“The Origin of Financial Crises” by George Cooper (April 2008).

Note: The notes below combine quotes from the book combined with my comments in italics. I have also bolded some text in the quotes for added emphasis. I have quoted the book selectively so this note does not cover all of what it has to say. 

Ch 1 – Introduction

“The central thesis of this book is that our financial system does not behave according to the laws of the Efficient Market Hypothesis, as laid down by the conventional wisdom of today’s prevailing economic theory. The Efficient Market Hypothesis describes our financial system as a docile animal that, left to its own devices, will settle into a steady optimal equilibrium. By contrast, this book argues our financial system is inherently unstable, has no steady state equilibrium and is habitually prone to the formation of damaging boom-bust cycles. It is argued that this instability requires central banks to manage the credit creation process. However, it is also explained how central bank policy can inadvertently slip from providing a stabilising influence on economic activity to one that, over time, amplifies boom-bust cycles.”

Comment: With the benefit of hindsight, the EMH is probably not as widely accepted now as it was when Cooper wrote his book. Notwithstanding, his observations regarding the relevance of Minsky’s hypothesis are still relevant. What I found especially useful is the observations made regarding the way in which central bank attempts to manage the cycle can tend to allow cyclical pressures to build up in ways that ultimately result in more severe corrections. The analogy with Maxwell’s steam engine governor was also very useful. 

Lopsided Policy (Ch 1.1)

Comment: “lopsided policy” references the tendency for macro economic policy focus on supporting growth and not to worry about asset bubbles. Cooper advocates a more “symmetrical” policy approach under which excessive credit expansion is considered as big a problem as excessive credit contraction. He notes however that his view is not consistent with the prevailing economic orthodoxy that drives macro economic policy and risk risk management.

Cooper notes that “… financial crises are becoming larger and more frequent” and proposes that avoiding these financial crises “… comes at the price of permitting, even encouraging, a greater number of smaller credit cycles. And also at the price of requiring central banks to occasionally halt credit expansions. … Key to the success of any such policy will be a political climate that accepts the need for symmetric monetary policy; excessive credit expansion should be fought with the same vigour as is used to fight excessive credit contraction.”

Cooper notes that his proposal is unlikely to be welcomed because “… economists have taught us that it is unwise and unnecessary to combat asset price bubbles and excessive credit creation. Even if we were unwise enough to wish to prick an asset price bubble, we are told it is impossible to see the bubble while it is in its inflationary phase. We are told, however, that by some unspecified means the bubble’s camouflage is lifted immediately as it begins deflating, thereby providing a trigger for prompt fiscal and monetary stimulus.

In recent years this lopsided approach to monetary and fiscal policy has been further refined into what has been described as a “risk management paradigm”, whereby policy makers attempt to get their retaliation in early by easing policy in anticipation of an economic slowdown, even before firm evidence of the slowdown has been accumulated. This strategy is perhaps best described as pre-emptive asymmetric monetary policy.

To followers of orthodox economic theory, based on the presumption of efficient financial markets, this new flavour of monetary policy can be justified. Yet, current events suggest these asymmetric policies have gone badly wrong, leading not to a higher average economic growth rate, as was hoped, but instead to an unsustainable level of borrowing ending in abrupt credit crunches.”

Efficient Markets – More Faith than Fact (Ch 1.2)

Cooper summarises the traditional interpretation of the laws of supply and demand under which “… prices jostle up an down keeping supply and demand in perfect balance [and] this process generates a stable equilibrium state … that also ensures the best possible arrangement of prices, leading to the optimal allocation of resources [because] if a better, more-economically productive, allocation of resources could be achieved , then those able to make better use of the resources would be able to pay more for them… [consequently] … the laissez-faire school of economic theory, … argues that market forces be given free rein to do as they choose. The logic of the laissez-faire school being that, if free markets naturally achieve an optimal equilibrium, any interference with market forces can at best achieve nothing, but more likely will push the system away from equilibrium toward a sub-optimal state.”

A Slight of Hand (Ch 1.3)

Comment: Cooper notes that the explanation of how markets achieve equilibrium typically uses examples of markets for goods and services but then simply assumes that the same principles will work in the markets for labour, land and capital inputs without considering the unique features of the specific markets. He refers to this as a slight of hand.

