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Book review: The Origin of Financial Crises

G.K. Chesterton once observed, “to be clever enough to get all that money, one must be stupid enough to want it”. Our current financial predicament might be described by an approximately converse contention: that to be stupid enough to lose all this money, we must be clever enough to understand economic theories.

Dr George Cooper has written an excellent book on the origin of financial crises. The financially literate should find that his explanation of the forces behind our current ‘credit crunch’ greatly enhance their understanding of the relevant financial and economic processes. The author is a ‘front line’ worker, despite his title: he has worked in various roles for Goldman Sachs and Deutsche Bank, and most recently as head of interest rate research for JP Morgan. His book thus manages to combine a sense of the real with an intelligent search for ‘the truth’, doing so in an unusually clear and readable way.

What is his thesis? We might do well to take a step back and consider how one can proceed in subjects such as economics or metaphysics, where by nature of the subject it is generally impossible to set up meaningful laboratory-style experiments. There are two ways to approach the interaction between a theory or ‘belief system’ and the evidence: we can start with the evidence, and seek a theory that fits the evidence (induction); or we can start with a theory, and consider to what extent the evidence supports the theory (deduction).

Although the latter approach can be fruitful if applied with an open mind, it becomes problematic as soon as we choose a belief system that suits us for social/historical reasons, or reasons of academic convenience, and then filter the evidence in the light of that belief system.

Cooper’s starting argument is that economists have largely fallen into this trap: having some time ago adhered to the Efficient Market Hypothesis, economic orthodoxy continues to interpret the financial world through that lens; however, much of the evidence of the last 80 years shows that position to be untenable, at least in the context of the asset markets.

The author goes into some detail in justifying this last point, and then moves to discuss a hypothesis suggested by the various ways in which the Efficient Market Hypothesis fails: Minsky’s Financial Instability Hypothesis. Mathematically inclined readers will be interested to learn that Mandelbrot (he of fractal fame) separately developed models of market behaviour that seem to fit with Minsky’s. The chapter ‘Minksy meets Mandelbrot’ will be particularly interesting from the perspective of actuaries working in the domain of quantitative risk management systems, and is structured around the insightful Donald Rumsfeld’s conception of ‘known unknowns’, ‘unknown knowns’, and so on.

Having set the scene with the above points, together with some discussion of the role of central banks, Cooper presents in the book’s core chapter an exposition of market stability, showing how the negative feedback process which helps to steady markets in consumer goods can become a dangerously destabilising positive feedback process in asset markets. This asset market instability will be exacerbated by widespread collateralised lending, and the examples provided here have ready parallels for insurers forced to sell at market lows to comply with solvency regulations. The author also notes how the difference in investor behaviour between ‘goods customers’ (who purchase for consumption) and ‘asset customers’ (who purchase with a view to potential price changes) makes the responses of goods markets and asset markets to price changes fundamentally different.

Cooper concludes with recommendations for avoiding such crises in the future, largely by moving from consumer price inflation to asset price inflation as the principle measure of financial market health, and applying a symmetric approach to market management (whereby expanding markets would be pricked just as deflating markets would be stimulated). He does not mince his words, and it is refreshing to read something so forthright – for instance, this paragraph from his concluding chapter:

“If blame must be laid anywhere it must be placed at the collective feet of the academic community for having chosen to continue promoting their flawed theories of efficient, self-regulating markets, in the face of overwhelming contradictory evidence.”

The main shortcoming of the book relates to the expectations of the typical reader, who is likely to be as interested in practical cures as in economic epidemiology. Although the book deals with the subject promised by its title, there is little on what should be done to extricate ourselves from our current malaise. But perhaps that is because there is nothing to be done.

Matthew Edwards is a former editor of The Actuary.

For other reviews by him on books relating to financial crises, see http://www.the-actuary.org.uk/693751

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