By SwyxPublished: Friday, August 14, 2009Posted in: Cat 1: Articles, Finance, Library of Summaries 
Notes: This is easily the best macroeconomics book I have -ever- read, and it neatly summarizes and adequately explains its points in all of 195 pages, including appendices. I have decided to keep a copy of this and Fooled By Randomness with me instead of discarding them as usual, and will gladly loan it out to any kindred spirit with an open mind.
I am making extremely detailed notes, so the following summary is as yet incomplete. What is here, though, is golden.
Dr. George Cooper is a principal of Alignment Investors, a division of BlueCrest Capital Management Ltd. He was born in Sunderland and studied at Durham University. George has worked as a fund manager at GS and as a strategist for DB and JPM.
- Preface to the Vintage Edition
- Preface to the Original Edition
- Introduction
- Efficient Markets and Central Banks?
- Money, Banks and Central Banks
- Stable and Unstable Markets
- Deceiving the Diligent
- On (Central Bank) Governors
- Minsky Meets Mandelbrot
- Beyond the Efficient Market Fallacy
- Concluding Remarks
- Appendix – On Governors by JC Maxwell
The Origin of Financial Crises by George Cooper
Detailed Notes
Preface to the Vintage Edition
In the six months since I completed this book the financial crisis has intensified to the point at which, in October 2008, the entire global banking system came close to collapse. If it were not for the announcement of massive state-funded bailout packages, it is probable that not just the financial markets but also our global trade system would have ceased to operate. Capital losses, shattered confidence and the drag of a partially nationalized banking system will impair economic progress for years to come.
To prevent the next crisis, we must look beyond the details of today’s mortgage bubble to the underlying monetary system which helped facilitate it.
Current events represent the wholesale failure of monetary policy as practiced over recent decades.
Preface to the Original Edition
This book has been written in response to the current credit crisis to explain
why the global economy finds itself caught in a seemingly endless procession of asset price bubbles,
followed by devastating credit crunches.
It describes
the processes that generate these cycles and
the reasons behind the policy mistakes that have tended to exacerbate them.
If we are to break out of this damaging cycle of booms and busts, all participants in the economy must recognise the proper role and limitations of macroeconomic policy.
Politicians and voters must acknowledge that it is neither possible nor desirable to use fiscal and monetary policy to immediately counteract any and all economic downturns.
Central banks
must return to their core purpose of managing the credit creation process and
must learn to resist political and private sector pressure for an endless credit-fuelled economic expansion.
The central thesis of this book is that our financial system does not behave according to the laws of the Efficient Market Hypothesis as conventionally subscribed.
Left to its devices, the financial system will not settle into a steady optimal equilibrium – it is inherently unstable, and habitually prone to the formation of damaging boom-bust cycles.
This instability requires central banks to manage the credit creation process.
However central banks can inadvertently slip from providing a stabilizing influence on economic activity to one that amplifies boom-bust cycles.
It is also argued that the US Fed has slipped into a mode of monetary policy that is generating a series of ever-larger credit cycles which will significantly impair the prospects of the US economy.
Introduction
Lopsided Policy
We are told it is impossible to see the bubble while it is in the inflationary phase. We are also told that by some unspecified means the bubble’s camouflage is lifted immdiately as it begins deflating, thereby providing a trigger for prompt fiscal and monetary stimulus. This is called a “risk management paradigm”.
Current events suggest these asymmetric policies have gone badly wrong, not leading to a higher average growth rate but instead to an unsustainable level of borrowing ending in abrupt credit crunches.
Efficient Markets – More Faith Than Fact
Quote from Samuelson textbook: “The equilibrium of supply and demand will be restored. What is true of the markets for consumers’ goods is also true of markets for factors of production such as labor, land, and capital inputs.”
Laissez-faire school: if free markets naturally achieve an optimal equilibrium, any interference can at best achieve nothing, at worst push the system to suboptimal.
A Sleight of Hand
What applies for goods market does not apply for asset markets.
The Market for Bling
Conspicuous consumption as a counterexample to Samuelson’s goods markets.
When The Absence of Supply Drives Demand
Other, more serious counterexamples
oil – when producers are reducing production, speculators are increasing purchases
stock market – who would buy shares if company kept issuing shares after it rises above a certain level?
when we invest we seek a degree of scarcity value, in defiance of the core principle in LF school that supply should move to meet demand.
in asset markets it is the rate of change of prices that stimulates shifting demand.
in asset markets demand does not stimulate supply, rather a lack of supply stimulates demand.
Price rises can signal a lack of supply thereby generating additional demand, or conversely, price falls can signal a glut of supply trigering reduced demand.