“This logical trick is pervasive in economic teaching: we are first persuaded that the markets for goods are efficient, and then beguiled into believing this to be a general principle applicable to all markets”

The Market For Bling (Ch 1.4)

“We can easily find a counter example to … well-behaved supply-and-demand driven markets. In the marketplace for fine art and luxury goods, demand is frequently stimulated precisely because supply cannot be increased in the manner required for market efficiency:

The phrase “conspicuous consumption” was cited by … Thorstein Veblen to describe markets where demand rose rather than declined with price. Veblen’s theory was that in these markets it was the high price, the publically high price, of the object that generated the demand for it. Veblen argued that the wealthy used the purchase of high-priced goods to signal their economic status”

Comment: The market for art and luxury goods can be dismissed as a minor distortion but similarly effects can be seen in the housing market where the increase in price does not automatically dampen demand or stimulate new supply in the way that economics 101 assumes. 

When The Absence Of Supply Drives Demand (Ch 1.5)

Comment: Cooper offers examples where, contrary to what standard economic theory prescribes, a lack of supply can stimulate demand at higher prices in part because it is the scarcity of supply that drives the demand and perceived value. If the supply is no longer scarce then demand will evaporate. This is especially true when speculators are a significant force in the market. 

“While the markets for bling can be dismissed as economically irrelevant, there are other much more important markets which also defy the laws of supply and demand, as described by Samuelson.

This simple observation of how consumers and speculators respond in different ways to supply constraints gives us the first hint that a fundamentally different market mechanism operates in the markets for assets to that which dominates the markets for goods and services.

As a rule, when we invest we are looking for an asset with a degree of scarcity value, one for which supply cannot be increased to meet demand. Whenever we invest in the hope of achieving capital gains we are seeking scarcity value, in defiance of the core principle that supply can move in response to demand.

To the extent that asset price changes can be seen as a signal of an asset becoming more or less scarce, we can see how asset markets may behave in a manner similar to those of Veblen’s market for conspicuous consumption goods. In Veblen’s case it is simply high prices that generate high demand, but in asset markets it is the rate of change of prices that stimulates shifting demand.

Frequently in asset markets demand does not stimulate supply, rather a lack of supply stimulates demand. Equally price rises can signal a lack of supply thereby generating additional demand, or, conversely, price falls can signal a glut of supply triggering reduced demand”

Introducing The Efficient Market Hypothesis (Ch 1.6)

“To economists the importance of efficient markets lies … in the ability of the pricing mechanism to maximise economic output via an optimal allocation of resources. To financial professionals he emphasis is more directly on the pricing of the items being traded”

“The key message of the Efficient Market Hypothesis is that asset prices are always and everywhere at the correct price”

“The Efficient Market Hypothesis has no room for asset price bubbles or busts; under this theory the wild asset price swings commonly referred to as bubbles are nothing more than markets responding to changing fundamentals.”

“The idea that markets are always correctly priced remains a key argument against central banks attempting to prick asset price bubbles. Strangely, however, when asset prices begin falling the new lower prices are immediately recognised as being somehow wrong and requiring corrective action on the part of policy makers.

Another interesting result of the Efficient Market Hypothesis is that it can be used to infer the manner in which asset prices move, which in turn allows for the calculation of the entire probability distribution of potential future asset returns. Sadly, these theoretical distributions tend not to fit with the reality of financial markets, which in practice tend to generate extremes of both positive and negative returns that simply cannot be explained with the statistical models derived from the Efficient Market Hypothesis. The clash between the theoretical statistics predicted by efficient markets and those observed within real financial markets is known as the “fat tails” problem.”

We Already Have A Better Theory (Ch 1.7)

Cooper argues that “… there is an alternative theory of how financial markets operate, one that is fully able to explain the credit crunch we are now witnessing and … the erratic behaviour of financial markets. The theory in question is the Financial Instability Hypothesis, developed by the American economist Hyman P Minsky. Minsky himself credited many of his ideas to … John Maynard Keynes, whose famous 1936 book … provide a comprehensive refutation of the idea of efficient markets”

Cooper notes that “For now, conventional wisdom remains with the Efficient Market Hypothesis; however, this latest financial turmoil has shaken at least some of the faithful and the term “Minsky Moment” has now made its way into the popular press as a phrase describing the point at which a credit cycle suddenly turns from expansion to contraction”

Internal Or External? (Ch 1.8)

The key difference between the Efficient Market Hypothesis and Minsky’s Financial Instability Hypothesis comes down to the question of what makes the prices within financial markets move. As discussed, efficient market theory says that markets move naturally only toward equilibrium, and after reaching equilibrium they remain in this quiescent state until influenced by a new, unexpected, external event. The emphasis here is on the external nature of the force causing financial markets to move. By contrast, Minsky’s Instability Hypothesis argues that financial markets can generate their own internal forces, causing waves of credit expansion and asset inflation followed by waves of credit contraction and asset deflation.

