Customer Reviews

The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy (Vintage)

5 star:		(13)
4 star:		(11)
3 star:		(5)
2 star:		(2)
1 star:		(2)

 

 

There's a lot to like in this book. George Cooper (GC) provides one of the most lucid and concise descriptions of the role of central banking you're ever likely to encounter. He carefully distinguishes among the philosophies of different central bankers, such as between the Federal Reserve and the European Central Bank. His critique of the Efficient Market Hypothesis (or "fallacy", as he prefers to call it) is trenchant and clear, as is his analysis of why the "fundamentals" of a stock aren't fundamental. He highlights the heterodox theories of Mandelbrot and Minsky, which are closer to the truth than the orthodox ones Ben Bernanke used to teach at Princeton. And he writes with a wry sense of humor, including a nice one-liner about boom-bust cycles that I'm surprised other reviewers haven't mentioned: "The invisible hand is playing racquetball" (@105).

That said, this book won't give you the whole story in understanding the current financial crisis. For one thing, GC never mentions credit default swaps or other derivatives, which in the aggregate dwarf the "real" economy. Even when GC describes why balance sheets are misleading, he doesn't mention any off-balance sheet instruments, of which derivatives are one category.

For another, GC tends to be overly accepting of microeconomics, and even of the diligence of lenders. For example, he says, in a kind of defense of bond ratings analysts, "When ratings analysts are assessing the quality of a loan, ... or the mortgage broker is assessing the safety of a mortgage, they evaluate each loan against the prevailing market prices for the loan's corresponding assets. In this procedure the tacit assumption is that the asset in question can be sold to repay the loan. At the micro level this is always a reasonable assumption" (@115). GC's point is that there is a "fallacy of composition" in reasoning from the micro scale to the macro -- the macro-level reality is not simply the sum all the micro transactions. OK. But why is the assumption he mentions *always* reasonable at the micro level? And why doesn't GC mention that in the current financial crisis, ratings agencies, mortgage brokers et al. did NOT follow the careful procedures he describes? (to say nothing of explaining *why* they didn't). The recent books by George Soros, Charles Morris and especially the fantastic "Structured Finance and Collateralized Debt Obligations" (2nd. ed. 2008) by Janet Tavakoli will tell you much more about this aspect of the story.

GC rightly points out that many economists' arguments operate on the principle of "proof by assertion" (@6), but he doesn't entirely avoid this trap himself. For example, GC's simplified descriptions of the history of finance are mostly based on "toy model" analogies, such as bakers and farmers selling their wares in a town square (Chapter 3). This picture isn't entirely historically accurate; e.g., when he asserts that central banking was necessary for the development of venture capital "in the truest sense of the word," whatever that means (@55), he overlooks the venture investments of the Medici during the medieval period, as well as many forms of Islamic financial transactions. None of those investment structures relied on central banks. This gave me the feeling that other aspects of his explanation might be a bit too pat, as well, especially when he says that some particular institution or practice led to or enabled another.

As he shifts his argument to a more constructive point of view, GC invokes an ingenious analogy (Chapter 6) to 19th-Century physicist James Clerk Maxwell's mathematical theory of mechanical "governors" (gizmos that kept machines from spinning out of control; Maxwell's original paper is reproduced as an appendix). Ingenious, but problematic. Most of standard neoclassical economic theory is based on ingenious analogies to physics, too (see especially P. Mirowski's 1989 book, "More Heat Than Light"). Some of those analogies, such as to "equilibrium" in supply and demand for consumer goods, sound at first blush as plausible as GC's analogy to Maxwell: ask any mainstream economist. But that plausibility doesn't mean that any of the theories are right -- and indeed, in the neoclassical case, the theory is wrong. GC doesn't use any empirical data stronger than anecdotal evidence to show that his Maxwell analogy is apt to the real world. Nor does he provide evidence that the policy recommendations he deduces from that analogy are feasible.

