Summer 2009 / Issue 55 (originally published by Booz & Company)

Confused Credit Markets

A review of The Origin of Financial Crises, by George Cooper.

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

By George Cooper
Vintage Books, 2008, 204 pages

British financial market analyst George Cooper takes aim at one of the central tenets of classical economics — the belief that financial markets, like the economy as a whole, behave rationally and move toward equilibrium over time (the “invisible hand” of Adam Smith’s famous metaphor). In The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy, Cooper makes an eloquent argument that there is little evidence of this phenomenon in credit markets. Indeed, the evidence is that these markets are inherently unstable, and that the markets, far from being able to handle disruptions, tend to amplify them.

This difference between what should happen in theory and what does happen in practice, as the author shows, is reflected in the widely divergent philosophies and mandates of central banks. Most conventional economic theory claims that markets are efficient and should be left alone, but experience suggests that crises are inherent in the system and central authorities are needed to regulate and control it. To compound this confusion, central banks have conflicting practical mandates — to restrain credit and money creation for financial stability and inflation control, and to promote it for economic growth and to avoid economic contractions. Capping it all off, central banks are customarily run by economists who often don’t believe in the necessity of their role in the first place. Talk about confused!

Cooper turns for guidance to Minsky, Mandelbrot, and Maxwell. The late American economist Hyman P. Minsky developed his “financial instability hypothesis” in the 1960s, suggesting that self-reinforcing expansions could flip into self-reinforcing contractions in what have come to be called “Minsky moments,” but his work was largely ignored. Benoit Mandelbrot, the French mathematician best known as the founder of fractal geometry in the 1970s, has long argued that transactions in financial markets are not independent, as required by the efficient markets hypothesis, but exhibit a form of “memory.” James Clerk Maxwell — the Scottish mathematician and physicist — pioneered the scientific study of control system engineering in the 19th century. All three men, the author contends, have something to teach us about the behavior of financial markets. Minsky and Mandelbrot help us understand why financial markets are inherently unstable, and Maxwell shows us how to control them.

The essence of control of any complex system is patience and a light touch, a combination that allows the system to settle down over a period of time. Impatience and efforts to impose heavy controls introduce further disturbances into the system and may send it careening out of control. Unfortunately, the margins between the light and heavy approaches are narrow and they may move over time, creating the potential for central bankers to be disruptive rather than calming presences. Cooper suggests that a lot must change if we are to manage financial markets effectively, both in the way that economists and finance theorists measure the probabilities of extreme market events, and in the operating procedures of central bankers. The clarity and vigor with which the author makes his arguments compel our attention.

Reprint No. 09211

Author Profile:

  • David K. Hurst is a contributing editor of strategy+business. His writing has also appeared in the Harvard Business Review, the Financial Times, and other leading business publications. Hurst is the author of Crisis & Renewal: Meeting the Challenge of Organizational Change (Harvard Business School Press, 2002).
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