank runs is entirely ignored by financial theory and therefore by financial risk systems.  That is to say, our risk systems may be inherently designed to work only when they are not required like the proverbial chocolate teapot; it works only while not in use!

Central Banks – Everyone has one, but with differing views.  The Fed sees its role as combating any credit contraction, whereas the ECB sees its role as combating excessive credit expansion.

Teams of financial analysts use even the most banal utterances of senior central bank officials as an excuse to convert perfectly good trees into mountains of sometimes less-than-useful reports.

Central Banks use interest rate policy to control the capital markets.  Yet economic theory tells us markets are efficient and should be left to their own devices!  Why then do we need Central Banks to set interest rates?

It is a strange paradox that today’s central banks are generally staffed by economists, who by and large profess a belief in a theory which says their jobs are, at the very best, unnecessary and more likely wealth-destroying.

If central banks are necessary because of inherent instability in financial markets, then manning these institutions with efficient market disciples is a little like putting a conscientious objector in charge of the military; the result will be a state of perpetual un-readiness.

The efficient market story goes as follows.  All asset prices are currently at their correct level.  If we were able to reliably predict how any asset price were likely to move in the future, we would be able to reliably make a profit from buying or selling that asset.  But if it were possible to reliably make a profit through buying or selling the asset, then that asset’s current price must be wrong.  Therefore, according to the Efficient Market Hypothesis, asset prices must be unpredictable!

In summary, the Efficient Market Hypothesis requires the following to hold:

  1. Asset price bubbles do not exist; the prices of all assets are always correct.
  2. Markets, when left alone, will converge to a steady equilibrium state.
  3. That equilibrium state will be the optimum state.
  4. Individual asset price movements are unpredictable.
  5. However, the distribution of asset price movements are predictable.

The data just does not fit that theory.  We don’t find normally-distributed markets; we do find huge market discontinuities and a static, stable equilibrium has never once been observed anywhere in financial markets.

The theory can explain neither inflation nor central banking.

If one subscribes to the Efficient Market Hypothesis and also happens to be cursed by intellectual rigour, the unavoidable conclusion is that central banks should be abolished.

Example: Nobody applies those market principles to central banks and to the determination of interest rates.  Why?

There are two main schools of thoughts:

  • Friedman school: Central Banks make markets inefficient.
  • Keynes/Minsky school: Markets are inefficient and central banks make them more efficient.

Minsky suggests that financial systems do not settle down into a stable state.  Instead, they have basically two states; expanding or contracting credit.

Unfortunately, some of the most powerful central banks are operated according to a confused mishmash position based on one economic philosophy for an expanding economy and another quite incompatible philosophy for a contracting economy.

Had Isaac Newton subjected himself to these same standards, he would have given us three laws of gravity: one telling us how an apple behaves when thrown up into the air; another quite different law telling us how it then falls back to earth; and a third law telling us the apple never moves at all.

In some central banks, a misguided loyalty to the idea of market efficiency is leading to policies that inadvertently amplify, rather than attenuate market instability.

There is a very close connection between taxation and inflation.  The two are almost synonymous, with inflation representing a retrospective taxation.  If one accepts that taxation is necessary, then there is nothing inherently wrong with using inflation mechanism to generate tax income, though it would be healthier if the mechanism were more widely understood.

Money and debt are created in pairs; from nothing, live for a while, and then vanish when they recombine.  Taking out a loan creates a money-debt pair, paying off the loan destroys a money-debt pair.

  • 1) Private sector banking cannot be responsible for permanent inflation.
  • 2) That’s why some central banks worry so much about money supply growth.  Money growth means debt growth and it’s the debt that causes financial instability.

The original and still primary purpose of central banking is not, as widely believed today, to fight inflation, rather it is to ensure financial stability of the credit creation system.

Credit creation must stay and we must find a way to live with the instability that comes with it; it is better to have a volatile and growing economy than a stable and stagnant one.

The presence of the central bank created a perverse incentive structure within the banking industry.  It promotes risky lending practices and therefore a greater level of debt.

However, central banks have performed over time a minor move, from a reactive to a pro-active policy that turns a central bank from a mode of operation which it attenuates crises, to one which it amplifies crises.

Dealing with the private sector mortgage debt in the US will quite likely result in an inflationary wealth redistribution.  Those that saved would see the purchasing power of their savings eroded, while those that had borrowed money would see the real cost of their debt also eroded.  The upshot of all of this would be a net transfer of wealth from the prudent to the reckless, hence, the term “moral hazard”.

Government and central bank stimulus policies applied after borrowers had experienced the cathartic lesson of a recession is a sustainable strategy, but pre-emptive stimulus is ultimately not sustainable.

Bubble spotting – Credit Growth Is Key: If credit creation is running substantially ahead of economic growth, then that growth is likely itself to be supported by the credit creation and will not be sustained once the credit expansion ends.  If asset price inflation is unusually high compared to the income generated by those assets, then the assets may be overvalued.  This is particularly important in the stock market where credit creation flows so directly into both earnings and price side of the price-earnings ratio.

Given the mechanism by which most macroeconomic data can be distorted by financial bubbles, credit creation is not just an important macroeconomic variable, it is the most  important macroeconomic variable.

Credit creation is the foundation of the wealth-generation process; it is also the cause of financial instability.  We should not allow the merits of the former to blind us to the risks of the latter.

Today, we model the financial world as if it were governed by a procession of coin flips, but there is overwhelming body of evidence, suggesting this assumption to be wrong.  If we use the wrong tools, derived from the wrong theories, we should expect to get the wrong answers.  As Mandelbrot argues, to get to the right answers, we need nothing short of an entirely new statistic, one derived to fit real market behaviour, taking into account the real positive feedback processes operating within these markets.

While we continue to base our risk models, our regulatory regimes, our investment decisions, and our macroeconomic policy on mild randomness of efficient markets, we will remain perpetually unprepared for the shocks thrown at us by the financial markets.

  • Only the fittest theories should survive.  This requires the adoption of the scientific method; we must twist the theories to fit the facts, not the other way round.  Theories, such as the Efficient Market Hypothesis, which fail to pass this most fundamental of tests, should be cast unceremoniously aside.
  • The significance of monitoring credit creation must be stressed, while the value of balance sheet analysis should be downplayed.
  • New suite of tools that are able to describe patterns of asset returns under the influence of erratic self-reinforcing systems.
  • Shift central bank’s mandate from targeting consumer price inflation to that of targeting asset price inflation.
  • Changing our mindset—from one of unquestioning faith in market efficiency—to one that accepts the need for governance of aggregate credit creation (should be the role of the central banks) and the occasional tough choices that this requires.

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