Financial Turmoil in Europe and the United States

In 1980, when Ronald Reagan was elected president of the United States and Margaret Thatcher was prime minister of the United Kingdom, market fundamentalism became the dominant creed in the world. Market fundamentalists believe that financial markets would assure the optimum allocation of resources if only governments stopped interfering with them. They derive that belief from the efficient market hypothesis and the theory of rational expectations. These esoteric doctrines are based on certain assumptions which have little relevance to the real world, nevertheless they have become very influential. They dominate the economics departments of the leading American universities and from there, their influence has spread far and wide. In the 1980s they came to guide the policies of the United States and the United Kingdom. These countries embarked on deregulating and globalizing financial markets. That initiative spread like a virus. Individual countries have found it difficult to resist it because globalization allows financial capital to escape regulation and taxation and individual countries cannot do without financial capital.

Unfortunately the basic tenet of market fundamentalism is plain wrong: financial markets, left to their own devices, do not necessarily tend toward equilibrium—they are just as prone to produce bubbles. History shows that ever since financial markets came into existence they have always generated financial crises. Every crisis provoked a response from the authorities. That is how financial markets developed, hand in hand with central banking and market regulation.

When I started my career in finance, banks and currencies were strictly regulated. That was the legacy of the Great Depression and the Second World War. When the global economy became normalized under the Bretton Woods regime, financial markets started to revive. But financial markets, far from tending to equilibrium, generated imbalances which led to the gradual abandonment of the Bretton Woods regime.

The financial authorities function even less perfectly than markets. In the 1970s the Keynesian policies that had been inspired by the Great Depression allowed inflation to develop. Two successive oil shocks resulted in large surpluses for oil-producing countries and large deficits for oil importers. The imbalances between them were mediated by commercial banks. That is when the banks started to escape from the straight jacket they had been confined in by regulation.

Whenever the financial system ran into serious problems, the authorities intervened. They liquidated failing institutions or merged them into larger ones. The first systemically important disturbance occurred in the United Kingdom in 1973 when unregulated fringe banks like Slater Walker endangered the clearing banks financing them. The Bank of England intervened in the fringe banks in order to protect the clearing banks although the fringe banks were outside their normal sphere of competence. This set a pattern that was later followed during the super bubble: when the system is endangered the normal rules are suspended. This phenomenon was given a name—moral hazard.

Bubbles are characterized by the unsound extension of credit and leverage. The intervention of the authorities created the super bubble by preventing ordinary bubbles from running their normal course. The authorities took care of failing institutions and if the economy was in danger they increased the money supply or applied fiscal stimulus.

The first international banking crisis of the super bubble occurred in 1982 when the credit extended to sovereign countries in the inflationary period of the 1970s became unsustainable and collapsed. The international monetary authorities banded together, used their clout to "persuade" the banks to roll over their loans, and lent enough money to the failing countries to pay the interest. The banking system was saved and the heavily indebted countries were subjected to severe discipline. Eventually the banks built up sufficient reserves to be able to write down the accumulated debt to manageable levels. At that point so-called Brady bonds were introduced to achieve orderly debt reorganizations. Latin American and other debtor countries lost a decade of growth in the process.

A number of localized financial crises were similarly contained—the Savings and Loan scandal of the mid-1980s was the most memorable of these. The next major international crisis began in 1997. It started in Asia where a number of countries tied their currencies to the dollar and used borrowings denominated in dollars to finance domestic growth. Eventually the accumulation of external deficits made the dollar pegs unsustainable and when the peg broke, many of the loans became delinquent. Again, the International Monetary Fund protected the banks and subjected the debtor countries to severe discipline. From Asia, the crisis spread to other parts of the world. In Russia, a default could not be avoided. This in turn exposed the vulnerability of Long Term Capital Management (LTCM), an extremely highly-leveraged hedge fund employing highly-sophisticated risk management techniques based on the efficient market hypothesis. This posed a real threat to the global financial system because most of the largest banks were involved both in lending to LTCM and in holding the same positions for their own account. The Federal Reserve Bank of New York brought representatives of the major banks together in the same room and persuaded them to bail out LTCM. A meltdown was prevented and the super bubble continued to grow.

The next major episode was the high-tech bubble which burst in 2000. It was different from the other bubbles because it was fueled by the overvaluation of stocks rather than the unsound expansion of credit and leverage. Nevertheless, when the bubble burst the Federal Reserve lowered interest rates, eventually down to 1 percent, in order to prevent a recession. Alan Greenspan kept interest rates too low, too long. This gave rise to a housing boom which peaked in 2006, caused a financial crisis in August 2007, and terminated in the crash of October 2008.