The implications of Minsky’s suggestion are that financial markets are not self-optimising, or stable, and certainly do not lead toward a natural optimal resource allocation. In short, Minsky’s arguments attack the very foundation of today’s laissez-faire economic orthodoxy, as did those of Keynes before him.

Answering the question of whether or not Minsky is correct boils down to the challenge of identifying processes, internal to the financial markets, which may build upon themselves becoming strong enough to push the markets away from any given equilibrium position

Two internally-generated destabilising forces have already been introduced in the form of: supply, or the lack thereof, as a driver of demand in asset markets; and asset price changes as a driver of asset demand. The bulk of the rest of the book will follow Minsky’s lead and focus on explaining the much more powerful destabilising forces generated within the banking system and the credit creation process broadly

An introduction to bank runs

“… a minor default, affecting only a tiny fraction of the fund’s assets, can quickly spiral into a self-fulfilling cycle of withdrawals. The end result of which is to leave the last few investors holding all of the losses – in financial markets loyalty frequently does not pay.”

Comment: This is the same point Mervyn King makes – the “prisoners’ dilemma” leads to sub optimal outcomes when participants cannot cooperate or coordinate their actions. It is better for all depositors not to panic but individual depositors are better off if they pull money out first.

The discussion of bank runs seems to be a side track – not critical to Gorton’s main argument – but another example of the EMH not explaining the realities of financial systems when positive feedback loops take over. That said, this basic conflict between guaranteeing return of capital, while also putting that capital at risk, is a key channel through which financial instability can be, and recently has been, generated. Similar to Gary Gorton’s point about the role of safe assets in the financial system.

CH 2 Efficient Markets And Central Banks?

Central Banks – Everyone has one but they are not well understood

Despite the importance of these institutions, and the intense scrutiny under which they operate, Gorton argues that central banks are still very poorly understood

Opinions Differ (Ch 2.3)

“Being ignorant of the methods and purpose of central banks is a forgivable sin; even the central bankers themselves disagree on what they are trying to achieve and how they should go about it.”

“Having spent more than a decade analysing the policies of central banks on both sides of the Atlantic, I believe the key elements of the differences in strategy between the Federal Reserve and the ECB can be expressed as follows.

The US Federal Reserve does not appear to believe there can be an excessive level of money growth, credit creation or asset inflation. They do, however, believe there can be an unacceptably low level of all these variables. As a result, the Fed’s monetary policy can be characterised as one in which policy is used aggressively to prevent or reverse credit contraction or asset price deflation, but is not used to prevent credit expansion or asset inflation

The ECB, by contrast, appears to believe that money supply growth can become excessive; this is consistent with excessive credit creation and is also consistent with asset inflation being excessive. However, there is general reluctance to acknowledge the connection between excessive money supply growth and excessive asset price inflation

The upshot of these different world views is that the Fed sees its role as combating any credit contraction, whereas the ECB sees its role as combating excessive credit expansion. (emphasis added).

Comment: Gorton notes that there is no consensus on what central banks are intended to do but he does see a key distinction between the American and European approaches; namely that the Fed seems to be more concerned with managing the risk of credit contraction while the ECB is more concerned with excessive credit expansion. 

Gorton’s summary is presumably based on his professional career as a fixed income analyst  Is the distinction drawn valid? Where would the RBA & RBNZ sit?
This distinction seems to be a useful way of thinking about stress testing

Should We Even Have Central Banks?

“Central banks use interest rate policy to control the capital markets. Yet economic theory tells us markets are efficient and should be left to their own devices.

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 unreadyness”

Comment: Gorton argues that a central bank is unnecessary if you are a true believer in the EMH but the reality is that markets do not converge to stable equilibriums. 

Time To Take Stock (Ch 2.8)

“The idea that markets are efficient requires the following to hold:
1. Asset price bubbles do not exist; the prices of all assets are always correct.
2. Markets, when left alone, will converge to a steady equilibrium state.
3. That equilibrium state will be the optimum state.
4. Individual asset price movements are unpredictable.
5. However, the distributions of asset price movements are predictable.

The only fly in the ointment of this grand story is, as noted, the data just doesn’t fit the theory. We don’t find normally-distributed markets; we do find huge market discontinuities and, let’s be honest, a static stable equilibrium has never once been observed anywhere in financial markets.”

Two Schools Or The Mad House (Ch 2.10)

While Keynes, and then Minsky, set out in one direction to formulate a new alternative theory of how the world works, which fitted with the experimental evidence, another group set out in the opposite direction, determined to rescue the idea of market efficiency and the all-important doctrine of laissez-faire that accompanies it.

