The best books on Financial Crashes

To start with, tell me about the Kindleberger book, Manias, Panics and Crashes. Is there an overall theory of crashes here?

Kindleberger’s great virtue is that he was both a respected economist and a student of human nature, and he knew that human nature could never be bottled up in an economic model. His book is a terrific narrative of a series of bubbles, going back to pre-industrial days – the Dutch tulip craze, the South Sea bubble, and so forth.

None of them is exactly the same, of course. They take place at different periods, involve different instruments and different kinds of mind-sets. But each one is about people getting caught up in one sort of enthusiasm or the other. Why would a company like Merrill Lynch think that housing prices that rose in real terms by 97 per cent between 2002 and 2005 would continue to rise?

House prices went up 97 per cent in real terms in a few years?

Yes, in the US. The same things happened in other places too, in Britain, Spain, Ireland, and the banks said: ‘Gee, this is great.’

People are enjoying the bubble so much that…

It was an obvious bubble. Even I could see it, so how come they couldn’t?

Maybe because you weren’t raking in the money. What could we do to help us foresee crashes?

I made a point in a half-joking way in a book once, but I think it was really right. We should look at the top five or ten investment banks that every year hire a bunch of top graduates from MIT and Harvard Business School. Then we should watch what those guys work on because that’s where the next crash is going to be.

“The reason banking and finance is so risky is that it’s highly leveraged. It’s playing with borrowed money.”

It’s true! It takes about five or six years but they assign the brightest guys to whatever is new and on the cutting edge and every time it gets pushed over the brink until there’s some kind of crash. Most of the time it’s a fairly modest crash. What was so strange about this one is, I think, for the first time all the regulators helped make it happen. One of the points that the Rogoff and Reinhart book, This Time It’s Different, makes is that this happens all the time and has always happened – the whole world gets caught up in the same kind of enthusiasms.

Is there a difference between the two books?

Well, Kindleberger tells a very rich narrative of crashes, but the great thing that Rogoff and Reinhart have done is they’ve assembled this huge database. They’ve gone back 800 years and you can see roughly what’s been going on with government borrowing and lending over that time.

Eight hundred years?

Eight hundred years. We’ve been having banking crises for a long time. I did not put a book of mine on this list – Money, Greed and Risk – but it says the same kind of thing. It sort of shows the cycles and shows that all these things are essentially the same.

A point to make is that nothing gets really crazy unless at first it’s a good thing. So there’s some innovation that makes the market work better and the guys who think of that get very rich because finance is always done with other folks’ money. So when you make an innovation, the first, second and third movers make a lot of money. Then everybody else rushes in to try to do it too, and the reason banking and finance is so risky is that it’s highly leveraged. It’s playing with borrowed money. You’re not putting up your own cash, or you’re putting up a little bit and getting the bank to provide the rest. So if you can invest in an innovative way then you’re making buckets. If you’re making something real, like steel, you might overproduce it, but you can’t have such a wild kind of production that you do in banking.

What was the crisis 800 years ago?

It was something in China. But a good example is from the 14th and 15th centuries when a merchant trader would load a ship up with goods and he would sail around the world, sometimes for years, trading the goods he had for the goods he wanted. It was goods for goods and it was a slow process.

Then the Italians invented the paper bill of exchange – basically a cheque, drawn on a banking house back in Venice or Genoa. And for the first time the trader could give a piece of paper in return for goods. Trade boomed. This was a brilliant invention. So other banks came in and started issuing these pieces of paper and in 60 years there was a huge crash that brought down the Italian and Dutch banking houses.

OK, let’s talk about Skidelsky’s book on Keynes.

What’s so wonderful about Keynes was that he didn’t trust economics. He understood that this was a human study, that it was not a scientific or mathematical study. He didn’t trust economic data – he said it’s useful, but it doesn’t really tell you what’s going on. He didn’t trust mathematical models – he said they’re very helpful when you try to think through what’s going on, but don’t think it’s the truth because it’s not. What comes through that book is what a deep thinker Keynes was and that he basically understood that economics is a metaphor for complex, semi-random, not very rational human interaction. And you read it and you think: ‘Gee, if we only had Keynes.’

