1. George Cooper March 2009 The Origin of Financial Crises: Central banks, credit bubbles & the efficient market fallacy

2. Some of the key players 2 John Law (1671-1729) Adam Smith (1723-1790) James Clerk Maxwell (1831-1879) Gordon Brown (1951- )

3. Two Schools or... 3 The Friedman School Markets are inherently efficient......but we have spoilt this efficiency with government and central bank interference......hence today’s crisis or The Keynes School Markets are inherently inefficient and unstable Financial crises are a natural feature of our financial system......requiring macroeconomic management through fiscal and monetary policy

4. ...the mad house 4 Markets are inherently stable… …but we need central banks to stabilise them… …but only when the economy is contracting Alan Greenspan in 2003: "At times, policy practitioners operating under a risk-management paradigm may be led to undertake actions intended to provide some insurance against the emergence of especially adverse outcomes. For example, following the Russian debt default in the fall of 1998, the Federal Open Market Committee (FOMC) eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, was likely to continue to do so.“ A Frankenstein blend of free market fundamentalism with hyperactive Keynesian interventionism

5. Mr. Bling – Not all markets are created equal 5 Thorstein Veblen Conspicuous consumption goods are purchased for their high price Higher prices generate higher demand Asset markets Assets are purchased for price changes Scarcity generates demand Surplus weakens demand Supply ≠ Demand Asset markets behave like Veblen goods

6. Goods Markets Vs Asset Markets 6 The Efficient Market Hypothesis was developed from Adam Smith’s analysis of markets for goods and services The Financial Instability Hypothesis was developed by Hyman Minsky’s analysis of the markets for capital

7. Investors: rational but confused 7 How do investors decide when to buy and sell? Efficient markets require ‘value’ driven investors Investors build ‘models’ to tell them fair value and trade accordingly Which variables go into these models? Balance Sheet Variables Income Statement Variables Macroeconomic Variables

8. Mr Maxwell and his Control System Theory 8 A centrifugal steam engine governor

9. Maxwell’s Governors 9

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11. Maxwell’s Governors 11

12. Maxwell’s Governors 12

13. Mr Maxwell and his Control System Theory 13 Maxwell said that a governed system can respond to a disturbance in one of four ways The disturbance can ‘self amplify’ – the financial instability hypothesis The disturbance can ‘self correct’ – the efficient market hypothesis The governor can over govern – responding too quickly and too harshly producing a series of ever wilder swings in activity The governor can correctly govern – producing a series of ever smaller swings in activity

14. Central banks and Maxwell’s Governors 14 With each successful pre-emption of a crisis confidence and willingness to borrow increases As the debt stock grows the fiscal and monetary policy response needed to stabilise the system becomes larger......monetary policy swings grow wilder over time......until eventually the zero interest rate bound is breached Unfortunately this occurs only once the economy has accumulated an unsustainable debt stock......leading to debt deflation

15. The Risk Management Paradigm Caused The Great Moderation 15 "At times, policy practitioners operating under a risk-management paradigm may be led to undertake actions intended to provide some insurance against the emergence of especially adverse outcomes. For example, following the Russian debt default in the fall of 1998, the Federal Open Market Committee (FOMC) eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, was likely to continue to do so.“ "One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility....Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation 'the Great Moderation'.”

16. Implications for Optimal Central Bank Policy 16 Monetary and fiscal policy is necessary but should be reactive not proactive small recessions are the necessary price to pay for avoiding larger depressions Too much effort to fix the boom and bust is the problem Monetary policy should be symmetric willing to fight excessive credit creation with the same vigour as credit destruction Monetary policy should occasionally shock – the recent fashion for policy transparency may be a mistake Central banks should conduct surprise financial fire drills