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The Origin of Financial Crises: Central banks, credit bubbles and the efficient market fallacy

By George Cooper

‘The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.’ John Maynard Keynes

The central thesis of this book is that our financial system does not behave according to the laws of the Efficient Market Hypothesis, as laid down by the conventional wisdom of today’s prevailing economic theory. The Efficient Market Hypothesis describes our financial system as a docile animal that, left to its own devices, will settle into a steady optimal equilibrium.

Each and every day financial markets move in ways that simply cannot be explained by our theories of how these markets work. Nevertheless, despite overwhelming evidence to the contrary, the Efficient Market Hypothesis remains the bedrock of how conventional wisdom views the financial system, the key premise upon which we conduct monetary policy and the framework on which we construct our financial risk systems.

Fortunately, there is an alternative theory of how financial markets operate, one that is fully able to explain the most recent credit crunch, and one that, with a little thought, can also explain the erratic behaviour of financial markets. The theory in question is the Financial Instability Hypothesis, developed by the American economist Hyman P. Minsky.

The implications of Minsky’s suggestion are that financial markets are not self-optimising, or stable, and certainly do not lead toward a natural optimal resource allocation. In short, Minsky’s arguments attack the very foundation of today’s laissez-faire economic orthodoxy, as did those of Keynes before him.

Positive feedback systems are those in which an event at one time causes more of that same event to occur in the immediate future; investors withdrawing money today cause more investors to withdraw money tomorrow.

As will be explained later, an essential element of the Efficient Market Hypothesis is the idea that the next move in an asset’s price must be entirely random and therefore uninfluenced by any previous price movement. It is this property that allows financial analysts to build estimates of probability distributions of future asset price movements. In turn, these probability distributions permit the development of the quantitative financial risk systems on which banks, analysts, ratings agencies and regulators now rely.

Building financial risk systems on the premise of the Efficient Market Hypothesis requires these systems to ignore the possibility of scenarios like bank runs. That is to say, our risk systems may be inherently designed to work only when they are not required.

Despite the importance of these institutions, and the intense scrutiny under which they operate, the central banks are still very poorly understood. Few people know why central banks move interest rates, or can explain the importance of their independence from political control.

The failure to agree on the role of money supply growth in central bank policy is a symptom of the prevailing wisdom within the economics profession having profoundly failed to comprehend the purpose of central banking.

The US Federal Reserve does not appear to believe there can be an excessive level of money growth, credit creation or asset inflation.

The ECB, by contrast, appears to believe that money supply growth can become excessive; this is consistent with excessive credit creation and is also consistent with asset inflation being excessive.

The upshot of these different world views is that the Fed sees its role as combating any credit contraction, whereas the ECB sees its role as combating excessive credit expansion.

It is a strange paradox that today’s central banks are generally staffed by economists, who by and large profess to believe a theory which says their jobs are, at best, unnecessary and more likely wealth-destroying.

If central banks are necessary because of an inherent instability in financial markets, then manning these institutions with efficient market disciples is a little like putting a conscientious objector in charge of the military; the result will be a state of perpetual unreadyness.

The idea that markets are efficient requires the following to hold:

Asset price bubbles do not exist; the prices of all assets are always correct.

Markets, when left alone, will converge to a steady equilibrium state.

That equilibrium state will be the optimum state.

Individual asset price movements are unpredictable. However, the distributions of asset price movements are predictable.

The only fly in the ointment of this grand story is, as noted, that the data just doesn't fit the theory. We don't find normally-distributed markets; we do find huge market discontinuities and, let’s be honest, a static stable equilibrium has never once been observed anywhere in financial markets.

So we’ve got ourselves into something of a pickle with the Efficient Market Hypothesis. We’ve polished it into a well-honed economic philosophy of laissez-faire, and we’ve also refined it into a testable theory of financial market behaviour, and then we have found that it fails its own tests.

While Keynes, and then Minsky, set out in one direction to formulate a new alternative theory of how the world works, which fitted with the experimental evidence, another group set out in the opposite direction, determined to rescue the idea of market efficiency and the all-important doctrine of laissez-faire that accompanies it.

If one subscribes to the Efficient Market Hypothesis and also happens to be cursed by intellectual rigour, the unavoidable conclusion is that central banks should be abolished.

The current political orthodoxy is in a similarly schizophrenic state. The rigorous application of market forces to the management of state-controlled institutions is now universally presented as the path to better governance. Despite this, almost no one has thought to apply these market principles to central banks and to the determination of interest rates.

The alternate viewpoint is that markets are not fundamentally stable or self-optimising, and as a result require oversight and management. Both Keynes and Minsky emphasised the government’s role in providing this management through state spending and fiscal measures. Central banking can be viewed in the same way as these fiscal measures, as being a necessary part of, in Minsky’s words, ‘stabilising an unstable economy’.

As with Friedman’s position, the Keynes/Minsky perspective is attractive for its intellectual consistency in that it fits with real financial market behaviour and with the real institutions operating in our economies. While both the Friedman and the Keynes schools are logical they cannot both be correct; to one, central banks cause financial instability, to the other they cure it.