Introducing the Efficient Market Hypothesis
To financial professionals this has a bearing on the pricing of items being traded: Asset prices are always and everywhere at the correct price. Wild price swings are just markets responding to changing fundamentals.
NASDAQ bubble – “To these researchers the NASDAQ was correctly priced at 1140 in March 1996, at 5048 in March 2000, and again correctly priced at 1140 in 2002.”
The clash between the theoretical statstics predicted by efficient markets and those observed within real financial markets is known as the “fat tails” problem. For example, a hedge fund experienced adverse “25 standard deviation events several days in a row”. It is exceedingly highly impossible. Statistically speaking, a pair of 25 std dev events is not an example of bad luck; its an example of bad statistics and bad science.
We Already Have A Better Theory
Financial Instability Hypothesis by Hyman Minsky (who credits Keynes)
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?
The key diff between EMH and FIH is the quesiton of what makes prices within financial markets move: an external, unexpected event, or by internally generated forces of credit expansion/contraction and asset inflation/deflation. To prove FIH, internal forces must be found.
Two have already been identified – supply as a driver of demand in asst markets, and asst price changes as a driver of asst demand. The rest of this book focuses on explaning other forces within the banking system and the credit creation process.
Money Market Funds – A Banking System in Miniature
The object of stable-dollar MMFs is to provide its investors with a rate of interest usually available only on longer term deposit accounts, while at the same time giving investors instant access to their cash.
Stable dollar US money market funds – as banks
Individual investors see constantly moving streams of money whereas the fund manager sees a largely stagnant, and therefore investable, pool of money (typically >90% of assets).
This all works fine until the moment comes when a large number of investors decide to ask for their money back at the same time.
Conflicted objectives
The industry is intensely competitive. Money moves in and out of funds quickly based on rates. In money markets, as with most debt markets, the way to earn the highest rates of interest is to make loans for the longest possible periods to the lowest quality, least-reliable investors.
This high risk lending strategy directly conflits with the MMF commitment to return all money plus interest at no risk of loss.
An introduction to Bank Runs
One default
Bank spreading out the loss over all deposit accounts
Reducing average yield of accounts
Some investors withdraw
Losses spread out over smaller number of accounts. Rinse and repeat. This happened to Northern Rock and Bear Stearns. (NR was technically caused by fear of future defaults, causing both retail investors and commercial MM lenders to refuse to lend to the bank)
Memory and Risk
The EMH relies upon the fact that market movements are uninfluenced by previous movements. The FIH accounts for positve feedback.
Efficient Markets and Central Banks?
Central Banks – Everyone Has One
CBs can help raise living standards for all citizens, but also trigger recession, deflation, stagflation, or hyperinflation in Zimbabwe and Germany.
An Expanse of Confusion
Few people, even professionals, can explain why CB’s exist, much less why they do things, or what makes good or bad CB policy.
Opinions Differ
Even CBs defer in opinions. Both ECB and Fed say they want price stability. But how to achieve this? ECB: M3 money supply targeting. Fed: M3 is useless (superfluous).
Fed: doesnt believe there can be an excessive level of money growth, credit creation, or asset inflation. But there can be an unacceptably low level of them.
ECB: believes money growth/CC/AI can become excessive. But reluctant to connect money growth and AI.
Should We Even Have Central Banks?
“It is a strange paradox that today’s central banks are generally staffed by economists, who by and large profess a belief in a theory which says their jobs are, at the very best, unnecessary and more likely wealth-destroying. If central banks are necessary because of an inherent instability in financial markets, then manning these institutions with EMH disciples is a little like putting a conscientious objector in charge of the military; the result will be a state of perpetual unreadyness.”
Efficient Market Hypothesis – Is Flipping Coins
Mocking EMH, incl Random Walk + trend, and lognormal adjustments .
Coin Flipping and Volatility – Foundations of the Options Industry
Testing the Hypothesis
If we record data on asset price changes over time, compile into realised return distributions, compare with what had been forecast, we can test EMH. Bear and NR corroborate the failure (he asserts) but the best example is LTCM. It quadrupled NAV for four years and lost it all and more in just a few weeks. LTCM disproved EMH by making profits that should not have been available and then incurring losses as the result of sudden market movements which should also not have been possible.
Time to Take Stock – EMH requires these to hold, but they dont:
Asset price bubbles do not exist; the prices of all assets are always correct.
Markets when left alone will converge to a steady equilibrium state.
That equilibriums state will be the optimum state.
Indiv asset price mvmts are unpredictable.
But distributions of asset price mvmts are.
