If you have been reading the newspapers, you have some understanding of what caused the current financial and economic crisis. Banks got themselves and the whole economy into trouble by over-leveraging—that is, using relatively little of their own capital, they borrowed heavily and bought extremely risky real estate assets. In doing so, they used confusing, complex instruments like collateralized debt obligations. The prospect of high returns and thus high compensation led account managers to accept excessive risk rather than seek more prudent investments. Banks made all these mistakes unknown to the public, because so much of what they were doing was off-the-books financing. Regulators, in the meantime, appeared to be asleep, failing to use what little power the waves of deregulation had left them.
Expect a deluge of books on the economic and financial crisis to pour out in the coming months. The four books discussed here were published during 2007 and 2008, with two of them republished in late 2008 and early 2009 with new prefaces accounting for rapidly changing events. A third, the book by George Soros, contains four new chapters and has changed the title’s wording from the “credit crisis” to the “crash” of 2008. The books yet to be published will attempt to explain what caused the crisis and what should be done. They will range from blaming the market and deregulation to blaming government interference with normal market processes. These four books were basically written in the early stages of the developing crisis and, therefore, they can be judged on how well they got it right. Did they foresee the depth and extent of the crisis?
Boom and Bust
The Ascent of Money is Niall Ferguson’s excellent but uneven guide to the history of finance and financial crises. A professor of history at Harvard, Ferguson shows how money and credit have helped raise humans from subsistence farmers in the ancient world to “Masters of the Universe” on Wall Street. “The ascent of money,” he argues...
has been essential to the ascent of man. Far from being the work of mere leeches intent on sucking the life’s blood out of indebted families or gambling with the savings of widows and orphans, financial innovation has been an indispensable factor in man’s advance from wretched subsistence to the giddy heights of material prosperity that so many people know today.
As a history of money and the evolution of financial markets, Ferguson’s book is sketchy but fascinating to read. A key lesson is that this financial history was always characterized by boom and bust cycles, with sooner or later every bubble bursting with all the attendant destructive effects before the cycle started over again.
What has been true of the financial system has been true of the economic system as a whole. Two facts stand out from an examination of the history of capitalist development. First, it has produced unprecedented amounts of goods and services, a growth that has proceeded unevenly between countries and within regions, creating great disparities of wealth and income. Second, it has always proceeded cyclically, through euphoric booms and painful busts in every country and region. This process has extended to individual industries and even households. One of the great economists of the 20th century, Joseph Schumpeter, emphasized the positive side of this dynamic process, calling it creative destruction. Such a vision, however, is scant solace to workers thrown out of their jobs, farmers facing a collapse of demand for their produce or towns and villages that progress leaves behind.
There are two possible responses to this reality. The first proclaims that there is no alternative to allowing the “natural” laws of the economy to work themselves out. Attempts to reform capitalism will only cause greater harm. The second argues that in fact capitalism can be, needs to be and has been reformed without destroying the creative dynamics of the system.
From the beginning the great economic debate in the United States has been about the question: Can the destructive side of the capitalist development process be mitigated while not doing significant damage to the creative side?
With stock markets collapsing, financial institutions going bankrupt and governments around the world stepping in to bail out failing companies, the prospects for investors, the financial community and taxpayers are not bright. And with the effects of recession on employment in other sectors almost certain to result in continuing job losses, the impact from the current market turmoil is going to be widely felt. That is, the bubble has burst on financial speculation and the real economy has entered the recession phase of its boom-bust cycle. This double whammy creates a perfect storm of challenges for policy makers.
How Did We Get Here?
Charles R. Morris, in The Two Trillion Dollar Meltdown, shows how we got into this mess. He explains the arcane financial instruments, the chicanery, the policy misjudgments, the dogmas and the delusions that created the greatest credit bubble in world history. This global crisis originated in the United States, though many other countries jumped on the bandwagon. Morris explains:
At its core, it was a crisis of the classic “Argentinean” variety—a debt-fed party, marked by a consumer binge on imported goods, and the strutting of an ostentatious new class of super-rich, who had invented nothing and built nothing, except the intricate chains of paper claims that duller people mistook for wealth.
This has led to such distortions; Morris believes that only a serious recession can squeeze out the dross that cripples the economic system—too much consumption, too few savings, over-leveraged financial institutions and ruinous amounts of toxic assets. He points to how Paul Volcker slew the inflation dragon in the early 1980s and set the stage for the high performance economy of the 1980s and 1990s. The required restructuring for the current crisis will be at least as painful as the very difficult period of 1979-83.
