The economic meltdown

Since Horse, Wheel, Language is a big, thick book and will take time to finish (and hence comment on), and since I wanted to get this blog off to an active start, I thought I would comment in the meantime on some recent books I've read about a topic on all our minds.

George Cooper: The Origin of Financial Crises. I recommend this book highly. Cooper writes very clearly and precisely, providing helpful examples and carefully building a powerful case. Cooper focuses on two big themes. First, he rescucitates Hyman Minsky (whose name is being bandied about more and more often these days) to explain why financial markets are inherently unstable. Unlike rising prices for consumer goods, increasing asset prices often lead to more, not less demand, and sell when prices decline (people buy in a rising market and sell in the reverse). This leads to feedback loops, boosting asset values ever higher - or ever lower. These loops are related to ideas of Frank Knight and the now-ubiquitous Nassim Taleb. Sometime in the 1920s or 1930s Knight distinguished between risk and uncertainty. Markets that tend toward equilibrium can be better characterized in terms of risk, which can be priced. Markets that tend away from equilibrium - like financial markets - fall under the much scarier uncertainty rubric. Taleb's distinction between normal and wild randomness seems similar.
The second point Cooper focuses on is that once a country's currency is no longer backed by any real value (gold, say) and it becomes "fiat currency" in the hands of the government, the temptation and ability of the government to engage in loose monetary policy grows enormously. Now if I remember correctly, Cooper doesn't advocate returning to the gold standard, for a number of reasons. In recent years, the US Fed engaged in an asymmetric policy - responding aggressively to the least sign of a recession, but refusing to prick - or even identify - asset bubbles.

The second book I can recommend, though perhaps not so strongly, is Mohammed El-Erian, When Markets Collide. El-Erian is the co-CEO of Pimco, the bond giant, and for a few years in this decade ran Harvard's wealth management outfit. He knows what he's talking about, and he especially knows global markets. The basic point of this book is that we are in the midst of a secular transition between two kinds of global system - the old system was dominated (both in terms of economic output and control of international organizations such as the IMF and World Bank) by western powers; the new one will involve a balance between the old players and new kids on the block, the emerging economic powers. Once we've gotten to this new balance, the prospects for growth - and for investors - will be tremendous (already the Economist is arguing that more than half of the world's population - 3+ billion - is middle class, with 30% disposable income). However, getting there will be a bumpy ride. The governance mechanisms are increasingly outdated - they reflect the old market, dominated by western powers. Think of the G-7 or G-8, with weakly Italy at the table. We need new governance mechanisms that reflect the new or emerging balance of power. For example, if east Asian countries are not to hoard foreign currencies - something that contributed to the glut of lending in the US and elsewhere - they must have a greater stake in the IMF and hence confidence in international interventions (the rapid outflow of foreign money from south east Asian countries helped trigger their collapses in 1997-8; one lesson learned by them (and China) was that private investors are fickle, we need to build up our war chests so this doesn't happen again). But as we've seen with institutions like the UN Security Council, old powers, even when they have lost ground, perhaps especially then, are going to be very reluctant to cede their prerogatives in these organizations. Another problem of reform has to do with coordination problems and numbers: Bretton Woods was designed by two powers, if one is kind to the British, by one if one more honest. How will the G-20 ever be able to agree on a new architecture?