The Origin of Financial Crises | George Cooper

Summary of: The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy
By: George Cooper


Get ready to delve into the fascinating world of financial crises, as we explore George Cooper’s book, The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy. This summary will guide you through the crucial flaws in the Efficient Market Hypothesis (EMH), which is the prevailing theory used by central banks, governments, and businesses. By demonstrating the inconsistencies of EMH and highlighting the alternative ideas of John Maynard Keynes, the book aims to offer solutions to prevent the cascading effects of economic bubbles and improve the monitoring of credit growth. Discover the importance of adjusting macroeconomic policies and learn how central banks can play a crucial role in stabilizing financial markets.

Inefficient Markets and the Global Debt Crisis

The global debt crisis witnessed in recent times is a result of the inefficient market hypothesis, a flawed model that has led to disastrous economic dislocations. The belief that markets left to work on their own will reach equilibrium and any attempt to shape them will only make them less efficient has led governments, businesses, and even private citizens to take on debt at cosmic levels. The markets, however, are not efficient, as evident from the exorbitant prices of rare art that rise even further with increasing demand. The collapse of the credit bubble in 2008 and 2009 was a direct consequence of this flawed hypothesis, and its widespread impact has made it clear that monetary policy, as practiced over the years, has failed. While the proponents of the hypothesis blame it on rare circumstances causing such events, the truth is that their statistical models are flawed. The Financial Instability Hypothesis presents a better alternative, which suggests that markets are inherently unstable. Governments and central banks play a vital role in managing aspects of their economies, and their intervention is necessary for financial stability. The use of ‘fiat money’ – currency that has value because the government issuing it says it does – backed only by the full faith and credit of the issuing government has further complicated matters. Therefore, a complete overhaul of the regulatory framework is essential, and these reforms are required at both the national and international level.

The Dangers of Government-Induced Inflation

Governments play a major role in the creation of inflation, which destroys the value of savings and slows economic activity. Extreme cases of inflation, known as hyperinflation, can cause societal instability. Private economic activity rarely causes inflation due to competition and consumer substitution. Central banks, in their conflicting objectives of keeping prices stable and promoting economic growth, pose a challenge to the efficient market hypothesis and the public’s patience for rebalancing the economy.

Detecting Financial Bubbles

The Efficient Market Hypothesis (EMH) argues that free markets adapt to supply and demand changes and find optimal prices. However, this argument falls apart when it comes to financial assets because banks can create money at will. Changes to underlying financial conditions can affect the value of assets behind certificates of deposits. EMH proponents argue that asset price bubbles or busts have no place in their model, even though there are internal and external economic forces that can destabilize markets undermining EMH’s fundamental claims. Experts recommend monitoring the credit growth and asset prices simultaneously to detect any signs of an oncoming financial bubble. If an asset appreciates more than the income it generates and lending is cheap and easy, this signals an unsustainable bubble, probably caused by overly rapid credit creation.

Dampening the Economy

London’s Millennium Bridge faced wobbliness issues, which were resolved by adding dampers to counteract the vibrations. The economy, unlike the bridge, is a more significant problem that lacks a single response frequency. To deal with the inflation and aftereffects of bubbles, James Clerk Maxwell’s approach of using feedback from the economy itself can be useful for central banks. They can use credit creation variables to dampen bubbles, reducing their impact. Central banks need to keep an eye on credit creation and not only focus on consumer price inflation to create a robust dampening system.

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