GC's failure to enagage with the derivatives issue is pertinent in this context too. One of GC's main constructive ideas is that central bankers should "prick" asset price bubbles as soon as they can identify that they've begun. (BTW, GC uses the word "asset" not as you might have learned if you took an accounting class, but in the finance pro's narrow sense of referring to stocks, bonds and other financial instruments.) If this sends the economy into small cycles of good times and tougher times, so be it -- in GC's view, that's better than the long ride up and crashing ride down we've experienced so often under Greenspan and his successor. However, GC says *the* key macroeconomic variable for identifying bubbles is the rate of credit creation (@125). Many derivatives contracts, like the ones that made trouble for A.I.G. in autumn 2008, are a form of credit creation -- just like bets placed with a bookie, any form of gambling creates debts. But derivatives are notoriously non-transparent: it's hard to know how many of these contracts are out there at any time. In that case, the visible data (mainly loans, bonds, etc.) might understate the amount of credit in the economy and also understate the rate of credit creation. So how's a central banker supposed to know the right time to prick? Since GC doesn't show how this approach has worked in the past, it's a matter of faith as to whether it might in the future.

This is a clear, witty book from which you can learn a lot. And some of GC's recommendations aren't so controversial, such as his suggestion for using a different form of statistical analysis (e.g., à la Mandelbrot) for looking at financial markets. But ultimately, the book is stronger when criticizing current practice than when proposing new policy.

Cooper covers the same subject as Kindleberger's Manias, Panics, and Crashes: A History of Financial Crises (Wiley Investment Classics); and that is Hyman Minsky theory that the credit cycle exacerbates both asset bubbles and crashes. Credit is too plentiful when the price of the collateral goes up; and too restrictive when the price of the collateral goes down. By doing so, creditors fuel both bubbles and crashes.

But, Cooper and Kindleberger treat the subject very differently. While Kindleberger develops an encyclopedic model of crises since the 1600s, Cooper obsesses in using Minsky's theory for rebutting the Efficient Market Hypothesis and blaming the Fed for not pricking bubbles. But, Cooper over reaches.

Cooper overlooks that his remedy (pricking bubbles) has been tried. And, the track record is scary. Two central bankers did it. One exacerbated the Great Depression. The other caused a 20 year deflation cycle in Japan.

He does not factor that the inflation/deflation risk trade off is asymmetric. It is easier to curb inflation (raise interest rates) than getting out of deflation (can't lower rates below 0%).

Cooper overlooks that a central bank mission is to manage inflation and GDP growth by responding to macroeconomic shocks. Also, asset prices (stocks, real estate) are often negatively correlated to GDP growth and inflation. For the Fed, this would mean having a single set of breaks for four different cars running in opposite directions. Thus, if the Fed was to preempt various asset bubbles, it would run into a constant policy paradox. Does it preempt a bubble and risk a dangerous deflation cycle or not? To avoid this situation, the Fed instead focuses on inflation targeting.

Another area where Cooper and Kindleberger diverge is who to blame for excess credit expansion. Kindleberger sticks closer to Minsky's theory and blames partly the banking sector that is too happy to lend on their rising collateral value. Instead, Cooper blames mainly the Fed. Meanwhile, the data shows that even throughout the housing bubble in the first half of this decade the growth in the money supply was moderate. And, the Fed increased the Fed Funds rate from 1.00% to 5.25% between May 2004 and July 2006. So it was not an expansive monetary policy that caused the housing bubble. It was an outdated regulatory framework. Cooper blames the Fed for running a chronic expansive monetary policy that causes inflation. But, he ignores the data. Since 1987, the money supply has grown at a moderate pace combined with a low inflation rate. Low inflation has also been supported by the emerging World's savings glut as elegantly explained in Wolf Fixing Global Finance (Forum on Constructive Capitalism).

In chapter 7, Cooper takes an excursion in Mandelbrot's fractal geometry from his book The Misbehavior of Markets: A Fractal View of Financial Turbulence to rebut the Efficient Market Hypothesis (EMH). (I invite the reader to read my review on this interesting book). The problem with Mandelbrot is that he comes up with a model that is even less robust than the EMH. Mandelbrot mentions a long term memory embedded in the markets regarding price and volatility. But, when looking at monthly data of S&P 500 returns since 1950 this memory is no where to be seen for both price change and price volatility. Meanwhile, such data does fit a Normal distribution fairly well even though the data is less disperse than the Normal distribution (positive Kurtosis). So much for the fat tail problem. Cooper states that our risk management problems are due to our not picking the correct distribution. I wonder if the problem is more that we don't go back far enough to fully capture the volatility in the data. This was the case for Long Term Capital Management failure as well reported by Lowenstein in When Genius Failed: The Rise and Fall of Long-Term Capital Management.

