24 January 2010

The origin of financial crises

I recently finished reading The Origin of Financial Crises by George Cooper, according to which a careless disregard for the growth of credit, 1 a mis-reading of Keynes, 2 unfounded faith in the stability of capital markets 3 and a misunderstanding of the role of the central bank 4 are the causes of the current financial crisis.

There are three routes now open to us: allow asset deflation to run its course and purge the rottenness from the system, thus triggering another Great Depression; continue to increase debt levels (as governments round the world are currently doing), thus delaying and also worsening the eventual contraction; or creating inflation, in order to reduce the real level of debt. Inflation, despite its destructive effect on pensions and savings, is likely to be the least unpalatable of these three options. 5

Furthermore, financial crises are caused by unsustainable expansions in credit, so could be prevented in future if central banks concentrated on targeting asset prices instead of consumer prices. 6

And, as a footnote, the reason that inflation has never been seriously pursued as a policy option in Japan, is because the destructive effects on savings (particularly on those of pensioners invested in government bonds) would have been politically unacceptable. The governments of the US and the UK are likely to be less constrained (much of their debt is held by overseas investors and pensioners are a smaller proportion of the electorate than in Japan) even if letting inflation rip destroys the credibility of their respective currencies. 7

All in all, a very interesting read. Highly recommended.

1 George Cooper, The Origin of Financial Crises, 2008, page 125:

“Given the mechanism by which most macroeconomic data can become distorted by financial bubbles, credit creation is not just an important macroeconomic variable, it is the important macroeconomic variable.”

2 Page 82:

“Keynes’ repudiation of market efficiency has been almost entirely ignored; while his policy of fiscal stimulus, derived from that repudiation, has been accepted wholeheartedly and applied with a degree of enthusiasm which almost certainly far exceeded his original intention.”

3 Page 105:

“The combination of debt-financing and mark-to-market accounting conspire to give price movements in the asset markets a fundamentally unstable positive feedback characteristic. In the goods markets Adam Smith’s invisible hand is the benign force guiding the markets to the best possible states. In the asset markets the invisible hand is playing racquetball, driving the markets into repeated boom-bust cycles.”

4 Page 25:

“If central banks are necessary because of an inherent instability in financial markets, then manning these institutions with efficient market disciples is a little like putting a conscientious objector in charge of the military; the result will be a state of perpetual unreadiness.”

5 Pages 165-6:

As things stand today, the combined debt stock, accumulated through the procession of bubbles stretching back two or more decades, is almost certainly already unsustainable. Broadly speaking, this situation leaves us with one of three unpalatable options:

1. The free market route

Allow the credit contraction and asset deflation to run its course. This “purge the rottenness” out of the system was famously advocated by Andrew Mellon in response to the Great Depression when he argued to: “Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate.” Such a strategy would almost certainly lead to another great depression and would therefore be, to say the least, inadvisable.

2. When in trouble double

Alternatively we could attempt to encourage yet another massive debt-fuelled spending spree, using fiscal and monetary stimulus, in the hope of triggering another self-reinforcing expansion, with sufficient power to negate the current contraction. In the short term, this strategy would appear more palatable than the free market solution. However, this is precisely the short-sighted strategy that was used to deal with the aftermath of the 1990s corporate borrowing binge and led directly to today’s crisis. Even if we could find another credit bubble to inflate, a further layer of debt-fuelled spending would only delay and amplify the problems. This strategy is also inadvisable.

3. Unleash the Inflation Monster

The third option is to engage the printing press. Use the printing press to pay off the outstanding stock of debt, either directly with state handouts of indirectly with inflationary spending policies. This strategy gives borrowers a “get out of jail free card”, paid for at the expense of savers. This strategy is also deeply unpalatable, but is nevertheless the least inadvisable of the three available options. The recent oil, gold, and food price rises, together with the falling value of the dollar, are almost certainly signs of this strategy being both anticipated and deployed.

6 Page 163:

“The conflict between consumer price targeting and the management of credit can easily be resolved by dispensing with consumer price targeting altogether…if excess credit and monetization is avoided, inflation will look after itself. In practical terms this would mean shifting our central bank’s mandate from targeting consumer price inflation to that of targeting asset price inflation.”

7 Page 90:

“Japan’s inflation-generating capacity has been constrained by two factors. Most importantly, Japan has enjoyed a considerable trade surplus throughout its period of deflation. Any attempt to generate inflation through monetization (printing money) would have caused the value of the yen to fall sharply. This in turn would have caused an already large trade surplus to grow still larger. something that would have been intolerable to Japan’s trade partners. Secondly, Japan’s political/demographic structure places the balance of power in the older generation who have significant pension assets, largely invested in bonds. For this cohort, mild deflation is a perfectly acceptable state of affairs, again suggesting political factors put limits on the degree to which the printing press could be deployed.”

d. sofer