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Book Ends to the Financial Crisis of 2008

No one knew in 1989, with the fall of the Berlin Wall, that this momentous event would be the start of a decades-long excursion into a global economic rollercoaster. The emergence of free market fundamentalism and the Washington Consensus as the heir apparent of global hegemony was the immediate outcome of the battle between the communist and capitalist ideologies. This framework has proven to be somewhat fragile, as all world citizens discovered, beginning in about 2008. And, upon further reflection on the excesses of the 1990s and early 2000s, there has been a growing recognition of the tears in the fabric of the global economy. Several important books have been written that recount the underlying causes of the meltdown. This article will summarize the key points of several of these analytical efforts to dissect the causes of the crisis.

Three Books

A searing analysis by Justin Fox, the founder of The Curious Capitalist blog, entitled The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street (Harper Collins, 2009) is an intellectual excursion into the personalities and of Wall Street. It brings to life the ideals that have shaped the modern world; from the “efficient markets hypothesis” to the psychological models that are now taking hold to explain the herd behavior of the markets. Beginning before the 1930s depression he outlines in detail the rise and fall of the ‘quants,’ that is, those financial analysts that relied heavily on quantitative analysis for predicting outcomes. And he shows how the errors in the quantitative models led to the first strong signal that the efficient markets hypothesis model was in error. This first signal was the demise of Long Term Capital Management in 2000, a hedge fund founded by Saloman Brothers’ John Meriweather. Their remarkable profits (up to 40% at the beginning) led to a highly leveraged portfolio that ultimately lost $4.6 billion dollars in the four months after the Russian financial/currency crisis of 1999. He also shows the delicate balance between monetary policy driven by Chicago-school thinkers like Alan Greenspan, and the impacts on real economy in a rapidly globalizing world. These are just two of the events that Fox meticulously uses to illustrate how underlying ideas and concepts spanned actions that, in the end, led to the crisis of 2008. Written in journalistic style, the book is easily accessible to people that have no formal training in economics or finance. This is because he is such a good story-teller and he brings the history and the people to life throughout the book.

A book that treats the subject matter with less empathy is Naomi Klein’s The Shock Doctrine: The Rise of Disaster Capitalism (Vintage Canada, 2007). This author uses the lens of political economy to illustrate her revealing points about the more brutal side of free trade and globalization. Her hypothesis stems from a Darwinian view of capitalism that she claims has, in practice, wrecked havoc on the world. Her conceptual linkage between the torture tactics applied to prisoners to extract confessions (true or false) and the tough love applied by the global economy generally and the International Monetary Fund (IMF) specifically through austerity programs is key to her theme. The actions of the U.S. are most in focus in this expose’; however, the real culprit in her eyes is the capitalist ideology. Importantly she uses the role of privatization of public assets as a way to illustrate the breakdown of the basic infrastructure for public goods and services. She uses the U.S. government’s response to the Katrina hurricane in New Orleans to illustrate this point. She then extends this argument to illustrate how private interests controlled the outcome in instigating and maintaining the conflict through the Iraq war. The net effect is a vilification of the profit motive.

A more sober treatment of the crisis of capitalism is by Richard Posner, Senior Lecturer in Law at the University Of Chicago Law School. A Failure of Capitalism: The Crisis of ’08 and the Descent Into Depression (Harvard University Press, 2009) is a highly technical analysis of the topic that shows how the discipline of finance borrowed many theoretical constructs from the economics sciences and then devised tools for practical applications and analysis. From the concerns by Irving Fisher of over the deflationary effects of indebtedness to the fallacies of the Capital Asset Pricing Model (CAPM) Posner dissects the causes of the 2008 crisis and prescribes policy approaches for avoiding a similar meltdown in the future. The interlinkages between the credit risk agencies, investment banks, and mortgage lending institutions are carefully mapped. He explains in great detail the various exotic instruments that were developed as part of the derivatives market stemming from sub-prime mortgage lending. He also delves into the work that has been done in the cognitive sciences with respect to decision-making and rational versus irrational actions. He explores the nexus between the economics and psychological sciences with respect to herd behaviors; so important in analyzing stock and equities market activity.

Conclusion

These are only three of the books that I’ve been reviewing in my own efforts to make sense of the global economic crisis that we are still experiencing. There are many more that I will be reviewing on this blog in the future. As a long-time advocate of free trade, I have used these treatises to expand my knowledge of the economic, financial, political and social impacts of globalization. The fall of the Berlin Wall provides a useful starting point for examining the public policies and private and corporate actions that led to the fall of the U.S. sub-prime mortgage market. These two events are like book-ends to a chapter in history that will entice historians for centuries. The work of these three authors I have highlighted here today will contribute, each in their own way, to the story of our time as it emerges.