This second team has a different explanation for why market behaviour fails to fit with the Efficient Market Hypothesis

… noting that financial markets are not free markets but are heavily manipulated by government and especially central bank interference. This leads to an intriguing possibility: that boom-bust asset price cycles and non-normal return distributions are not due to some inherent failure of the markets, but are instead the result of central bank interference

Comment: The fact that markets do not converge to stable equilibriums forces the EMH school to identify ways to reconcile the evidence with the theory. One argument is that central banks impede reaching equilibrium

The Friedman School – central banks make markets inefficient.

“… Milton Friedman … believed central banks distorted financial markets and should be abolished … [and that it would] … be preferable to abolish the Fed entirely and just have the government stick to a monetary growth rule”.

Comment: Gorton argues that Milton’s opposition to central banks was based on a concern that the fiat money system is inherently biased to inflation when placed in the hands of government bureaucracy and that misguided policy actions can cause boom-bust cycles.

The Keynes/Minsky School [holds that] markets are inefficient, central banks make them more efficient

“The alternate viewpoint is that markets are not fundamentally stable or self-optimising, and as a result require oversight and management. Both Keynes and Minsky emphasised the government’s role in providing this management through state spending and fiscal measures. Central banking can be viewed in the same way as these fiscal measures, as being a necessary part of, in Minsky’s words, ‘stabilising an unstable economy’.

As with Friedman’s position, the Keynes Minsky perspective is attractive for its intellectual consistency in that it fits with real financial market behaviour and with the real institutions operating in our economies. While both the Friedman and the Keynes schools are logical they cannot both be correct; to one central banks cause financial instability, to the other they cure it.”

Comment: Gorton contrasts the opposing schools as follows:

  • One philosophy of economics and finance tells us that crises shouldn’t happen and can be avoided, provided we stop tinkering with the economy and shut down the central bank
  • Another says that these crises are inherent in the system and we need central banks to help manage them 

In Summary

“… the next chapter argues the Efficient Market Hypothesis is flawed beyond redemption, financial markets are pathologically unstable, and central banks are a vital part of our financial architecture. The subsequent chapters then argue that, in some central banks, a misguided loyalty to the idea of market efficiency is leading to policies that inadvertently amplify rather than attenuate market instability.”

Ch 3 – Money, banks and central banks

The Inflation Monster and the Efficient Market Hypothesis (Ch3.2)

Comment: Cooper uses some ECB educational material as background to a discussion of why inflation exists. The ECB explanation emphasises the role of excess money supply in creating inflation but Cooper does not accept the ECB explanation. He argues that, if markets were efficient, then price competition would keep inflation in check but this is not the case.

“Once again we have another glaring hole in today’s economic parable: the efficient market model can explain neither inflation nor central banking – and there may just be a link between these two mysteries”

Hunting the Monster: A Brief (Partially Fictional) History of Money(Ch 3.3)

Comment: Cooper argues that understanding inflation starts with an understanding of the history of money.

  • His history starts with barter 
  • With gold the first big breakthrough in finance as it became both a means of exchange and a store of value
  • Cooper argues that “money becoming a store of value was the start of monetary inflation cycles” though there was “no systematic trend towards higher prices”
  • Gold coins is the next stage in his history of money and the process by which their value was debased by the sovereign progressively reducing the gold content the start of inflation
  • Next comes the invention of certificates of gold deposits and gold depository banks
  • Gold certificates in turn leads to credit creation as bankers work out that not everyone demands their gold at the same time so the banker can lend out the idle deposits
  • Gorton argues that this process contributes to financial instability Depository banks were at risk of a run
    • Over time, the banks created an increasingly complex web of obligations between themselves 

Money and anti-money

Recognising that private sector credit creation works through generating money and debt in combination is important in two respects. Firstly, it helps make it clear that private sector banking cannot be responsible for permanent ongoing inflation.  Secondly, it helps clarify why some central banks worry so much about money supply growth; money growth also means debt growth, and it’s the debt that causes financial instability.

Today there is a widespread misconception that private sector credit creation causes inflation. The truth is rather more subtle than this. As credit is being created – loans made – an inflationary impulse is generated, however when the credit is destroyed again – loans repaid – a deflationary impulse is generated. Provided loans are being made and destroyed at roughly equal rates the inflationary and deflationary impulses will tend to cancel, leaving prices stable. However, if either credit generation or credit destruction becomes dominant at any point, then respectively a temporary inflation or deflation will be generated. Financial instability can be generated if there are systems within the economy that tend to cause a predominance of credit creation in one period, followed by a predominance of credit destruction in the next.

