Central Banks, Credit Bubbles and the Efficient Market Fallacy” -

In his 2009 book “The origin of financial crises“, Dr. George Cooper sets out to explain the reasons behind the instability of our financial system and how it interacts with the ‘real’ economy.

Dr. Cooper first proceeds to prove that the current economic theory, the Efficient Market Hypothesis (EMH), is not only plainly wrong, but also at the source of our ills. This theory is based on the basic goods markets analysis, in which demand and supply meet to establish a market price that reflect both current conditions. A natural equilibrium is thus created and the market is perceived as ‘efficient’ since it provides an accurate feedback to market participants.

However, mainstream economics theory projected this analysis on other markets, including labour, land, and capital inputs without any theoretical support. Yet if the goods market price usually is the equilibrium between demand and offer, other markets behave in very different ways. For example, to which extent is the luxury market driven by conspicuous (or status) consumption rather than supply and demand? Or do increases in share prices create more or less demand for the same shares?

Yet the EMH swiftly brushes away these concerns and instead asserts that prices are always efficient since free markets will always converge to an equilibrium reflecting market actors’ supposedly perfect knowledge. In turn, this reasoning asserts that bubbles cannot exist. On top of it, prices are assumed to be unpredictable while their distribution are not. In other words, the EMH fitted economic reality into a more malleable and convenient mathematical possibility, discarding any inconvenient facts such as human irrationality or uncertainty, even though empirical studies all point to their existence.

The focus on the price mechanism as the centre of economics led to the development of support for ‘free markets’, in which governments interference are perceived to intrude into the ‘natural’ state of equilibrium (also defined as maximum output) which leads to the obsessive focus on GDP growth, a metrics that “measures everything in short, except that which makes life worthwhile” in the own words of Mr. Robert Kennedy. Again, private monopolies (that would equal private interference) are little researched and not explained.

However, economic history has shown us that free markets coupled with adjustment by prices has a high social price paid through growing inequalities and repeated financial crisis that require government intervention to smooth out business cycles. This led to the creation of central banks, which were supposed to act as lenders of last resorts in order to support cash strapped but otherwise viable companies to limit unnecessary damages. Over time, central banks came to oversee credit creation through the setting of the interbank rate.

The trick is that central bankers act outside democratic control and have fallen under the free market ideology. This creates a paradox in which institutions created for the purpose of government intervention are staffed by people believing against it. It thus follows that if the equilibrium is the maximum output of any economy (a dubious but nonetheless widely held hypothesis), the Central Bankers would put a floor to any unwanted slow downs thanks to easier credit creation.

Repeated central bank support through the 1990’s and early 2000’s decreased the ability of players to correctly assess risk and kept alive firms that should have gone bust, thus interfering with the process of weeding out the most inept companies (a key market mechanism that is strongly supported by free markets believers, which ironically includes central bankers). The sustained economic growth and resulting accumulation of debt thus created the roots of the Great Financial Crisis.

As a result, our economies are now capitalistic during time of profit but losses are socialized, a far cry from the free market vision. Yet central bankers and economists refuse to acknowledge the existence of bubbles, arguing that market prices are always reflecting the information held by market agents (who possess, according to the EMH theory, perfect information). This flies in the face of history, as shown by the the relatively low number of crisis during the post WWII economic expansion, and is also proven wrong by a variety of works showing that bubble (and bursts) are a intrinsic feature of financial markets.

In addition, the various statistical and analytical tools used by market participants are in fact dependent on inputs that make them impossible to correctly assess the existence of a bubble. Indeed, as prices rise, creating more demand and a circular paradigm, so does the propensity of actors to borrow and lend (thanks to fractional banking). And the ability of operators to borrow and lend is a function of its collateral at its disposition, which (thanks to mark-to-market) rises and falls with market sentiment.

In other words, the market is going through accelerated booms and busts thanks to increasing leverage using at best misleading metrics which both understate the risk, give a dangerous feeling of control and are utterly useless once credit expansion stops. If this is free market, it is difficult to see why anyone would chose to have an economy dependent upon such a system.

Dr. George Cooper offers a solution for all these ills: look at credit growth to evaluate the existence of a bubble, review economic hypothesis in light of empirical studies instead of wacky theories, decrease central banks transparency to keep market operators on their toes… Even though imperfect, these solutions are still better than leave a financial system on an unsustainable and socially damaging course.

Indeed, capital is now directed on increasingly risky, short term investments that are feeding boom and accelerating busts when things go upside down. This seesaw pattern is increasing inequalities and decreasing investment in longer term, less rewarding but essential social services, R&D and capital expenditure that are necessary for an economy to thrive.

Dr. Cooper’s “The origin of financial crisis” thus offers a powerful and detailed call to review all mainstream economics theory and put an end to our increasingly volatile and dangerous economic mechanism who are creating tremendous damages for our societies. TheOriginOfFinancialCrisis

About Carlito Riego

"Great perfection may appear imperfect, but its usefulness is inexhaustible. Great abundance may appear empty, but its usefulness cannot be exhausted. Great correctness may appear twisted, great skills appear crude, great eloquence appear awkward. Activity conquers cold; inactivity conquers heat. Clear serenity governs the world." - Lao Zi