Morris’s solutions include allowing the recession to do its job, reregulating the financial system and then redirecting subsequent growth with investments in infrastructure and health care. His praise for Volcker, however, should give us pause. It was Volcker who, as chairman of the Federal Reserve, pushed up interest rates and contracted the money supply, thus triggering a worldwide recession that caused devastation in many poor countries.
What Is Needed
In both editions of The Crash of 2008 and What It Means: The New Paradigm for Financial Markets, the legendary financier George Soros argues that a new paradigm is urgently needed if we are to understand better what is going on. The paradigm used until now by most economists holds that markets are self-correcting, that they naturally tend toward equilibrium. Economists have therefore frequently argued against regulation or government intervention of any kind, since it would interfere with the natural forces of the market.
The new paradigm that is needed, according to Soros, must incorporate what he calls the theory of reflexivity. Reflexivity examines the relationship between thinking and reality. In the investment world, this means that when investors are promoting, say, housing or mortgage-backed securities, their values are driven up, not because they become intrinsically more valuable but because everyone else is thinking they are more valuable. That is, what we think affects the reality by our acting on what we think.
If a physicist predicts that a liquid heated to a certain temperature will boil, the prediction has no effect on the outcome. But if an economist predicts that the stock market will rise next week, this can change participants’ thinking and thus their behavior and can in turn change the outcome. Thus, Soros argues that the natural science methods used by economists do not work. The think-act mechanism that drives the market up is self-reinforcing but ultimately self-defeating. The market can go from euphoria to despair overshooting the top, and ultimately the bottom too. Witness today’s housing market.
In the new Part III, Chapters 9 to 12, Soros now recognizes that the financial crisis is more severe than he earlier thought. He never expected the financial system actually to break down and the global economy to collapse. He now sees the effect on the global economy of allowing Lehman Brothers to go into bankruptcy “was equivalent to the collapse of the banking system during the Great Depression.” While admitting he underestimated the depth of the crisis, Soros claims that the standard efficient market hypothesis “has been well and truly discredited by the Crash of 2008.”
This is an important book but probably not bedside reading. The author’s major interest is in arguing for his theory of reflexivity. Thus much of the book is abstract and technical despite the fact that it offers many interesting examples. Moreover, Soros never convinces me that his theory is workable, even if prevailing market theory is no better.
In The Squandering of America, Robert Kuttner also attacks the free market orthodoxy that has ruled politics and economics since the 1980s, but he expands his target from the financial sector to the economy as a whole. Many of the policies, institutions and regulations put in place by liberal administrations from the 1930s to the 1980s have been abandoned in favor of a more business-friendly orientation. Kuttner argues that these changes have further enriched the already wealthy at the expense of America’s lower and middle classes, exacerbating inequality and systematically weakening the economy.
Writing in 2006-7, Kuttner points out time and again that many of the prerequisites for financial disaster are already in place. First and foremost there is too much money in the hands of too few people. Second, the repeal of the Glass-Steagall Act in 1999 paved the way for the rampant and irresponsible financial speculation that we have witnessed over the past 10 years. Kuttner also points to hedge funds and private-equity firms as major culprits in this deepening crisis. But most of all he points to the dismantling of the government protections enacted before 1980 and to the free market policies enacted since then:
...the precarious prosperity of the past fifteen years has been built on cheap money and a series of asset bubbles. Broad-based prosperity has been eroding since the 1970s because of the assault on managed capitalism, but debt has kept the economy on artificial life support. For workers and consumers, increased borrowing partly substituted for declining real wages. People increased their credit card debt and borrowed against their homes.
Kuttner believes the financial and economic crisis facing us today is the result of misguided free market policies and can be combated by establishing institutions for a managed capitalism. “There is a coherent alternative to what is occurring,” he writes. “It requires a cogent ideology and politics of a managed, rather than laissez-faire, brand of capitalism.”
Certainly some kinds of government regulation—from truth-in-advertising to food-and-drug laws—can reduce distrust and thus economic inefficiency, providing gains for all concerned. Government regulation, however, has its limits. Where the regulated have concentrated power (electric companies or financial firms, for example), the regulators may end up serving the industry more than the public—which was clearly the case with the Securities and Exchange Commission. In addition, there are clearly situations in which government operates to serve the self-interest of the members of its bureaucratic apparatus. Government can serve the common good, but it has clear limits.
Kuttner says at one point that “the risks of writing a book predicting economic trouble are multiple.” That may be, but his book seems prophetic—as do the other three. Their proposed solutions, however, await trial.