Enter the central banks – as lender of last resort

Financial crises happen with and without a gold standard

The original and still primary purpose of central banking is not, as is widely believed today, to fight inflation, rather it is to ensure financial stability of the credit creation system. Financial instability can occur in any credit-dominated system, with or without the gold standard.

To re-establish financial stability would require not the reversion to a gold standard, or the abolition of the central banks; it would require nothing less than the abolition of credit creation. In other words we would need to return our economies to the dark ages. Credit creation must stay, and we must find a way to live with the instability that comes with it; it is better to have a volatile and growing economy than a stable and stagnant one.

Bastardising the insight of Keynes

In the period of a little more than seventy years since Keynes wrote his General Theory”, his policy recommendations and his theoretical insight have undertaken two quite remarkably divergent journeys: 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.

Keynesian policy is now enacted through two channels. Governments use fiscal stimulus to boost economic activity by spending more than their tax revenue. And central banks use monetary policy to encourage the private sector to borrow, thereby boosting consumption and investment relative to income. Both government deficit spending and the lowering of the private sector savings rate have the effect of boosting spending and therefore demand in the economy.

It is important to recognise that both fiscal and monetary stimulus policies work in the same way by spurring debt-fuelled spending

Where modern stimulus policy differs substantially from Keynes’ original  recommendations is in the timing of how these policies are deployed. Keynes was writing in the 1930s at the depths of the Great Depression, and was therefore advising the implementation of stimulus policies as a way of getting out of a depression, that is from a point of already depressed activity. Today Keynesian stimulus is used not to exit depressions but rather to avoid going into recessions. The difference between these two applications of Keynesian policy is subtle, but forms an important part of the financial instability story and the story of today’s credit crunch.

As originally advised, Keynesian policy requires stimulating an economy once it has already suffered an economic recession, when the overall level of economic activity has already contracted significantly. The first flavour of Keynesianism means policy is reactive, coming after the credit contraction; the second flavour means that policy is proactive, and is applied to prevent the credit contraction. If successful, this proactive version of Keynesian policy can avoid a recession altogether, or at least make it much shallower and less painful than it would otherwise have been. Today we deploy Keynesian stimulus not when activity has already fallen, but instead when the rate of growth of the economy is slowing, or expected to slow.

4 Stable And Unstable Markets

Adam Smith used the metaphor of an “invisible hand” to refer to the way in which the self interested actions of individuals seem to be coordinated in a way that promotes the public good  without any conscious intention on the part of the individuals.

Cooper notes that the term “invisible hand” has come to be “… used to describe the idea that markets have an inherently self-optimizing, self-stabilising quality. Central to this philosophy is that markets must be adaptive and stable. Put differently, for markets to be efficient stable systems they must, when disturbed, be able to reorganize themselves in response to the disturbance, and be able to find the new configuration of market prices that correspond to a new optimal allocation of resources, in the new equilibrium state. What absolutely cannot happen in an efficient market is for the effect of a small initial disturbance to become amplified without limit by forces generated by processes internal to the market. The thesis of this chapter is that the presence of market stability has been plausibly argued for the markets of goods and services, but that these arguments do not hold for asset markets, credit markets and the capital market system in general. It will be argued that once disturbed asset and credit markets are prone to undergo expansions and contractions that, in principle, have no limit and no stable equilibrium state.”

“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 a benign force guiding the markets to the best of possible states. In the asset markets the invisible hand is … driving the markets into repeated boom-bust cycles”

5 Deceiving The Diligent

The Irrational Investor Defence

“Up to this point the challenge to the Efficient Market Hypothesis has relied upon demonstrating the existence of destabilising positive feedback processes within credit and asset markets, with the power to push markets away from equilibrium.
Bank credit creation, mark-to-market accounting, debt-financed asset markets, cyclical dependence of credit spreads, scarcity-driven demand and price-driven demand all provide positive feedback mechanisms with the potential to cause financial markets to behave in a way inconsistent with the theory of efficient markets. These internally generated destabilising forces could be dismissed as unimportant if it could be shown that there were even more powerful countervailing forces tending to maintain the markets in a condition of equilibrium.

According to efficient market theory the equilibrating forces which maintain market stability are generated by investors selling assets when they become overvalued and buying them when they become undervalued. Through this process, it is argued, asset prices are maintained in line with their underlying fundamental value.”

“… according to efficient market theory asset price bubbles are prevented by investors’ appetites to buy assets on the cheap and sell them when too expensive. It follows that an asset price bubble can only be formed if investors are willing to buy assets when they are already overpriced, implying that asset bubbles require investors to behave irrationally. This line of reasoning leads to the irrational investor defence of the Efficient Market Hypothesis: to disprove market efficiency it is necessary to prove that investors behave irrationally.”