Disproving One Theory Should Lead To a Better Theory -> What Keynes, Minsky and Mandelbrot did was make a new, instability theory. Others like Friedman noted existing imperfections like CBs and blamed them.
Two Schools Or the Mad House
The Friedman school – central banks make markets inefficient
Today’s economic orthodoxy parrots Friedman’s reverence of free markets, but does not apply his intellectual rigour in extrapolating what efficient markets imply about the role of CBs. Political orthodoxy too. Exception: Ron Paul who introduced legislation aiming to abolish the US Fed. in 2002
Their concerns cite the inherently inflationary bias of a fiat money system in the hands of a govt bureaucracy, and the potential for misguided policy actions.
The Keynes/Minsky school – markets are inefficient, central banks make them more efficient
The mad house – markets are efficient and we need central banks
Is This Science?
In cycle after cycle the same script is acted out. An asset bubble begins inflating, together with its associated credit bubble. The lead singers of the free market school strike up their familiar song: markets know best, markets are efficient, there are no bubbles, let the markets run. While asset prices rise and credit expands, the doctrine of market efficiency reigns supreme. But immediately as asset prices begin falling and the credit bubble begins contracting, the singers swiftly change tune. The free-marketeers cast aside their message and, without even the decency to blush, strike up a new song: central banks must cut rates, governments must stimulate, credit must not contract, asset prices must not be allowed to fall. While the lead singers flip from song to song, apparently unaware of their discordant lyrics, the backing singers maintain a constant comical chant: markets are stable, markets are stable, markets are stable.
In Summary
Money, Banks and Central Banks
The ECB’s Inflation Monster – a cartoon on the ECB website showing hyperinflation. Told that too much money chasing too few goods causes inflation.
The Inflation Monster and the EMH – EMH concludes that deflation (disinflation) should be the normal state of affairs due to competition.
Hunting the Monster: A Brief (Partialy Fictional) History of Money (without the seashell swapping – he recommends The Great Wave, Price Revolutions and the Rhythm of History by David Fischer for the full story)
Barter Exchange – All goods exchanged in real time – no finance means no financial instability.
Gold Exchange – chickens-gold-firewood. Means of exchange and store of value. This was the start of monetary inflation cycles and instability. Overproduction would cause deflation and vice versa. But these would be negative feedback cycles.
Gold money (coins) – units of gold. But coin clipping also emerged – start of monetary debasement. Isaac Newton put the lines on edge of coins to stop it. But governments did it on large scale – recall coinage, melt it down, reform coins with lower gold content. But recoinage was a difficult and thus occassional process – causing only bursts of inflation. Newton’s recoinage was a result of England’s war with Europe. Connection between inflation and war financing. Inflation representing a retrospective taxation.
Gold certificates, and gold depository banks. Groups of merchants got together to form merchant banks to hold their gold. Merchants who deposited their gold rarely came back to collect it.
Gold certificates and credit creation – they lent it out. The individual depository banks were not in a position to redeem all their certificates at once – there were more certificates than actual gold. Therefore even under the gold standard the monetary system was predominantly secured on debt.
Banking crises with depository banks. Happened under the gold standard (cf The Moneymaker by Janet Gleeson – France in 1716)
Private sector credit creation is not the Inflation Monster: even under a banking system with far more certificates of deposit outstanding than reserves in the vaults – fractional reserve bankin – each indiv receipt still retained its full theoretical claim to a fixed qty of gold. Cycles are still present – inflation with bank confidence, deflation without. Credit creation amplifies cycles, but no secular trend toward ever higher prices.
Money and anti-money – borrowing from Werner Heisenberg. 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. (they just cause credit cycles) Second it helps clarify why some central banks worry so much about money supply growth; money growth also means debt growth, and its the debt that causes financial instability. The credit crisis today can be thought of as a result of excessive credit creation in previous years. Great Depression story is similar: 1920 credit growth with hire purchase and instalment payments. Most GD explanations ignore this and attribute overtight MP in the 1930s.
Enter the central banks – as a lender of last resort – undoing it is not an option. growth and prosperity, true venture capital had been opened up. But we needed a way to prevent bank panics spreading throughout the entire system. CBs are to support institutions through confidence crises, and to wind down banks with bad loans.