This housing bubble was also different from the ordinary, or garden variety, of real estate bubbles. It was distinguished by the widespread use of synthetic financial instruments and sophisticated risk management techniques based on the efficient market hypothesis. That hypothesis assumes that financial markets tend toward equilibrium as determined by a universally and timelessly valid scientific theory; but it failed to take into account the effect that the widespread use of these instruments and techniques had on the behavior of financial markets. For instance, mortgages were converted into Collateralized Debt Obligations. CDOs were based on the assumption that declines in real estate values never occur uniformly throughout the United States, so they were supposed to reduce risk through geographic diversification. In fact, the widespread use of CDOs created a nationwide boom which ended in a nationwide bust—an unprecedented event. Similarly, the use of sophisticated risk management techniques efficiently controlled risks but ignored unquantifiable or Knightian uncertainty. This left financial institutions ill-prepared to cope with the bust. Moreover, the use of synthetic instruments extended the scope of the bubble beyond housing. There were many more CDOs issued than there were mortgages. Consequently when the bust came it was not confined to the subprime mortgage market but disrupted the entire international banking system. All this came as a surprise to market participants and regulators, both of whom were misguided by a false doctrine.

The authorities badly mishandled the crisis. Treasury Secretary Hank Paulson made a fatal mistake when he declared that he would not use the taxpayer's money to bail out Lehman Brothers. When Lehman Brothers failed the entire system broke down. Within days he had to reverse himself and come to the rescue of American International Group (AIG), an insurance company that became heavily involved in insuring CDOs by selling Credit Default Swaps (CDS) covering them. The commercial paper market seized up. Later in the same week, one of the money market funds "broke the buck," precipitating a run on money market funds. Before the end of the week Paulson had to request from Congress a rescue fund of $700 billion that became the Troubled Asset Relief Program (TARP).

To prevent the international financial system from collapsing, it was put on artificial life support. The finance ministers of the developed world announced that no other systemically important financial institution would be allowed to fail. In effect, the authorities substituted the credit of the state for the commercial credit that collapsed. Their intervention yet again prevented the super bubble from bursting. But, as I explain in the essays included here, the crash of 2008 carried the seeds of the current financial crisis. The authorities engaged in a delicate two-phase maneuver. Just as when a car is skidding the driver first has to turn the wheel into the direction of the skid to prevent it from rolling over—and only when he has regained control can he correct the car's direction—so the authorities could correct the excessive use of credit and leverage only by flooding the market with the credit of the state both in the form of guarantees and the issuance of sovereign debt.

The maneuver was successful. The authorities regained control and financial markets returned to functioning more or less normally. But the imbalances that developed during the super bubble were not corrected and financial markets remained very far from equilibrium. Eventually the credit of the state that rescued the financial system in 2008 also came under suspicion. The euro became the epicenter of the current crisis because of the defects inherent in its construction. Some of these flaws were known to the designers of the euro, others became apparent only in the course of the crisis.

The financial system is riddled with false dogmas, misunderstandings, and misconceptions. Reality is far removed from the postulates on which the theories that prevailed during the super bubble were built. I was guided by a different interpretation of financial markets. It was based on a conceptual framework I started developing in my student days, long before I became engaged in the financial markets. Indeed the framework is not about the financial markets; it deals with one of the foundational problems of philosophy, namely the relationship between thinking and reality. Let me offer a brief outline.

Reflexivity interferes with the two functions that compose it. In the absence of reflexivity each function has an independent variable. In the cognitive function the situation is supposed to be the independent variable that determines the participants' views. In the causative function the participants' views are supposed to be the independent variable that determines their actions. When both functions are at work simultaneously neither function has a truly independent variable. This introduces an element of uncertainty or indeterminacy both into the participants' views and into the actual course of events that would be absent if the two functions operated independently of each other. It gives rise to a divergence between the participants' views and the actual state of affairs and to a lack of correspondence between the participants' intentions and the outcome of their actions.

It should be emphasized that reflexivity is not the only source of uncertainty; agents base their decisions on an imperfect understanding of reality for other reasons as well. Reflexivity is closely connected with imperfect knowledge or fallibility. The two concepts look like twins but actually fallibility has to take logical precedence. If people acted on the basis of perfect knowledge their views would be identical with reality and reflexivity would not be a source of uncertainty, either in the participants' views or in the actual course of events. Consequently there can be no reflexivity without fallibility, but thinking agents are fallible even in the absence of reflexivity.

