Book Review: The Origin of Financial Crises
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In The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy, Dr. George Cooper, a former head of fixed income at JPMorgan Chase and currently a principal at Alignment Investors, argues that credit excesses are the wellspring of financial crises. Cooper’s book is a vigorous indictment of the EMH (efficient market hypothesis), in which laissez-faire economic theories are applied to financial markets. He skillfully dismantles the prevailing theoretical paradigm, which has failed to predict or explain the recent carnage in financial markets, and suggests an alternative based on economist Hyman Minsky’s financial instability hypothesis, which Cooper contends better fits recent market facts. Applying Minsky’s theory, Cooper proposes modifications of the mandates of central banks and suggests prescriptions for the current economic malaise. The book is a deftly reasoned contribution to the torrent of criticism surrounding orthodox financial market theories.
Cooper attacks the EMH’s most important premises and exposes its logical contradictions. He contends that the obvious trail of booms and busts in financial markets challenges the central assertion of the EMH. In fact, says Cooper, no “invisible hand” orders markets to the optimal allocation of resources and to the most efficient setting of asset prices. Repeat cycles of credit creation and destruction cause asset markets to behave differently than goods markets driven by supply and demand. Bubbles and crashes are organic aspects of asset markets, and financial instability is the price of economic progress; no market equilibrium exists.
Cooper provides a handy primer on the origins of money, the credit-creation process as a driver of wealth generation, and the expected role of central banks in dampening the effects of credit cycles. He contends that policies that perpetuate debt-fueled binges are the unfortunate result of misplaced faith in the wisdom of markets, combined, ironically, with deliberate intervention to protect us from markets’ penalties. By repeatedly bailing out debtors via monetary accommodation, while failing to puncture inflating bubbles, policy makers defer the inevitable implosion that results from the accumulated burden of debt.
Markets are not efficient. They operate in a feedback loop with the real economy, cycling into credit-induced manias that produce “Minsky moments,” or regime shifts, when those bubbles disastrously collapse under their own weight, bringing on painful periods of deflation reinforced by the Keynesian “paradox of thrift.” Irrational investors do not cause asset prices to oscillate between unknowable extremes, says Cooper, as he takes a swipe at the behaviorists who tried to bridge this logic gap for critics of the EMH. Rather, prices gyrate thanks to self-reinforcement; that’s the reason they’re not normally distributed, despite the assumptions of many asset-pricing and risk-management models.
Cooper has a practitioner’s familiarity with markets, and an academic’s ability to weave competing ideas into a coherent alternative to the EMH. He argues that the roots of all financial crises lie in our belief in our flawed theories, in the inevitable cycles of credit creation, in the markets’ inherent feedback loops, and in the amplifying role played by central banks with their feet on the monetary accelerator.
If Cooper is right, central banks’ expected role in mitigating credit cycles needs modification. Since perfect stability isn’t possible, it shouldn’t be sought. Bankers should encourage frequent corrections that purge credit excesses, disciplining excessive risk taking. Central banks should behave symmetrically, pricking asset bubbles. Bankers must discriminate between recurrent credit cycles—a necessary evil—and truly dangerous inflation pressures caused by monetary debasement.
Applying his thesis to solutions for the present financial crisis, rather than deterrents to future crises, Cooper is less convincing. Even with an extensive revision of our theories of financial market behavior, policy makers have a frustratingly short and familiar list of options: let debt deflation run wild, create another credit bubble, or soften the landing with the printing press. Even armed with Cooper’s new and well-articulated insights, we are still reliant on conventional policy options when confronting the epic debt built of our historical profligacy.
–Kathleen DeRose, CFA, is a senior managing partner and head of portfolio management and research at Hagin Investment Management, a long/short equity manager.