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86 of 90 people found the following review helpful:
4.0 out of 5 stars
Well-written critique, but affirmative points less convincing, December 2, 2008
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.
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39 of 44 people found the following review helpful:
4.0 out of 5 stars
Review in "The Economist", September 16, 2008
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."
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25 of 27 people found the following review helpful:
2.0 out of 5 stars
Disconnected from the historical data. Unrealistic recommendations, January 12, 2009
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.
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