Cooper's recommendations are as controversial as his analysis. He suggests that the Federal Reserve abandons managing inflation, as he believes that goods and services operate within efficient self-stabilizing markets (unlike assets). He wants the Fed to solely focus on managing credit creation so as to prevent asset bubbles. He also wants the Federal Reserve to have control of both monetary and fiscal policy.

Reviewing Cooper's recommendation, we observe that the Fed has been very successful at managing inflation and somewhat successful at managing money supply growth. The latter is only one component of credit creation. The latter depends on many other factors beyond the Fed's control. This is especially the case for the Budget Deficit (fiscal policy). His proposal that the Federal Reserve control fiscal policy is politically unrealistic.

FYI--this book receives a good review in "Credit and blame: a must-read on the origins of the crisis," The Economist 388(8597), 13 September 2008:79.
"The [credit] crunch has lasted long enough to spawn its own publishing mini-boom, as authors have raced to give their diagnoses in print. George Cooper, a strategist at JPMorgan, an investment bank, has produced by far the best so far, skewering both academic orthodoxy and central bank policy in the process...Mr Cooper's book is by far the most cogent and reasoned of the modern-day 'credit excess' school."

I completely agree with the positive recommendations of The Economist Magazine and the reviewers. George Cooper has combined a strong technical and practical investment background to produce a modern thoughtful study of how to best manage our complex economy. However, I disagree with Brady on its readability, I feel Cooper opens this subject up to any thoughtful investor {regardless their background) by writing in down-to-earth English. He uses everyday examples, like a baker making and selling bread. His clear understanding of the material and deep sympathy for the reader motivate him to use such everyday examples to completely dispense with mathematical equations. He still maintains the needed precision.
I was persuaded that economic crises are inevitable, and enjoyed his ideas on how we might deal with them. I want to encourage every investor and student who is curous about how we can improve our economy to read Cooper's clear, cogent presentation.

This book is well written. It is very well organised and structured, engaging, easy to read, clear and interesting.

According to the author, one can hold one of 3 views:
1) one can think that the markets are efficient (auto-equilibrating) and believe the central banks are required (mainstream thinking). According to the author, this is logically untenable because if the markets are efficient, then logically one would not need a central bank to correct desequilibria as they would not occur.
2) one can think that the markets are efficient and therefore no central banks are required (Friedman). According ot the author this is more logical but empirically false as reality shows that markets are inefficient and severe crisis do occur on such a regular basis as to invalidate the theory of automatic auto-regulation of the markets
3) one can think that the markets are inefficient and that we needed an interventionist central bank. This is the point of the author. In one chapter, the author recommend a strategy of "monetary regulation" copied from Maxwell's "governors" in physics: this is required precisely because (again according to the author) markets are as inherently instable as the Eurofighter plane is (the plane though is this way by willful design for manoeuvrability purpose and the instability is corrected electronically by a "governor").

There can be little argument against discarding 1).

So the difficult part is deciding on between 2) and 3).

Let's say we go along with the author and choose 3). Then we are facing with a nightmarish situation. You would need to have always a very competent (actually a genius) economist to direct the "governor" of the central bank. Although it needed not be perfect (and the author make it seem almost easy to design), most people can express doubt about this and the actual result. And then consider what happens when one day a president names his loyal (but incomptetent) friend (of course, this could never happen in the real world!) at the helm of the central bank and this friend is seated on the cockpit to pilot the "inherently unstable" eurofighter/economy! You guess it... we might not enjoy a soft landing but a terminal crash! Scary prospect. No wonder there is a market for gold, even nowadays.

Let's now consider option 2). Like another reviewer I was stunned when the author discarded the option by merely writting (p. 55):

"It soon became apparent through repeated waves of financial crisis, that this new credit generation system was highly unstable. However it was equally apparent that this new system was also leading to dramatic economic expansion, wealth generation and improving living standards. Going backward to a world before depository banks and credit creation was not an option. The process of credit creation had opened up a whole new channel for economic growth and prosperity. Venture capital in the truest sense of the word was now possible. Equally the new banking system permitted channels by which risk could be pooled and shared; larger ventures became feasible."