We have one philosophy of economics and finance that tells us these crises shouldn't happen and can be avoided, provided we stop tinkering with the economy and shut down our central banks. We have another philosophy that says these crises are inherent in the system and we need central banks to help manage them. Then there is a third school, which also happens to be today’s conventional wisdom, which is a confused mishmash of ideas drawn from both camps. This school professes to believe in efficient markets and in the necessity of central banks. It is, however, unable to articulate a coherent description of what central banks are for or how they should operate. Unfortunately, some of the world’s most powerful central banks are operated according to the confused position of this third school.

For a field of study aspiring to the status of a science, today’s economic consensus is in a risible state, both internally inconsistent and entirely in conflict with the experimental evidence. Had Isaac Newton subjected himself to these same standards he would have given us three laws of gravity: one telling us how an apple behaves when thrown up into the air; another quite different law telling us how it then falls back to earth; and a third law telling us the apple never moves at all.


Financial instability can be generated if there are systems within the economy that tend to cause a predominance of credit creation in one period, followed by a predominance of credit destruction in the next. Processes able to generate credit cycles are not part of the Efficient Market Hypothesis.

The credit crisis and deflationary pressure of house prices today can therefore be thought of as a direct result of excessive credit creation in previous years. This is a pattern followed religiously by all asset boom-bust cycles.

Presenting monetary contraction in the 1930s as a major cause of the Depression is akin to a bankrupt who blames his predicament on his bank’s refusal to extend him additional credit. While technically true – additional credit could delay the bankrupt’s bankruptcy – it is a woefully incomplete analysis. When adopted as the principle framework of monetary policy it is downright dangerous, suggesting as it does that the answer to excessive borrowing is even more excessive borrowing, while neglecting the need to avoid the excesses in the first place.

The American 1907 crisis helps answer the question of whether or not central banks are responsible for financial markets not behaving according to the predictions of the Efficient Market Hypothesis; the misbehaviour was already present before central banking emerged. Financial instability caused central banking, not the other way around.

To re-establish financial stability would require not the reversion to a gold standard, or the abolition of the central banks; it would require nothing less than the abolition of credit creation. In other words, we would need to return our economies to the dark ages.

Central banks were introduced to stabilise the credit system but then found that their presence encouraged more risky lending and inadvertently destabilised it.

The introduction of a central bank created a race to the bottom, with all banks incentivised to take on more risk than their competitors.

On 15 August 1971, Nixon announced the closure of the gold window, as a result the US dollar ceased to be a certificate of gold deposit currency.

The closure of the US gold window and the end of US dollar-convertibility into gold ushered in an entirely new monetary regime. Previous devaluations had generally involved setting a new lower exchange rate between the currency and gold, but under the post-1971 arrangement the convertibility of money into gold was dispensed with entirely.

The new currency regime, without a gold exchange rate, is known as fiat money. The movement from a currency backed by gold to one with no fixed gold price represented a momentous shift in our financial architecture.

The advent of fiat money allowed for an entirely new mechanism of monetary creation. Governments had now awarded themselves the right to create their own money without any corresponding liability. Since there was no longer a promise to convert the printed money into gold, there was no longer a liability associated with printing that money.

The invention of fiat money had given governments the keys to the monetary drinks cabinet, allowing them to binge on the wealth of their citizens. However, the economic damage caused by the resulting price spiral could not be tolerated indefinitely.

It is important to recognise that this new fiat money system has only been in operation since 1971. What’s more, the inflationary problems associated with the abandonment of the gold peg were not immediately appreciated and as a consequence central banks have had less than four decades experience of how best to adapt to their new task of inflation policemen, and to learn how that task interacts with their still existing role of ensuring the stability of the private sector fractional reserve banking system.

Some central banks think they should not accept the role of restraining credit creation, while others believe they should resist the role of demand management. Those that believe in efficient markets also believe in manipulating markets, using policies devised by a man who explained markets were not efficient. Remarkably, this dog’s dinner of conflicting objectives, incoherent theories and confused policies, represents the current state of the art of central banking. Unremarkably, we find ourselves caught in a succession of ever larger financial crises as a result. *

The credit crisis, which began in 200,7 was big enough to endanger the entire global economic system, we can therefore no longer afford to ignore the failings of our monetary and fiscal policies.

Central to this philosophy is that markets must be adaptive and stable.

Market stability has been plausibly argued for the markets of goods and services, but that these arguments do not hold for asset markets, credit markets and the capital market system in general. It will be argued that, once disturbed, asset and credit markets are prone to undergo expansions and contractions that, in principle, have no limit and no stable equilibrium state.

In debt-funded asset markets, price declines beget asset sales that beget more price declines, morphing into a self-reinforcing positive feedback cycle.

The process also works in the opposite direction.

The critical difference between markets for goods and those for assets is how the markets respond to shifting prices, or equivalently shifting demand. In the goods market, higher (lower) prices trigger lower (higher) demand; in the asset market higher (lower) prices trigger higher (lower) demand. One market is a stable equilibrium-seeking system and the other habitually prone to boom-bust cycles, with no equilibrium state.