Financial Crises happen with and without a gold standard. Financial instability happened well before central banking (1907, USA, before the central bank) This answers Friedman, at least initially. (Story – The panic of 1907, lessons learned from the Market’s Perfect Storm by R. Bruner and S. Carr required JPM to become CB due to inability of fin system)
Unintended consequences – enter the moral hazard. CB’s made banks more confident. CB’s also made depositors treat all banks as reliable. Depositors would seek out the banks offering the highest rates of interest on their deposits paying no attention to the security of the bank. However the banks that could afford to pay the highest rates were most likely to be those taking the most risk with depositor’s money. (This was Northern Rock – in the end all depositors were paid by govt). Friedman might have a point. The Fed also moved from reactive to preemptive policies – making it amplify crises (more later)
Central Banks and centralized money – the banks had to be controlled. Do away with different bank certificates, have one national currency. Much more control on lending. Standardization simplified the system tremendously as well. All certificates were now equally valuable even in a crisis. It was possible to stabilise the banking system and control moral hazard.
No need for the smelter – CB was the only place that gold could be exchanged for money, had a monopoly on printing money, giving it the power to change the amount of gold it was willing to pay out for each certificate in circulation. Made it easier to expropriate citizen’s wealth through devaluation. But still infrequent due to political lashbacks.
Closing in on the monster – the move to fiat currency. Most spectacularly in Germany in 1920s as a result of govt money printing resulting from the WW1 treaty (which forced Govt to pay away a large part of the gold reserves that backed its currency). but we focus on what US did.
Bretton Woods and the global gold standard – fixing all currencies to the USD and USD to $35 per gold (Keynes had wanted bancor). De facto monetary union.
Bretton Woods – the endgame. BW helped reindustrialize Japan and Europe rapidly (with the help of Marshall Aid Plan recycling USD out to ease the American trade surplus due to the necessity to import manufactured goods from US) (had their currencies been free to float during this period the shifting trade pattern would have produced a progressive appreciation, helping to maintain a more balanced trade pattern. In practice this arrangement allowed europe and japan to enjoy an artificial competitive advantage against USA, accelerating the rate of reindustrialisation in these countries. one of the consequences of today’s fixed exchange rates is that foreign goods look too cheap from a US perspective and no matter how much money US borrows from abroad that money is always recycled back into the American economy. As a result there is no mechanism to curtail US borrowing from abroad – foreign capital does not become more expensive no matter how much is borrowed) To the point that by 1960s America began to run a trade deficit with Rest of World. To keep the curr peg govts had to buy US Debt. Meanwhile the Vietnam war cost USG money, and it had to be paid for by taxes or devaluation (or borrowing, which is delaying taxes or devaluation) and the unpopularity of Vietnam ruled out taxes.
Time to meet the monster – So the US began printing more dollars, with the amt of gold constant. The result was a bank run on an unprecedented scale. The USG could not honor the convertibility, and foreign govts came in to claim their gold. So Nixon suspended it on Aug 15 1971, taking all BW countries off the gold standard. No need for devaluation to be announced: a rolling undeclared devaluation could be implemented.
Money, anti-money, and fiat money
first type of credit creation: Gold depository banks. Money creation that is accompanied by debt.
secondary: Govts have the right to create money without any corresponding liability.
From printing press to price spiral – British went for it. Germans saw it before and did not. Inflationary envt led to business uncertainty – it was now possible to get low economic activity and high inflation at the same time.
A little less brandy – the party stopped when govts accepted that they should balance their budgets, and when CBs were given the new responsibility of controlling inflation. The deal was basically: if the govt started generating inflation by printing money, the CB would respond by raising interest rates, making it more expensive for priv sector to borrow, making banks reduce their lending. An increase in printed money offsets decreased private sector credit creation. CB thus must have independence, somewhat undemocratically controlled.
An error of omission or commission Quotes Bernanke and ECB. Links between inflation and deficit spending are strong. Gold was $300 in 2002. Now its $1000, after several years of deficit spending. Central banks have had less than 4 decades experience on how best to adapt to their new task of inflation policeman together with their old role of stability guarantor
Aside On inflation and taxation – we target low inflation because people dont like cutting prices eg wages. It also makes int rates higher on average which gives CBs more room to cut them. third, it provides a convenient tax that people dont object to.
The modern taxation system is tremendously efficient. First you’re taxed when you earn money (income) and then again when you spend it (VAT). But between what you earn, after tax, and what you spend there is occasionally a little bit left over, which we call savings, and without inflation govts can find it very difficult to help themselfves to this bit in the middle. However, with inflation, a whole realm of taxes on savings becomes viable. Positive inflation increases asset prices, converted into capital gains and estate tax receipts. Even more importantly, higher inflation boosts interest rates and govts can then tax interest income.
Example with inflation rates of 0%, 2%, 4% and real rates at 2% and interest income tax at 40%, and comparing after-interest, after-inflation rates.