Wow! We are to take this at face value! Lots of details follow as to why the instability occurs but zero further explanation why the credit generation system is required and is the actual cause of the prosperity. It is supposedly "self-evident". This is like my mathematical teacher would say: the weak point in an argument is always the line where someone writes the disputed "obviously formula xyz applies in all case" and then spend all the rest of the article explaining, at great length, the obvious. In this case, the author spend virtually the entire book trashing the efficient market hypothesis, and zero line defending the most contentious point!

Indeed, there is a growing number of very knowledgeable economist who do believe that the central bank is not necessary and that fractional reserve banking not only is the no 1 source of instability of the system, but should be abandonned.

Now let's respond to the author point by point:

1) "venture capital in the truest sense of the word was now possible". Hummm. It ALWAYS had been possible. People have always pooled their money and give it to an adventurer going to India or America; people have always pooled their money to give to the inventor to create a new machine. You don't need a fractional reserve bank AT ALL to do this.
MOREOVER, without a fractional rerve banking system, you remove the main instability: if the endeavor/project fails, only the venture capitalist lose and they had themselves accepted the risk, no surprise. In a fractional reserve system, either the bank disappear (about 9,000 failed in the 30's in the USA...) destroying hard-earned savings of people who never thought their money was used for risky endeavor, or, the central bank is used to save the bank (2008 situation) and its risk-takers (or plain gambling as it now the case with derivatives the extent of which I doubt not even 0.1% of the population is aware of) at the expense of the entire unwitting population.

2) "the new banking system permitted channels by which risk could be pooled and shared": this is almost the dictionary definition of an insurance company! You don't need any fractional banking system for this! Again, with an insurance company in a world of fractional banking system it only worsens: they are rendered more instable and can only be resuscitated by a central bank otherwise the entire economy will collapse (think AIG). In a non-fractional banking reserve system, only the insurance company collapse - it is isolated from the rest of the economy penalising only its imprudent shareholders and customers.

Fractional reserve banking leads to instability and require a central bank. I think everybody agrees on this.
THE controversial point is: can the author show us why we NEED the (inherently unstable) fractional reserve banking? Why?

I am quite open to contrary viewpoint and could even change my mind about the subject.

Indeed I'd be delighted (and without a doubt, many others would also be) to purchase and read a book from the author titled "Why we need a fractional reserve banking system and its ensuing economic instability that can then only be rendered rendered stable by a eurofighter style "governor" piloted by a agile central bank".

It would especially be a delight reading that new book because I do enjoy the author's clear and well organised writing style. And I would love to write a review of that new book on Amazon!


I'll be patiently waiting...

This book was recommended to me, an engineer, by my bond-trading brother-in-law; I usually don't pick these books up. After a slow start, I am happy I did. Cooper, while at times repetitive, makes some nice points that made me think about the economy in a new way. At heart he is a Keynesian. He has a few theses. Most effort is spent on challenging the efficient market hypothesis, and arguing that asset prices are inherently oscillatory, and questioning the proper role of a central bank in controlling those oscillations. He introduces standard notions from engineering control theory, using J.C. Maxwell's theoretical foundation, to discuss how a central bank may or may not play the same role as successful and unsuccessful 19th century steam engine regulators. Though he keeps the engineering physics simple, his idea has merit: non-linear systems require great skill to control. Those familiar with notions from non-linear dynamics (e.g. limit cycles, chaotic oscillations, stable and unstable amplitude growth) will find seeds for their own ideas which might have application to the economy.

The book is written in a readable and provocative style, not unlike that found the "The Economist" magazine. Recommended.

Cooper manages to cram into 170 small pages ideas that a competent author sympathetic to the expenditure of his readers' time might encompass in 15 small pages.

Its ideas are simple:
(1) The notion of "efficient markets" has, at least since Maynard Keynes, been discredited.
(2) Financial markets differ from markets for goods and services: while the latter can exhibit negative feedback, the former almost invariably are plagued with positive feedback.
(3) Positive feedback, as every engineer knows, is subject to runaway behavior limited only by some form of undesirable event--a crisis.
(4) All this was worked out by James Clerk Maxwell (1868), John Maynard Keynes (1934), and Hyman Minsky (1974). It is not applied to best effect, even by central bankers, notwithstanding that these are insulated from political interference.

