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123 of 130 people found the following review helpful
4.0 out of 5 stars Well-written critique, but affirmative points less convincing, December 2, 2008
This review is from: The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy (Paperback)
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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Showing 1-9 of 9 posts in this discussion
Initial post: Dec 5, 2008 1:02:28 PM PST
Abacus says:
Wow, A.J. Sutter, outstanding review. You obviously understand that stuff and are able to uncover even an expert's blind spots. I certainly will read this book based on your review. I did read Charles Morris "The Trillion Dollar Meltdown" that you refer to also and found that book really outstanding. If this book is just half as good, that's pretty good. Keep writing such great reviews.

In reply to an earlier post on Dec 11, 2008 5:54:35 PM PST
A. J. Sutter says:
Thanks very much for your kind comments.

Posted on Dec 16, 2008 7:47:13 AM PST
Excellent review. I liked the fact that GC ignored CDOs, off-balance sheet tricks, and other problematic aspects. GC convinced me that the asset markets, unlike markets for goods and services, are fundamentally unstable. All these other financial tricks just amplify the instability.

In reply to an earlier post on Dec 16, 2008 5:21:08 PM PST
A. J. Sutter says:
Thanks for your comment. I agree with you, in the context of GC's negative critique of mainstream economics (micro and macro); they can only make things worse. Readers looking for background specifically on the current crisis, though, should be aware of the omission, since those factors are playing a role in current events. And as I mention, leaving out those topics does make it harder to see how GC's proposed solutions might work in practice.

In reply to an earlier post on Mar 25, 2009 6:09:15 PM PDT
J. Li says:
there is a short vid on youtube about the origin of this credit crisis by Frederic Mishkin (former Federal Reserve Governor), which i think could be viewed as a footnote to explain the role of credit derivatives.
http://www.youtube.com/watch?v=bJgaag7E69w

In reply to an earlier post on Jun 16, 2009 6:05:16 AM PDT
Has anyone looked at Richard Werner's New Paradigm in Macroeconomics? There is a complete explanation of recurring banking and financial crises and the shocking story of the role of central banks - as well as debunking of mainstream macroeconomics.

In reply to an earlier post on Jun 16, 2009 8:23:15 AM PDT
A. J. Sutter says:
Thanks for your suggestion. I will check it out -- though from living in Japan I'm skeptical of many "explanations" of this country, especially ones written by foreigners ...

Posted on May 23, 2010 6:23:51 PM PDT
el cid says:
great review!! you get the issues on the table great job!!

In reply to an earlier post on May 27, 2010 8:57:45 AM PDT
A. J. Sutter says:
Gracias, el cid, for your kind comment.
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