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Digging for the roots of the Great Recession

The greatest economic crisis the world has seen in nearly three-quarters of a century did not begin with the collapse of Lehman Brothers a year ago. But the bankruptcy of that storied Wall Street firm on Sept. 15, 2008, signaled a financial and economic meltdown that few had imagined possible. 

Credit, confidence and many other things have been in short supply over the 12 months. By contrast, there has been no dearth of books hitting store shelves that seek to explain how this all happened. I haven’t read all of them (life is too short for that), and I won’t claim to know which are the best of the lot. But reading a number of these books has given me a deeper understanding of this crisis, and you might find them well worth your time too.

Historian Niall Ferguson’s latest work, "The Ascent of Money: A Financial History of the World" (The Penguin Press), was completed prior to Lehman’s collapse, and it does not deal directly with the financial panic that gripped the world last fall. But it is of great value in laying a foundation for understanding the events of the last year. 

The book ranges from the financial innovations of the Italian Renaissance through various speculative bubbles and the origins of hedging to the latest exotic creations such as collateralized debt obligations. At times episodic, perhaps because it was written with a companion BBC series in mind, Ferguson’s book largely succeeds as a sweeping overview of global financial development. 

"The ascent of money has been essential to the ascent of man," Ferguson writes. Yet the path is strewn with boulders, as the current financial crisis-which began in the summer of 2007-has made so painfully clear. It has been, he notes, "a timely reminder of one of the per-ennial truths of financial history. Sooner or later every bubble bursts." 

The economist John Maynard Keynes once quipped that in a crisis, "markets can remain irrational longer than you can remain solvent." This quote appears in Ferguson’s book; it also goes to the heart of "The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street" (HarperBusiness) by Justin Fox, a Time columnist and former writer and editor at Fortune. His book explores the rise of the idea-which came to dominate thinking on Wall Street and in Washington, D.C.-that financial markets are rational, efficient and capable of self-regulation. 

While he acknowledges that the debate rages on and does a good job of presenting both sides, Fox makes no bones about his belief that the market’s rationality is an illusion. 

"Like physicists ignoring friction in building their models of the world," he writes, "economists became more and more comfortable with ignoring widely recognized realities of human behavior in order to build better models of it." 

The "efficient market hypothesis" had one powerful factor on its side: Decades of experience suggested it was true. Alan Greenspan, who famously fretted about "irrational exuberance," set those qualms aside, convinced that the market was wiser than he was-until he learned better. Testifying on Capitol Hill last October, the former Fed chairman said he was "shocked" by the financial meltdown "because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well." 

Fox does not quarrel with the notion that markets "are the best aggregators of information known to man." The problem, he writes, is that "mixed up amid the information in security prices is an awful lot of emotion, error and noise." 

What should make Fox’s book of particular interest to local readers are the many times the Simon Graduate School of Business pops up in its pages. While the efficient market hypothesis is most often linked with the University of Chicago, the business school at the University of Rochester-and, in particular, former Simon School professor Michael Jensen-played a key role in its intellectual development and application in the business world. 

Not everyone embraced the rational-market idea. Richard Thaler-another UR product-helped craft the behavioral economics countertheory. An even more well-known behavioralist is Yale University professor Robert Shiller, who issued an early warning about irrational exuberance in the stock market and more of the same in housing markets. With 2001 Nobel laureate George Akerlof, Shiller has written "Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism" (Princeton University Press). 

Their book seeks, in part, to answer the question: Why did so many people fail to foresee the current economic crisis? They blame conventional economic theories’ failure to include "animal spirits," a term Keynes gave to non-economic motives. In other words, people do not always act in their own economic self-interest. 

The bottom line for Shiller and Akerlof is this: "Capitalist societies … can be tremendously creative. Government should interfere as little as possible with that creativity. (But) left to their own devices, capitalist economies will pursue excess, as current times bear witness." 

Finally, the first book-and in many ways one of the most eye-opening works-I read after Sept. 15, 2008, was "The World Is Curved" by David Smick, founder of The International Economy magazine and a partner in a top investment and strategic consulting firm. 

In this book, written before Lehman’s collapse, Smick describes how the financial crisis emerged from a "crazy ocean of global liquidity" that developed after the fall of the Berlin Wall. 

"Globalization," he writes, "led to greater worldwide wealth, which created a volatile ocean of capital now roaming the world in search of investment opportunities." That in turn spurred Wall Street companies and others to securitize assets, eventually with little regard for the value of the underlying assets. 

Portfolio, a Penguin Group imprint, has just released a paperback edition of the book with a new epilogue on the current crisis. In it, Smick writes that we are "witnessing a new era of financial and geo-political unpredictability." 

In his view, the world has entered a new era of deglobalization, one in which the financing of entrepreneurial risk could be greatly impaired-not good news for the U.S. economy. 

Smick thinks this country can bounce back, but only if leaders of the private and public sectors pull themselves out from "under the cloud of a Bernie Madoff mentality that has led America on a selfish detour away from a collective effort to achieve a destiny of greatness." 

In the last 12 months, we have averted a disaster of epic proportions. Yet clearly, the work has just begun. 

[email protected] / 585-546-8303



09/11/09 (C) Rochester Business Journal. To obtain permission to reprint this article, call 585-546-8303. 



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