The book includes a few persuasive examples and (of course) avoids even a hint of differential equations.

The book has one welcome aspect--reminding its reader of James Clerk Maxwell's 1868 paper "On Governors". It cribs this by excerpting its first two pages.

Perhaps I don't agree with everything the author says in the book, but it is written well, easy to understand, and offers a different perspective from what we often hear on TV or read in the newspapers. At a minimum, it makes one think about various issues that affect all of our lives, and for that I give it 5 stars.

The Central banks should "curtail excessive credit creation and excessive credit destruction". Bubbles should be pricked before they burst. Credit growth is the key to bubble spotting ("if credit creation is running substantially ahead of economic growth"). If this was done the author asserts we could avoid booms and busts (at least the really big ones). But how do you actually do this, is not explained directly in economic terms (it is in steam engine terms in the appendix). No actionable, precise guidance is provided. What exactly does "excessive" "substantial" mean? The author does not even attempt to define or quantify these key words. Without attaching some hard numbers to key economic indicators diverse central bankers may never agree upon the existence of a bubble let alone its size (for example, only the hard number 7 saved me from the real estate bubble I calculated that a price greater than 7 times gross annual rent for income property was excessive, as a result I stopped buying real estate in 1980's even though it seemed everybody was still buying and enjoying rapid price appreciation -- the 7 is more precisely calculated in my book "How to Invest in Condominiums"). In the present economic crisis the media reports that the Federal Reserve is trying anything and everything practical in their power that might work to help get us out of this turmoil sooner and as gently as possible. It is difficult to imagine the Fed Chairman Ben Bernanke picking up this book to look for guidance. He has a PhD in economics so he must already know all about Minsky, Mandelbrot and certainly Keynes. And the Chairman's book on the Great Depression is loaded with economic statistics and mathematical demonstrations.

Near the end in Chapter 8 the author seems to undermine his earlier lectures about how central bankers should more wisely control the economy. On page 157 he states "our economic theories do not explain how our economies work." If that is true it makes no sense to even attempt to better control something you can't explain and don't really understand. George Cooper himself does not claim to have a theory that explains the economy. A valid theory does not exist, he writes, because the scientific method has nor been properly applied in the field of economics. That may or may not be true but data is the bedrock of science, symmetrical or not all markets feed on data, yet the author avoids economic statistics like the plague.

But in fairness the author does label his ideas as starting points and who can deny the possibility that some of his concepts may be fleshed out with economic data in the future and develop into a useful economic policy tool for central bankers

The recent financial crisis has produced a rash of books that all claim to provide some insight to our current dilemma. Cooper's book The Origin of Financial Crises first appeared in April 2008 and reprinted in October as the extent of our current crisis became more apparent and more widely publicized.

The book provides a brief outline of the history of money and the banking system. This introduction shows readers how the various pieces of our modern economic system came into being, and the reasons that precipitated their creation. One conclusion is that moving away from the gold standard and having a central bank are essential for our economic system to function. Next, the book simply and easily dismantles the Efficient Market Hypothesis (EMH). The arguments expose the theoretical flaws of EMH and the empirical evidence that suggests that financial markets do not behave as EMH would predict them to behave.

The book introduces the theories of Keynes and Minsky as alternatives to EMH and shows how these theories better fit the empirical evidence. The authors claim that nfortunately most contemporary institutions charged with stabilizing the economy adhere to EMH. This means that they hold conflicting views, and hence advocate inconsistent economic policies.

If the book's goal is to promote refined versions of Keynes' theories, then it does an excellent job. If its goal is to provide an alternative explanation to neoclassical economics, then other "heterodox" theorist need to be considered as well (such as those proposed by Mises or Hayek). To the book's credit, it does cite Ron Paul, and gives credit to Mandelbrot and Fischer. Despite these shortcomings, this book offers the most coherent and down-to-earth skewering of both academic orthodoxy and central bank policy of the books discussing the current financial crisis.

The writing style is crisp, the arguments are cogent and well-reasoned, and the examples are clearly and thoughtfully presented for readers with no formal economic background. Despite my criticisms, it is superior to most books about the current financial crisis on the market today.

Armchair Interviews says: Important read for people in business or who just want to better understand the economy.