The ability to print unlimited currency gives the govt the ability to repay any amt of (natl curr denominated) debt (including private sector, as is today – the upshot of that though is a net transfer of wealth from the prudent to the reckless), but it produces irreversible permanent inflation. It should be seen as a form of tax transferring wealth from private to state sector. It makes CBs unbreakable, but removes a key: financial discipline.
While inflation impoverishes many, it actually enriches some.
Demand Management – the CB’s third job.
Irving Fisher’s explanation of the GD – debt-deflation (published 1933) – GD caused by an overhang of debt accumulated in the boom of the 1920s: debt burden grows once economy begins to contract. Keynes went a step further in his Gen Theory, explaining how a depression was formed and how it could be reversed. Fisher’s credibility: declaring “stock prices have reached what looks like a permanently high plateau” in 1929. Keynes on other hand had been right on Germany. He advocated increased spending – it was the spending, not the productive task itself though, that got the economy out of the recession.
Bastardizing Keynes’ insight – his ideas have taken divergent journeys. Keynes’ repudiation of efficiency has been ignored, while fiscal stimulus was accepted wholeheartedly. Keynesian policy is now enacted both thru govt deficit spending and central bank monetary policy to encourage consumption and investment. However, we differ in the timing. Keynesian stimulus is not used to exit recessions but to avoid them altogether. As each recession is successfully prevented, the private sector borrowers become progressively more confident and therefore willing to build up an even greater stock of debt. Borrowers are denied the opportunity to learn that their excessive borrowign was indeed excessive, and thus preemptive stimulus is ultimately not sustainable.
EMH and the Keynesian stimulus
The private sector has a natural tendency to raise interest rates at times of crises.
When one realises that fiscal stimulus is a procedure whereby governments borrow and spend money on behalf of their citizens, because the governments judge that their citizens are saving too much of their own money, the full conflict with the principles of free and efficient markets becomes clear.
Who are the Keynesians? Free Marketeers embrace Keynesian policy:
Efficient market economies should never contract unless subjected to an adverse external shock, and this shock should be counteracted with stimulus policies. The unmentioned inconsistency in this argument is that efficient markets should be self-optimising and therefore able to adapt to external shocks without the help of stimulus policies.
Central Banks in today’s credit crisis – compared to US, UK and ECB were more reluctant to engage in early stage demand mgmt.
Conflicted objectives: demand manager, guardian of financial stability, and guarantor of price stability.
Central banking – the story so far
Where now?
Stable and Unstable Markets
Self-Interest becomes Efficient Markets
Monday and it’s Market Day – For Goods
Tuesday: Market Day for Assets
Collateralization, marking to market and the calling for margin
Marking to market and credit spreads
Investor behavior
Back at the Asset market
The Invisible Hand is playing Racquetball
Deceiving the Diligent
The Irrational Investor Defence
Fundamental Variables – Variable but not Fundamental
Beware the Balance Sheet
Credit Creation creates profit
The Macro Data Mirage
Macroeconomic Policy and Credit Creation
Fed Policy and the US Savings Rate
Bubbles Happen Without Irrational Behavior
Bubble Spotting – Credit Growth is Key
On (Central Bank) Governors
The Wobbly Bridge
The Wobbly Economy
The Wobbly Jet
Central Banking and the Eurofighter
Meet Mr. Maxwell
Two Types of Governor
Two Types of Central Bank Governor
Shocks – Good or Bad?
A Control System Perspective
Minsky Meets Mandelbrot
Known Unknowns
Unknown Unknowns – Knightian Uncertainty
Unknown Knowns
The Risk of Risk Measurement
Introducing Mr. Mandelbrot
Memory is important
Minsky Meets Mandelbrot
Altogether Now
Building A Better Risk Management Process
Beyond the Efficient Market Fallacy (EMF)
Only the Fittest Theories Should Survive
Minsky – Time for a new Hypothesis
Maxwell – time for a new monetary policy
Mandelbrot – time for a new statistics
Practical Steps
Debt drives inflation
Discard consumer price targeting
Adopt fiscal oversight
Near Term Options – 1970’s, 30’s or Another Bubble
The Free market route
When in trouble, double
Unleash the Inflation Monster
Concluding Remarks
US Fed is only reflecting prevailing economic wisdom – not wholly to blame.
Role of Jpn montary policy – the Jap borrowing binge of the 1980s has been converted into a 13 year long period of 0 or near 0 Jap interest rates.
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.The central banking system, if used properly, should be able to contain the inherent instability of our credit system, and thereby enhance our long-term wealth-generating capacity.
Appendix – On Governors by JC Maxwell (From the Proceedings of the Royal Society, No. 100, 1868
