The Origin of Financial Crises Book Summary – George Cooper

The Origin of Financial Crises Book Summary:

The Origin of Financial Crises Book Summary is a fantastic book on how financial crashes happen! It explains in simple terms the role credit plays and how and why governments print money. If you’re new to the world of finance or just want to understand how the economic system works then this is the book for you!

 

The Snowball:

The potential for a minor credit default to snowball into the collapse of an entire fund is an example of an inherent instability generated when an institution tries to combine the incompatible objectives of guaranteeing to return an investor’s capital, while, at the same time, putting that capital at risk. 

 

The Evolution of Credit:

As the system evolved, the amount of bank-generated certificates of deposit eventually came to vastly outnumber those backed by real gold reserves. Therefore, even under the gold standard, the monetary system was predominantly secured on debt. 

Private sector credit creation works like Heisenberg’s matter-antimatter pairs. Money and debt (antimoney) created in pairs, from nothing, live for a while and then vanish when they recombine. Taking out a loan creates a money-debt pair, paying off the loan destroys a money-debt pair. 

In the financial world the creation of a money-antimoney pair (credit expansion) adds energy or spending power into the system while the recombination of a money-antimoney pair (credit contraction) drains energy from the system. 

Recognising that private sector credit creation works throuch 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. 

 

The Role of Central Banks:

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. 

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. 

Central banks were introduced to stabilise the credit system but then found that their presence encouraged more risky lending and inadvertently destabilised it. 

 

Fiat Money and Government Printing:

The advent of fiat money allowed for an entirely new mechanism of monetary creation. Governments had now 

awarded themselves the right to create their own money without any corresponding liability. Since there was no longer a promise to convert the printed money into gold, there was no longer a liability associated with printing that money. 

We have a fiat money banking system with two distinct flavours of money creation: private sector credit creation (money created together with debt) and the public sector printing press (money created from thin air without offsetting debt).

The former creates financial instability and inflation-deflation cycles, the latter creates one-way irreversible positive inflation.

This brings us to one of central banking’s dirty little secrets. The Inflation Monster is part of government, and central banking is also part of government. 

With this new ability to print, some governments printed more and more money, and used this to increase their spending. The extra government spending pushed up prices, and reduced the spending power of people’s wages. Workers demanded higher wages, companies provided these higher wages by putting up their prices. These higher prices in turn reduced the spending power of the government, who responded by printing itself still more money. 

The commercial banks would therefore reduce their lending – an increase in printed money was to be offset by decreasing private sector credit creation. 

 

Pro-active Policy vs Reactive Policy:

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. 

The first flavour of Keynesianism means policy is reactive, coming after the credit contraction, the second flavour means that policy is proactive, 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. 

However, the successes of pre-emptive Keynesianism means that borrowers are denied the opportunity to learn that their excessive borrowing was indeed excessive. 

The Problem of Pro-activity – As each fledgling recession is successfully prevented by the government and the central bank, the private sector borrowers become progressively more confident and therefore willing to build up an even greater stock of debt. 

 

Interest rates and Demand Generation:

In the real economy additional borrowing from whatever source will, all else unchanged, tend to boost corporate profits.

Of course the opposite is true of decreased borrowing, or increased savings rates, which tend to depress profits. 

For this reason, if a central bank is working to maximise economic activity in the current period, it will tend to try to force down the savings rate of its economy.

Supporting demand through interest rate policy means one thing and one thing only: lowering interest charges to encourage more borrowing. However, as explained by the discussion of fractional reserve banking, more borrowing increases bank leverage, which in turn causes the type of financial fragility responsible for the sub-prime mortgage crisis. 

Financial stability therefore requires limiting credit expansion while demand management requires maintaining credit expansion – the two roles do not sit well together, 

 

The Problem with Saving:

‘Workers spend what they get, capitalists get what they spend.’ 

Attributed to the Polish economist Michael Kalecki, 1899-1970 

Consider what happens if we relax the ban on savings, and as a result the workers decided to save, rather than spend, some of their wages.

The revenue of Companies  would fall, by the amount of the savings and, as a result, the wages of companies would also fall by the same amount. These observations are the root of the first half of the quotation at the beginning of this chapter – ‘Workers spend what they get’ – if they don’t spend it they don’t get it. 

As it turns out, investment spending is also a key driver of corporate profits, with higher investment spending from one company flowing through to higher corporate profits at another; hence the ‘capitalists get what they spend’ part of Kalecki’s quotation.

 

Credit Contractions:

While credit is expanding, the economy will tend to grow, but once credit ceases expanding, economic expansion will stall, and should credit begin to contract, economic activity will also contract. If the central bank perceives its role as being to maximise economic expansion it must also seek to maximise credit expansion. 

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.

 

The Difference in the Goods and Asset Markets:

The critical difference between markets for goods and those for assets is how the markets respond to shifting prices, or equivalently shifting demand. In the goods market, higher (lower) prices trigger lower (higher) demand; in the asset market higher (lower) prices trigger higher (lower) demand. One market is a stable equilibrium-seeking system and the other habitually prone to boom-bust cycles, with no equilibrium state. 

In goods markets items are purchased for consumption, in asset markets items are purchased for their potential to change price, making the nature of how the markets’ participants respond to price changes fundamentally different. 

Once the cycle turns negative, however, and asset prices begin falling, the stock of outstanding debt quickly looks excessive. 

This is, of course, followed by the inevitable credit downgrades and the time-honoured witch hunt for culprits, who are often to be found in the credit rating agencies. 

 

The problem with credit ratings, they are time stamped:

When the ratings analysts are assessing the quality of a loan, or the equity analysts are assessing the condition of a company’s balance sheet, or the mortgage broker is assessing the safety of a mortgage, they evaluate each individual loan against the prevailing market prices for the loan’s corresponding assets. In this procedure the tacit assumption is that the asset in question can be sold to repay the loan. But, what happens when the assets value drops? 

 

The Failure of the Efficient market theory:

According to the ideas of efficient markets, asset prices are the thermometers taking the temperature of the real economy. On closer inspection asset price movements create the weather conditions that determine the temperature of the real economy. In such a system there is no defined correct equilibrium state. 

The aim of the modern quantitative risk management system is essentially that of eliminating Knightian uncertainty through the collection and analysis of historical data. The premise of this industry is the Efficient Market Hypothesis’ teaching that future return distributions are knowable and non-Knightian.