Fallibility is generally recognized, but reflexivity has not received the attention it deserves. That may be due to the fact that reflexivity connects two different domains, the cognition and causation. In each domain people seek perfection and they are inclined to disregard or eliminate a source of uncertainty. Nowhere is this more evident than in the financial markets. Economic theory has insisted on an interpretation of financial markets which deliberately ignores reflexivity.

I developed my conceptual framework in my student days very much under the influence of Karl Popper, the Austrian-born philosopher who became my mentor in my last year at the London School of Economics. When I became active in the financial markets it was only natural that I should turn them into a laboratory for testing my ideas. It proved to be a very lucky choice. Financial markets constitute a narrow segment of reality but they possess some features that make them particularly suitable to serve as a laboratory. They operate in a relatively transparent fashion and they produce a mass of quantitative data. Most importantly, the economic theories explaining how financial markets operate, namely the efficient market hypothesis (EMH) and the theory of rational expectations, dogmatically exclude fallibility and reflexivity from consideration. As a consequence there are very influential and widely accepted theories to be falsified. That turned financial markets into a testing ground of greater practical significance than any other I could have chosen.

I published my conceptual framework and its implications for financial markets in 1987 under the title The Alchemy of Finance. I called it the "Alchemy" rather than the "Science" of financial markets in order to emphasize the difference between my interpretation and the prevailing paradigm. Economists modeled their theory on Newton's physics, hence their focus on equilibrium. I argued that was a false analogy. Newton was dealing with phenomena that unfolded entirely independently of what anyone thought about them while economists deal with situations that have thinking participants. The causal chain does not link one set of facts with the next directly but only through the intervention of thinking agents. There is a feedback loop connecting the domain of causation with the domain of cognition.

The difference between the two kinds of phenomena is profound. Physics lends itself to the formulation of universally-valid generalizations which can be used interchangeably both for prediction and explanation. Popper constructed a beautifully simple and elegant scheme of scientific method and I was greatly impressed by it. It consists of three elements and three operations. The three elements are the initial conditions, the final conditions, and the universally-valid generalizations or scientific laws. The three operations are prediction, explanation, and testing. When the initial conditions are combined with scientific laws they provide predictions; when the final conditions are combined with those laws they provide explanations. In this way, predictions and explanations are symmetrical and reversible.

What is missing from this scheme is the verification of the laws. Here comes Popper's special insight. He asserted that scientific laws cannot be verified, they can only be falsified, and that is accomplished by testing. Generalizations of universal validity can be tested by matching initial conditions with final conditions in particular instances. If they fail to conform to the scientific law that is applied to them, that law has been falsified. Laws that are not subject to falsification do not qualify as scientific. One nonconforming instance may be sufficient to destroy the validity of a generalization but no amount of conforming instances is sufficient to verify it beyond any doubt. In this sense there is an asymmetry between verification and falsification. The symmetry between prediction and explanation, the asymmetry between verification and falsification, and the crucial role of testing are the three salient features of Popper's scheme. They fit in with his contention that our understanding of the world in which we live is inherently imperfect—the same as my postulate of fallibility.

Popper insisted on what he called the doctrine of the unity of scientific method. That is where I differ from him. How could the same methods and criteria apply to the study of natural phenomena and human affairs when there is such a fundamental difference between them? Thinking agents act on the basis of imperfect understanding and their fallibility introduces an element of uncertainty into human affairs that is absent in natural phenomena. Such a fundamental difference needs to be recognized. It does not mean that natural science can produce verifiably perfect knowledge, but it does mean that social science has to contend with an additional element of uncertainty and it must adjust its methods and criteria accordingly. The interpretation of financial markets developed by economists was modeled on Newtonian physics. It was to emphasize that I was taking a fundamentally different approach that I called my book The Alchemy of Finance.

When I started using financial markets as a laboratory, I developed a theory of financial bubbles building on the twin postulates of fallibility and reflexivity. I contend that every bubble is composed of two ingredients—a trend that prevails in reality and a misinterpretation of that trend, or a misconception relating to it. A bubble is an initial self-reinforcing, but eventually self-defeating, boom-bust process which goes through a sequence of well -defined stages. The sequence is predetermined but the size and duration of each stage is not. I can summarize the process as follows.