(Note: This is a re-post with minor edits. I once posted this summary in my old blog in 2009, which does not exist now).
The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy (by George Cooper)
This book argues that if we are to break out of the damaging cycle of booms and busts, all participants should recognize the proper role and limitations of macroeconomic policy. The writer points out that there are inconsistencies in macroeconomic policy, wherein:
- policy makers will let market move freely when asset prices are increasing even further when warnings of bubbles are all around, with the defense of the Efficient Market Theories (EMT, that assets prices are always and everywhere at the correct price, that markets move naturally only toward equilibrium, and new equilibrium only exists if a new external event occurs);
- but strangely when asset prices begin falling policy makers will take corrective action immediately, not letting the market correct itself (by keep cutting interest rates or other means, which only delay crises, and at worse times by means of bailouts).
Interesting question regarding validity of EMT: if EMT holds true, why do we need the existence of central banks if the theory tells us that markets are efficient and should be left to their own devices?
The writer offers a better theory, that is the Financial Instability Hypothesis developed by Herbert P. Minsky, which suggests that financial markets are not self-optimizing, or stable, and certainly do not lead toward a natural optimal resource allocation. In other words, in contrast to EMT, financial markets are inherently unstable. Accepting this new theory means we need better tools to deal with randomness, better risk management, new monetary policy (the one that accepts economic contraction as a normal part of a healthy vibrant economy).
In its concluding remarks, this book stresses the importance of changing our mindset from one unquestioning faith in market efficiency to one that accepts the need for governance of aggregate credit creation.
For me, it’s refreshing to read this book’s simplified history of money (and history of central bank and its changing and conflicting roles), in the attempt to show when in the history market/price instability or inflation appeared:
- Barter exchange evolved eventually into gold exchange. Gold exchange made it easy for everyone in exchanging goods; then gold became a store of value (there would have been inflation/deflation cycles linked to harvests, wars, disease etc, but on average markets are stable).
- Gold money (coins) made trade easier. Further development: Occasionally government will do re-coinage or debasement (by demanding population to turn over their coins and have them replaced by new worth-less coins) and thus extra money will flood into the system and there would be inflation (but once price established inflation would stop).
- Gold certificates and the start of credit creation: Since gold coins were troublesome, merchant banks then started issuing certificates of gold deposit (depositors would hold certificates stating entitlement of gold coins deposited in a bank). Merchant banks soon realized that they would have always available gold coins deposited with them (since depositors very rarely came back to collect it and inflows and outflows of coins on most days cancel one another out), thus came up with their own money making ruse by issuing their own certificates and lending them to merchants in return for interest. This started first serious instability (and note that financial instability could occur under gold standard): as more banks lent this way, there were risks of bank runs that was when defaulted loan(s) could psychologically brought rumors that a bank will have problems in fulfilling its obligations to depositors since it had less coins than the total of certificates it issued.
- Creation of central bank: Problem of bank runs was resolved by a system in which risks are pooled and shared and any troubled bank would be supported so that panic would be prevented, by creating a bank for banks: a central bank, as lender of last resort. Central bank will defend any troubled bank by honoring its obligations; the unintended consequence was moral hazard: depositors would treat all banks as equally secured and so would seek out the ones paying highest interest thus would make banks enter risky lending practices. This problem was then resolved by a new system in which banks could not lend unchecked, gold reserves would be collected together at the central bank, only one type of certificate issued by government (i.e. money). So now government took control of monetary system, it could print money based on the gold reserves and at times change the conversion rate (in time of needs, government will print more money using the same base of gold reserves, creating inflation or declining value of money).
- Bretton Woods and the global gold standard: Post World War II agenda was to ensure global currency regime that would help all sides rebuild their economic infrastructure. At a conference in the American resort Bretton Woods, it was agreed that all major currencies would be valued against the US dollar at a fixed exchange rate. US Dollar was fixed at USD35 per ounce of gold. Further development: By late 1960s re-industrialization outside America was so successful that trade position was reversed that America was buying more than it was selling (i.e. trade deficit for America, net outflow of US dollar). To maintain the fixed exchange rates, non-US countries were obliged to recycle the trade surplus back into America in the form of US government debt (in other words, trade deficit created debt for US).
- End of gold standard (fiat money): US debt became even larger due to Vietnam War and so US government had to resort to printing itself more money to pay off its debts, thus more number of dollars for constant gold reserves. Some informed non-US government then decided to request to convert their dollars into gold. On August 15th 1971, Nixon decided to refuse all requests for conversion, devaluate the currency and US dollar ceased to be a certificate of gold deposit currency, thus the end of gold standard. Governments were now free to print money at will; some governments printed more and more money thus created inflation spiral. After this departure from gold standard, central banks were given the job of maintaining price stability by preventing governments from printing too much money, and additional role to ensure economic recessions were avoided.
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