Crisis Economics: A crash course in the future of finance
Nouriel Roubini with Stephen Mihm
Allen Lane £25.00
Before buying the umpteenth book on the financial crisis, the reader might reasonably ask: what value does this one add? The answer is: quite a lot. Professor Nouriel Roubini, a noted economist, almost uniquely predicted the collapse of the housing bubble and, in its wake, that of the global banking system. His prediction was not just luck. Roubini realised that the 'efficient market' hypothesis, which claimed that markets always price risk correctly, was bunk.
Economic history showed that financial crises are 'creatures of habit ... probable ... even predictable'. The blend here of expert financial analysis and economic history makes a compelling story. It is not stylishly written, but key concepts likely to puzzle the non-specialist are clearly explained.
A main theme is that economies move through crises, not smooth adjustments, exhibiting a pattern of speculative boom, excessive debt and spectacular bust. This perspective punctures the fashionable view that what happened in 2007-2009 was a once-in-a-century event. It raises the question of why markets do behave so erratically, though it does not provide an answer.
Roubini and his co-author Stephen Mihm, associate professor of history at the University of Georgia, conveniently assemble the toxic elements that brought about the recent financial collapse: lax monetary policy, reckless financial innovation, moral hazard, poor corporate governance, growth of a shadow banking system and easy foreign money. Though the US was the centre of the storm, the same vulnerabilities existed elsewhere. The weight of the authors' explanation falls on deregulation. They claim that the Greenspan 'put', by assuring the markets that the Fed would always ride to the rescue of reckless traders, created moral hazard 'on a grand scale'.
The most interesting part of the book is its account of the highly unorthodox monetary responses to the crisis, spearheaded by Federal Reserve chairman Bernard Bernanke (and to a lesser extent by Bank of England governor Mervyn King). These brought about a huge extension of the central banks' 'lender of last resort' function. As orthodox monetary and fiscal measures failed to arrest deflation, the authorities started throwing money, by way of loan, subsidy or outright purchase, at specific markets and institutions, finally buying long-term government and corporate bonds in the open market ('quantitative easing').
These measures had a single aim: to repair private-sector balance sheets, so banks could restart lending, businesses borrowing and households spending. Roubini and Mihm conclude rather doubtfully that these unorthodox measures were necessary to stop the slide into depression, but that they are bound to bring big trouble further down the line by increasing moral hazard and the dangers of default and inflation. An especially acute observation is that Bernanke's extension of monetary policy blurred the line between monetary and fiscal policy, since it left the taxpayer potentially responsible for dodgy central bank assets.
Finally, the authors offer a radical portfolio of reforms. The usual suspects - restructuring compensation, regulating the derivatives market, reforming rating agencies and ensuring that banks have enough capital and liquidity to weather financial storms - are necessary but not sufficient. TBTF (too big to fail) institutions such as Goldman Sachs should be broken up through a re-enactment of the 1932 Glass-Steagall system, repealed in 1999, they say. This would create new firewalls to separate the many different kinds of financial firms now existing, as well as to curtail the sort of short-term lending that made the financial system too interconnected to fail.
The biggest weakness of the book is on the theoretical side. It has a lot about 'how it happened' and 'what to do', but much too little about 'why'. It pays lip service to John Maynard Keynes, but the authors don't know much about him, and chiefly rely on Frank Knight and Hyman Minsky on the causes of financial collapse, Irving Fisher on the weakness of orthodox monetary policy in face of 'debt deflation', and Austrian theory on the dangers of credit creation.
The authors toy with behavioural psychology to explain financial volatility but do not get very far. These fragments of theory leave unresolved the most fundamental question in political economy: under what conditions of knowledge do market participants decide what to do? The Roubini-Mihm view is that in 'normal' times the financial system is characterised by measurable risk but that uncertainty dominates in times of panic.
Keynes thought uncertainty was omnipresent, because the future is unknowable. We use various conventions (including that all risks are measurable) to hold it at bay, but the conventions are liable to collapse at any time because they are not rooted in anything solid. Keynes thought that monetary policy was impeded not by a liquidity trap but by liquidity-preference, rooted in uncertainty, and therefore that activist fiscal policy was key to recovery. He wanted macroeconomic policy to guard not against asymmetric information but against symmetric ignorance. Until these issues are settled, economics will remain in an epistemological no-man's land.
- Robert Skidelsky's book, Keynes: The return of the master (Allen Lane), was published last year.