March 2009

Arts & Letters

For a few dollars more

By Nicholas Gruen
Recent books about global finance

The four short books under review are by Cassandras of the crisis who hastened into print to join the collective puzzling and pontificating about our situation. They neatly organise themselves into the Good (Paul Krugman), the Bad (George Soros) and the Ugly-but-thoroughly-worthwhile (Martin Wolf and Robert Shiller). With the glorious exception of Krugman’s, they are all unsatisfying as books. The four authors have taken ideas they articulated before the financial crisis and repackaged them for the crisis-book market.

As the Berkeley professor and econo-blogger Brad Delong has pointed out, this wasn’t quite the crisis most doomsayers were expecting. The anticipated one was to be triggered by a plunging American dollar when the world woke up to the unsustainability of its borrowing and the international imbalances underlying it, as discussed in Martin Wolf’s Fixing Global Finance (Johns Hopkins University Press, 248pp; import). In fact, the crisis erupted organically within the American financial markets – in the infamous sub-prime residential-mortgage market – and the resulting global meltdown saw the American dollar rise as investors headed reflexively for the perceived safety of the international reserve currency. Old habits die hard.

Wolf has cobbled together a book by providing two introductory and two concluding chapters as bookends to a series of lectures he gave in recent years, in which he anatomised the growing foreign indebtedness of the Western – mostly English-speaking – nations to Asian developing countries and oil exporters. As insightful as they are, the lectures – some of which are now a few years old – sit uneasily next to the contemporary chapters, and frustrate the reader’s search for explanations of our current predicament.

Nevertheless, chapter two, ‘The Blessings and Perils of Liberal Finance’, is as masterful an introduction and exposé of its subject as I’ve seen. Wolf expounds, with regard to both the simplest first principles and the broad sweep of history, the profound significance of a financial system as a cultural, political and economic achievement. A financial system is a pyramid of promises. The trustworthiness of the state’s promises – in managing the monetary system and paying its debts – is the bedrock on which private promises can then, laboriously, be built.

That’s why the take-off of modern finance dates to the late seventeenth century, when Western sovereigns (in Holland and Britain) first became properly subject to the rule of law. The constraints this forced upon them rendered them creditworthy and so able to borrow vast amounts at modest interest. And, recent ideological enthusiasms notwithstanding, the central financial innovations of modernity were the work of governments at around this time, especially bond markets, central banks and the legal infrastructure for joint-stock companies. As Wolf explains, the resulting financial system “allows the creation of vast enterprises out of the combined capital, supplied at modest cost, of ... millions of people; ... it ... reallocates risk; it allows people to time their spending ... over their lifetimes; and it insures individuals against the big risks of life”.

Wolf counts US$145 trillion of financial promises held by the citizens of the world in 2005. And yet finance is beset by rottenness – indeed, by all the failings and fragility of our species: “Finance is a jungle inhabited by wild beasts.” So there you have it. A pyramid of promises, a miracle of sophistication and progress somehow delivered to us on the backs of wild beasts. If you don’t fancy buying the book, read chapter two in a library.

Robert Shiller’s The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It (Princeton University Press, 208pp; import) is a similarly flawed gem. It’s full of proposals both ingenious and radical, and yet which pose no insuperable political difficulties. Many could be acted on with great profit, but their elaboration doesn’t add up to a book. Like its weightier predecessor, The New Financial Order, with which this book shares many ideas and proposals, much of the discussion in The Subprime Solution is strangely unengaging and, despite its brevity, surprisingly repetitive.

Shiller foregrounds the way New Deal institutions democratised housing finance – doing nothing more revolutionary or risky than having governments underwrite long-term fixed-rate loans, where home borrowers had previously been required to risk refinancing every five years. He proposes numerous initiatives in the same spirit. Today’s markets offer no way for us to insure huge risks that we face – like our suburb falling out of favour in the property market, or our professional skills losing their economic value, or the economy falling into recession. And when you have a deposit on a house but need to finance the other 80-95%, existing markets will lend good risks the money, but won’t partner with them in the way investors in financial markets become partners of firms by buying their equity (in shares). Given that housing is the largest asset class – amounting to more than $3 trillion in Australia alone – this is as remarkable as it is ridiculous.

George Soros’s The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means (Scribe, 208pp; $27.95) is a complete contrast to Shiller’s and Wolf’s books. It’s an engaging, easy-reading mélange of diary, confession and manifesto. But it left me wondering: If this guy’s so rich, how come he’s not smart? Soros confesses his desire to be taken seriously – as a philosopher, not just a celebrity investor. And so his book showcases his “theory of reflexivity”, which explains that markets are full of positive feedback, where people’s expectations and behaviour depend on their understanding of the expectations and behaviour of others. This is not just a theory of the market, you understand, but a theory of life itself.