“The irrational investor argument is an ingenious construct, providing what looks to be an impregnable defence of market efficiency. The argument requires the doubters to prove that investors knowingly make bad investment decisions. But of course proving that investors knowingly make bad investment decisions is fiendishly difficult; indeed the idea is almost an oxymoron.”

“Is it really necessary to prove irrational investor behaviour, in order to call an asset price bubble a bubble? The questions:

  • Do asset price bubbles exist? and:
  • Do investors behave irrationally?

are frequently rolled up together but are actually two quite distinct

Buried deep within the Efficient Market Hypothesis is the unstated
assumption that investors always have to hand the necessary
information with which to calculate the correct price of an asset. If this
assumption turns out to be false and investors are sometimes denied
the necessary information to make informed judgements about asset
prices, or worse still if they are given misleading information, then it
becomes possible for asset price bubbles to form without investors
behaving irrationally.”

Fundamental Variables – Variable But Not Fundamental

“Market efficiency requires that the prices of financial assets move in response to some known set of externally provided fundamental variables….

If we start to relax this one-way causation and contemplate the idea that asset prices and economic fundamentals could interact via two- way causality – the economy driving asset prices and asset prices driving the economy – then a whole new set of problems open up for the idea of efficient markets; the processes through which investors are supposed to maintain the optimal equilibrium is undermined.”

“The variables used by investors to construct their estimates of asset value can be grouped into three classes: balance sheet, income statement and economic fundamentals. Unfortunately, all three of these sets of variables are influenced by financial markets in such a way as to undermine their ability to provide investors with objective external measures of value. Indeed, frequently these variables do not just fail to inform investors, they actively mislead them into supporting the destabilising processes described in the previous chapters.”

Beware the balance sheet

Cooper argues that balance sheet analysis is subject to a fallacy of composition, in which  analysis that is valid at the individual borrower level does not necessarily hold at the system level; e.g. it is relatively easy to sell a borrower’s collateral if they default individually but not if large numbers are defaulting at the same time and everyone is selling assets.

“Balance sheet variables, therefore, do not just fail to inform investors of impending economic problems, they may actively mislead them into believing conditions are safer than they really are. In predominantly debt-financed asset markets asset prices cannot be considered an independent metric of sustainable debt levels, nor can debt levels be considered an objective external variable with which to measure asset prices.”

Credit creation creates profit

“This process through which borrowing and savings drive economic activity is the essence of Keynes’ famous ‘paradox of thrift’ and of his recommendation for fiscal stimulus. In the paradox of thrift, if one section of the economy tries to save money, it will reduce the income of another section of the economy, and this will likely find its way back to undermine the income of the original savers, leading them to further reduce their spending, causing a self-reinforcing cycle of declining activity. If, for whatever reason, the majority of agents in an economy become more risk-averse, deciding to increase their savings rate together, they could find themselves in a self-fulfilling economic contraction.”

Minsky, however, took Keynes’ theory to the logical conclusion, arguing that borrowing can lead to a self-reinforcing positive spiral. This positive spiral could be thought of as a “paradox of gluttony” whereby higher borrowing produces higher profits, thereby ratifying the decision to borrow and spend more.

The paradox of thrift and gluttony are important because they are linked to the same credit creation process that drives asset market instability, described in the previous chapter. Importantly these cycles undermine investors’ ability to form objective judgements about asset prices

Once one appreciates the connection between asset inflation, credit creation and profit formation it becomes apparent that price earnings ratios, revenue growth, and other such variables reliant on money flow, do not provide investors with objective external measures of asset values. Over reliance on these numbers can lead to self-reinforcing positive and negative asset price and credit cycles. Once again diligent inspection of the numbers may actively mislead investors into fuelling boom-bust cycles

“… if asset-price inflation, credit creation and profits formation can form self reinforcing cycles then these three variables can also feedback into … the real economy”

5.3 Macroeconomic Policy And Credit Creation

“Through its role in asset price cycles and profit generation, credit formation (borrowing money for either consumption or investment) lies at the heart of the financial market’s fundamental instability”

“As each successive attempted credit contraction is successfully counteracted with engineered stimulus, the economy is pushed into a state of ever greater indebtedness, presenting the risk of a still more violent contraction in the future. Over time, a policy of always maximising economic activity implies a constantly increasing debt stock and progressively more fragile financial system.”

