In The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy , George Cooper offers an explanation for the current credit crisis and for other speculative bubbles that preceded it. Building on the theories of Hyman Minsky and John Maynard Keynes, Cooper, a principal at Alignment Investors, argues that such bubbles are the result of an inherent instability of the financial system. When financial assets are financed by debt and marked to market, a drop in asset prices sets off a downward spiral. Lenders force the sale of assets that serve as collateral on loans that become undercollateralized owing to the initial drop in asset prices. Conversely, an increase in asset prices facilitates an increase in financial leverage because the higher collateral value can support a larger amount of debt. To offset these destabilizing factors, Cooper recommends intervention by a government agency—namely, a central bank.
According to Cooper, existing central banks are ineffective because they focus on price stability of consumer goods whereas they should be focusing on stability of asset prices. Cooper believes that focusing on consumer price inflation is unnecessary because goods markets are inherently stable (that is, higher prices cause a drop in demand and vice versa). The reason central banks do not target asset prices is that they erroneously believe the fallacy of the efficient market hypothesis (EMH), according to which—by Cooper’s definition—assets are always correctly priced. He maintains that to achieve stability in asset prices, central banks should steer changes in the aggregate amount of credit creation. And every once in a while, for good measure, they should engage in a sudden withdrawal of liquidity as a sort of systemic fire drill that keeps market participants on their toes.
Cooper’s contention that central banks contribute to financial instability is not new, at least not to central banks. In a speech in September 2005, well before the current credit crisis began, Alan Greenspan, the U.S. Federal Reserve Board chairman at the time, acknowledged that if a central bank is successful in reducing fluctuations in the business cycle, it decreases systemic risk; but in so doing, it may inadvertently trigger risk complacency on the part of market participants. In a November 2008 speech, the Fed’s vice chairman, Donald L. Kohn, made the same argument.
Still, Cooper does make some worthwhile points. His charge that monetary policy is inconsistent if it means laissez faire during an economic expansion and interventionism during a contraction has some validity. Cooper is also correct that Keynes’ prescriptions were intended to move an economy out of a depression but are nowadays used more to avoid recessions than to exit depressions. Cooper also argues correctly that the achievement of so-called soft landings prevents borrowers from learning firsthand that their excessive borrowing is indeed excessive. And Cooper’s belief that “it is better to have a volatile and growing economy than a stable and stagnant one” is likely to find acceptance by many readers. Finally, Cooper does a commendable job in explaining the moral hazard problem inherent in central banks’ acting as lenders of last resort.
Nevertheless, Cooper’s criticism of the efficient market hypothesis and of its application to central banking misses the mark. In his view, the basic tenet of the EMH is that asset prices are always “correct” and that equilibrium is, therefore, the result. He is correct in contending that neoclassical economics probably focuses too much on equilibrium conditions and not enough on the process by which we move from one state to the next—in effect, never quite reaching equilibrium. But the EMH does not really imply equilibrium. It merely states that available information is reflected in asset prices. As new information arrives, prices change. Because new information arrives irregularly, prices change irregularly. Thus, there is no equilibrium. Likewise, the EMH makes no claims as to whether a price is “correct” (whatever a correct price might be). Similarly, aiming for stability in prices of goods—as most central banks do most of the time—is not quite the same thing as expressing a judgment about the “correctness” of the existing price level (again, whatever that might be).
The reason that central banks pursue price stability is that a fiat currency requires an inflation anchor. Cooper ignores such watershed episodes as the hyperinflation of the Weimar Republic in the 1920s, the Great Inflation in the United States in the 1970s, and—to cite a contemporary example—the inflation and socioeconomic unrest in Zimbabwe today. (In general, the book is featherlight when it comes to empirical evidence.)
Central bankers express two main reasons for not targeting asset prices: (1) It is virtually impossible to distinguish a bubble from a more justified increase in asset prices, and (2) a change in the monetary policy that would be required to deflate an incipient bubble might well trigger an economic recession. Cooper dispenses with these ideas in a single footnote. As an argument for the drastic change in monetary policy that he proposes or as an explanation for the current credit crisis, his thesis is woefully inadequate.