Some of the nonsense peddled by the economics fraternity in recent generations has been self-evidently silly, particularly some of the more extreme presumptions about the efficiency of markets. But a theory that announces the emperor’s nakedness doesn’t help him work out what to wear. If Soros had wanted to be taken seriously by economists, he might have told us how his theory of reflexivity differs from Keynes’s theory of the same thing. (Keynes gets one, off-hand mention.) And he might have shown us he was a philosopher by demonstrating a passing familiarity with at least a couple of philosophers other than Karl Popper. Soros confesses his disagreement with Popper’s doctrine of the unity of method between the social and physical sciences – the foundation on which Popper built much of his demarcation between science and nonsense. Yet I suspect Popper’s reaction to Soros’s theory would be that it is unscientific nonsense, because it is unfalsifiable.

I took two lessons from this book. The first is that honesty – to yourself especially – is an unusually good way to make your way through the wild beasts of finance. Echoing Warren Buffet’s candid confession that his company can prosper “despite some colossal mistakes made by your chairman”, Soros willingly hands over the incriminating evidence, in this case quoting his son:

My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit. I mean, you know the reason he changes his position on the market or whatever is because his back starts killing him. It has nothing to do with reason ... it’s very funny.

The second lesson is about the capriciousness of the market, or rather the ways in which you can lose money even when your analysis is mainly right: Soros anticipated the global crisis but miscalculated details of the form it would take, and so lost money through it.

The Return of Depression Economics and the Crisis of 2008 (Allen Lane, 208pp; $26.95), by Paul Krugman, stands out even from this mostly illustrious crowd. Alongside his work on trade and geography, which has won him a Nobel Prize, Krugman has always been interested in a much more policy-relevant subject: financial crises. And he’s been warning, at least since he studied Japan’s “lost decade” of stagnation in the 1990s, that it can happen anywhere. Now it has, he’s issued an updated version of his original, courageous and duly ignored book. Its central assertion is that Keynes’s great subject – the upside-down world that characterises an economy in depression, where the vice of profligacy is virtue and virtue of saving is vice – has not gone the way of the steam engine, a victim of increasing know-how. As Krugman puts it elegantly, in his conclusion:

Depression economics ... is the study of situations in which there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work. The true scarcity in Keynes’s world – and ours – was therefore not of resources, or even of virtue, but of understanding.

Of all our Cassandras, Krugman would have been the least surprised by the shape the crisis took, having warned of the capriciousness and dangerousness of financial crises for a decade or more. His book is a model of his pathological clear-headedness and simple, compelling style. Using the simplest explanations and examples, like a set piece about the Washington babysitting co-op that issued its own coupons – a brilliant allegory of the challenges of monetary policy – Krugman entertains and informs lay readers and experts alike. Whether they’re broadly chronological, as in early chapters, or thematic, like the later chapters, each works as might the chapters of a children’s book, as an episode in an unfolding story, setting the stage for the next. Krugman explains that the International Monetary Fund’s draconian demands on countries it has helped ‘rescue’ are a result of the pressures its own limited resources put on it to court the confidence of the market at all costs. Having exculpated the IMF, he then concludes: “which is not to say that there were no villains in the plot”. The next chapter’s subject is hedge funds. Its title: ‘Masters of the Universe’.

I recommend Krugman’s book unreservedly; it got me thinking afresh about the constraints on Australia. Ironically, The Return of Depression Economics makes me nervous that Krugman’s recipe for responding to the crisis, and those of other leading American and European economists – as appropriate as these may be for their own circumstances – will be transplanted here at our peril. Temporary deficits are sensible, even if they’re large and even if ‘temporary’ means quite a few years. But much of Europe does not depend on attracting large amounts of net capital investment from other countries, while the US is in the privileged position of issuing the world’s reserve currency, which continues to give it extraordinary leeway.

Our most recent fond hope – fading as I write – is that China’s growth will shield us from the financial crisis. Our last remaining hope is that, as with the US, the markets will choose to treat Australia leniently, and not punish us as they have other countries – whether these are countries we look down upon (Argentina, Brazil, Indonesia), countries we’re not sure about (Thailand, Malaysia), or even countries we suspect are more enticing investment destinations than our own (Hong Kong, Korea). That’s why this passage in The Return of Depression Economics gave me the willies: “After all, Indonesia’s current account deficits had been nowhere near as large ... as its neighbours’ – at less than 4 per cent of GDP, Indonesia’s ... deficit was actually smaller than, say, Australia’s.”

Australia’s current account deficit last year was around 6% of GDP, and this year may be around half as big again. Market sentiment may give us less room to spend our way through the crisis than we would like. As a result, more of our response should be directed towards increasing investment in, and the production of, traded goods and services: something that will be a lot easier said than done when profits and foreign demand are collapsing.

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