Isn’t this book three huge volumes?

Skidelsky does a one-volume version as well as the three-volume version. I’ve read them both and the one-volume version is really fine. It’s 900 pages, a wonderful read, with lots of beautiful luscious history in it – Cambridge in 1912 when there was that brief period prior to World War I when Cambridge may have been the very best place in the world that you could be if you were smart and had taste.

A Demon of Our Own Design by Richard Bookstaber.

What’s wonderful about Rick is that he was an engineer and…you remember the 1987 market crash that was about portfolio insurance? Well, Rick was running one of the biggest portfolio insurance desks and he tells this great story. He had a 30 billion dollar business and a young salesman came into his office and said: ‘I’d like to get this straight. The whole principle of this, the way you’re providing portfolio insurance for your clients, is that if the market falls you will start to sell stock futures? Right?’

Rick says: ‘Right.’

And the kid says: ‘And if the market falls fast you sell them fast? And every other bank will do the same thing? Right?’

And Bookstaber says: ‘Right.’

So the kid made a bet that the market would crash and hasn’t had to work since.

What was the kid’s name?

I don’t know and, even if the story has a slight fictional twist, it’s the real tale. That’s what really happened. And how in God’s name could they not see that? They were very bright folks. So what Bookstaber does is he steps back and looks at the whole theory of economics that drives modern markets. The underlying principle is that markets are a naturally equalising, optimising machine.

Which is the opposite of what Keynes and, presumably, Bookstaber think?

Of course. But this is the current theory. And Rick is a actual engineer, so how does an engineer build a complex system? They try to build it so that it will correct anything that goes wrong. You assume random events always happen and they always amplify. So, if you’re building an internet system you do not want rapid perfect data transmission – you always have firewalls, etcetera, etcetera. But the Chicago school rational market model has been foisting the opposite idea on us. When Greenspan was on his campaign against regulation he would say that what is wrong with regulation is that you are stifling innovation, you are slowing down market signals. Rick would say that’s exactly what you should do. The whole notion that there is some kind of perfect machine there is utter nonsense.

And Charles Taylor’s book.

This is not really an economics book. Sources of the Self is one of the great books of the last 25 years, I think. It’s a history of the understanding of the self in the West since the Greeks. A couple of thousand years ago, when the Greeks were doing their writing, the self was understood as kind of a cog in a broader cosmic system that operates outside of the self. Taylor traces through to the Reformation and beyond and how the reference point became more and more limited to the family or to the group or to the nation, so now you’re down to this atomised self-serving individual.

Oh, no – so we’ve gone from the cosmos to the individual in a couple of thousand years?

Exactly right. To this radical individualism, which is where we are in economics. And it’s odd that you see conservatives pushing this. How do you know that the poor are getting better off? Because they’ve got more television sets. That’s a radically modern point of view. You just count the things that they’ve got and know that they’re better off. That is a perception of the self that is only about a century old.

What would the ancient Greeks have counted?

They would have focused on…I mean, there were a lot of things wrong with Greek society, of course. Not every person qualified! But they would have asked: Are you happy? Do you have a balanced life, a decent set of human relations, a good place to live and enough to eat? How do you feel relative to how a person should fit into this cosmic kind of thing? So you’re always thinking of yourself, not as your goal but as part of a process.

So how did this happen to us? Is it Freud’s fault?

That’s what makes this book so great, is that he traces the whole process through to a frame of reference that’s fairly new, but for most of us now it’s very hard to think of any other way.

What was the trigger?

Well, I would say it’s something to do with economics and the tendency in economics to think it is a theory of everything. In the last 30 years economics has been colonising every science. Even something like education all comes down to incentives, and that mind-set has become pervasive. One of the good things about this recent crash is that it might counter that, because it’s clearly wrong.

When I grew up in the 1950s you were kind of part of a larger group and people were uncomfortable if they were a lot richer or poorer than the group, but we never thought about getting rich as kids. We thought about the satisfaction we might get out of work, but that’s different. My kids are in their 40s and they go from job to job, but their relationship to their firm is always as an independent contractor. They think it’s more efficient that way. And how do you tell that? Because you can buy more iPods or iPads or whatever they are.