Comment: The implication is that regular restructuring including deleveraging is important to keep the level of debt down and the system resilient. The system however is not designed to allow this. Central bank’s seek to counter act any decline in economic activity and politicians will add fiscal stimulus to the same end. 

5.4 Fed Policy And The US Saving Rate

“Over the last couple of decades the US household savings rate has fallen steadily by roughly 10% of GDP. Arguably this trend has occurred because of an activist policy of macroeconomic management; whenever the US economy has slowed down the central bank and government has responded with lower interest rates and higher government borrowing. These policies were effective in preventing any serious economic downturns. And in turn the avoidance of serious economic downturns helped “educate” households to believe that it was safe to lower their savings rate and to borrow more money.”

5.5 Bubbles Happen Without Irrational Behaviour

In order to assess the sustainability of a credit expansion it is not sufficient to ask:

Do the economic variables justify the credit expansion?

Rather it must be asked:

What would the economic variables look like without the credit expansion?

And: Would the current level of debt be sustainable under those new conditions?

5.6 Bubble Spotting – Credit Growth Is Key

“As discussed it is an unfortunate fact of our economic environment that neither the analysis of balance sheets, income statements nor (most) macroeconomic variables will flag up the onset of an unsustainable credit bubble. Fortunately, however, there are variables that can help identify the onset of bubbles and the emergence of fragility within the financial system. The clues comes in recognising that if credit creation is running substantially ahead of economic growth then that growth is likely itself to be supported by the credit creation, and will not be sustained once the credit expansion ends.”

“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.”

6 On (Central Bank) Governors

According to the Financial Instability Hypothesis, if left unchecked, credit expansions will continue without limit, as will credit contractions.

“The central bank’s job is to … measure economic activity and to adjust policy as necessary. When credit creation has entered an excessive, self-reinforcing expansion the central bank’s role is to tighten policy (raise interest rates) and push the economy into a self-reinforcing contraction. Once the contraction has run for long enough, the central bank’s role is then to ease policy (lower interest rates) triggering a self-reinforcing expansion.”

For the central bank to correctly perform the role of control feedback system it must first appreciate the necessity of the job, and accept that both credit expansions and contractions can be excessive

Comment: The other important insight is that seeking too tightly limit instability could itself create adverse feedback loops that accentuated the instability. Cooper uses Maxwell’s work on governing systems to argue that some level of cycling is preferable to absolute focus on stability and growth But this may not be politically feasible

Shocks – Good Or Bad?

Comment: Important point I think – allowing some room for shocks to have an effect creates a more resilient system than one in which the impact if the shock is always compensated for

To the efficient market school all negative shocks are destabilising events that should be counteracted. But to the financial instability school some shocks can be stabilising events, helping reverse previous cycles of unsustainable credit creation. Once the hurdle of acknowledging financial instability is cleared, it becomes apparent that the central bank should not necessarily counteract all adverse shocks. Occasionally it may actually be useful for the central bank to generate its own shocks

Today the central banks pride themselves on their transparency and predictability. The major central banks have adopted a pattern of behaviour whereby they pre-warn the financial markets of forthcoming policy actions. It may, however, be advisable to head in exactly the opposite direction. By mandating the bank to deliver occasional short- sharp-shocks – sudden unexpected withdrawals of liquidity – the banks may be able to perform the economic equivalent of a fire drill: testing the economy’s resilience to shocks; checking the sustainability of an expansion; and identifying those institutions in the most precarious financial position. If the financial markets came to believe a policy of performing occasional “financial fire-drills” were in place both lenders and borrowers would be encouraged to achieve higher levels of self-discipline.

Comment: Complete predictability is not always desirable

6.9 – A Control System Perspective

Viewing the function of a central bank as a feedback control system helps clarify the tasks ahead. We must work out what it is that needs to be controlled, the acceptable range of parameters in which we wish to achieve control, the correct control signal to monitor and the optimal method of applying the control impulse

At present we are attempting to control consumer price inflation, whereas the instability of the system arises through asset price inflation.

Comment: Consumer price inflation was a big problem in previous crises in part because it prompted increased labour costs which undermined competitiveness of the economy. 
Not clear that the downside of asset price inflation is properly understood

Key points
1) focus on asset price inflation – not consumer price inflation
2) focus on credit creation

7 Minsky Meets Mandelbrot

7.1 Known Unknowns

Today the quantitative measurement of financial risk is all pervasive through our banking, asset management and regulatory systems. These risk management systems are based on the premise of market efficiency, and the idea that we are able to determine reliable probability distributions for future asset price returns. As Northern Rock and Bear Stearns …demonstrated, the risk distributions predicted by these systems frequently underestimate real world scenarios.

Unknown Unknowns – Knightian Uncertainty

“[An] unknown outcome from an uncertain outcome is referred to as Knightian uncertainty after the American economist Frank Knight who first drew the distinction between events chosen randomly from a known probability distribution and events chosen at random from an unknown probability distribution.”

“The erratic nature of the boom-bust cycles predicted by the Financial Instability Hypothesis calls into question the whole idea that previous market behaviour can reliably be used to generate future return distributions. If a return distribution is derived during a period of an expanding credit cycle it will almost certainly be entirely unrepresentative of the return distribution produced in a contracting cycle; under the Financial Instability Hypothesis neither the shape of the asset’s return distribution nor its location are known with any certainty.

Most troubling is the implied tendency for the entire probability distribution to shift at the point in which the cycle flips between self- reinforcing expansions and contractions – the so-called Minsky Moments. Unfortunately, it is at these moments when risk systems are needed most. These flips are responsible for creating the illusion of extreme 25-standard deviation events …”

7.3 Unknown Knowns

“The increasing reliance on quantitative risk management systems, developed from theories based on the premise of market efficiency, has introduced the new problem of “unknown knowns” … things we’ve convinced ourselves we know but which we do not know. The Efficient Market fallacy teaches us that we know the probability distribution of asset returns, but the reality of the self-reinforcing processes within financial markets renders these distributions reliable one in quiescent market conditions”

7.4 The Risk of Risk Measurement

“The unfortunate side effect of … unknown knowns is their ability to lure financial market participants into a false sense of security. Modern risk systems … do not know what they claim to know and therefore may serve to increase confidence to inappropriate levels”

As with mark-to-market accounting, the modern risk management system was introduced to help make the financial system safer and more stable, but may have helped add to its instability”

7.5 Intoducing Mr Mandelbrot – Memory is important

Cooper introduces Mandelbrot who argues that there is a “memory effect” observable in market price movements “… whereby future market price movements have a higher probability of repeating recent behaviour than would be suggested by a purely random process.”

“One of the most fascinating aspects of Mandelbrot’s analysis is his claim to have identified evidence of markets having memory. Mandelbrot claims to have found evidence that market behaviour is influenced by its own recent behaviour, and evidence of a clustering effect causing large price movements to occur in short periods of time. Neither the memory effect nor the clustering effect can be explained by the Efficient Market Hypothesis. However, both can help explain the “fat tails” problem and the systematic underestimation of financial market risk by financial risk systems.”

The problem however is that Mandelbrot does not explain the mechanism by which this memory effect manifests.

Minsky Meets Mandelbrot

“When viewed through the … Efficient Market Hypothesis, the ideas of Mr Mandelbrot seem fanciful … However, when viewed through the lens of Minsky’s Financial Instability Hypothesis, Mandelbrot’s ideas look logical and something to be taken quite seriously.

Mandelbrot’s market memory can easily be interpreted as Minsky’s self- reinforcing positive feedback processes, which also works by repeating past events as if having memory.”

8 Beyond The Efficient Market Fallacy

Minsky – Time For A New Hypothesis

“Keynes set out on the path of finding a viable alternative to the Efficient Market Hypothesis; Minsky took us further down the same path. Minsky’s theory, with financial markets flipping between self-reinforcing expansions and contractions, explains real financial market behaviour. Until better ideas come along we should adopt the Financial Instability Hypothesis as our working assumption of how our financial system really works. We should then use this as a starting point from which to consider how best to reform our macroeconomic policies.”

“For a system as inherently unstable as the financial markets, we should not seek to achieve perfect stability; arguably it is this objective that has led to today’s problems. A more sustainable strategy would involve permitting, and at times encouraging, greater short-term cyclicality, using smaller, more-frequent downturns to purge the system of excesses”

Comment: Cooper argues that we should not seek to achieve perfect stability; in his view it is this objective that has contributed to today’s problems by allowing systemic stresses to grow rather than be addressed.

Practical Steps

Unravelling the confusion within our academic framework is only a stepping-stone toward achieving tangible policy reform. To achieve this we must also unravel the confused and sometimes conflicting objectives facing central bank policy makers.

Debt drives inflation

All these policies amount to the same process of paying off the debt stock through a retrospective taxation on the prudent (savers) for the benefit of the imprudent (borrowers and lenders).

Discard consumer price targeting

Adopt Fiscal oversight

9 Concluding Remarks

“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.

Credit creation is the foundation of the wealth-generation process; it is also the cause of financial instability. We should not allow the merits of the former to blind us to the risks of the latter.”

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