In goods markets items are purchased for consumption, in asset markets items are purchased for their potential to change price, making the nature of how the markets’ participants respond to price changes fundamentally different.

The combination of debt-financing and mark-to-market accounting conspires to give price movements in the asset markets a fundamentally unstable positive feedback characteristic. In the goods markets Adam Smith’s invisible hand is the benign force guiding the markets to the best of possible states. In the asset markets the invisible hand is playing racquetball, driving the markets into repeated boom-bust cycles. These self-reinforcing asset-debt cycles are the essential element of Hyman Minsky’s Financial Instability Hypothesis.

The boom-bust cycles of recent years have confirmed the presence of Minsky’s destabilising credit and asset cycles time and again, yet this simple common-sense analysis of why financial markets behave as they do remains a taboo subject to respectable economists. *

The restraint of self-reinforcing credit cycles is the raison d’être of central banking but this is denied by the dominant school of economics which unfortunately provides both the guiding principles by which these institutions operate and the managing principals who run them.

According to efficient market theory the equilibrating forces, which maintain market stability, are generated by investors selling assets when they become overvalued and buying them when they become undervalued. Through this process, it is argued, asset prices are maintained in line with their underlying fundamental value.

Therefore, according to efficient market theory, asset price bubbles are prevented by investors’ appetites to buy assets on the cheap and sell them when too expensive. It follows that an asset price bubble can only be formed if investors are willing to buy assets when they are already overpriced, implying that asset bubbles require investors to behave irrationally. This line of reasoning leads to the irrational investor defence of the Efficient Market Hypothesis.

The argument requires the doubters to prove that investors knowingly make bad investment decisions. But of course proving that investors knowingly make bad investment decisions is fiendishly difficult; indeed the idea is almost an oxymoron.

Buried deep within the Efficient Market Hypothesis is the unstated assumption that investors always have to hand the necessary information with which to calculate the correct price of an asset. If this assumption turns out to be false and investors are sometimes denied the necessary information to make informed judgements about asset prices, or worse still if they are given misleading information, then it becomes possible for asset price bubbles to form without investors behaving irrationally.

Needless to say, if asset-price inflation, credit creation and profit formation can form self-reinforcing cycles then these three variables can also feed back into what we refer to as the real economy. *

According to the ideas of efficient markets, asset prices are the thermometers taking the temperature of the real economy. On closer inspection asset price movements create the weather conditions that determine the temperature of the real economy. In such a system there is no defined correct equilibrium state.

An understanding of the significance of credit formation in the promotion of economic expansion helps explain the conflicts between the various roles of today’s central banks and the Efficient Market Hypothesis.

As each successive attempted credit contraction is successfully counteracted with engineered stimulus, the economy is pushed into a state of ever-greater indebtedness, presenting the risk of a still more violent contraction in the future. Over time, a policy of always maximising economic activity implies a constantly increasing debt stock and progressively more fragile financial system.

Given the mechanism by which most macroeconomic data can become distorted by financial bubbles, credit creation is not just an important macroeconomic variable, it is the important macroeconomic variable.

‘Mathematicians may flatter themselves that they possess new ideas which mere human language is as yet unable to express. Let them make the effort to express these ideas in appropriate words without the aid of symbols, and if they succeed they will not only lay us laymen under a lasting obligation, but, we venture to say, they will find themselves very much enlightened during the process.’ James Clerk Maxwell

According to the Financial Instability Hypothesis, if left unchecked, credit expansions will continue without limit, as will credit contractions. With boom-bust cycles of this type, economic activity passes only fleetingly through points that could be considered in any way “optimal”, and these points could never be considered as points of stable equilibrium. As a result, the economy’s natural tendency is to spend the vast majority of its time with credit creation, and economic activity is either too strong or too weak.

It is the idea that credit expansions can be excessive that is denied by the efficient market philosophy. *

At present we are attempting to control consumer price inflation, whereas the instability of the system arises through asset price inflation. In addition to this, some central banks are wilfully ignoring credit creation (money supply growth), which is the most valuable control signal, and focussing instead on other variables that tend to give misleading signals. If we are trying to control the wrong variable, with the wrong control signal, we have little to no chance of arriving at a strategy for delivering the correct control impulse.

Benoit Mandelbrot, the mathematician who invented fractal geometry, has been arguing that the behaviour of real financial markets just doesn't fit with the theories of efficient markets.

Mandelbrot’s work on financial markets should be praised for its honesty. In the first instance, because he is openly acknowledging what others only dare whisper; that the Efficient Market Hypothesis has already been comprehensively disproved. Secondly, it is refreshingly scientific in its method, in the sense that it attempts to fit theory to data, and not data to theory.

When viewed through the lens of the Efficient Market Hypothesis, the ideas of Mr Mandelbrot seem fanciful and something to be viewed with suspicion. However, when viewed through the lens of Minsky’s Financial Instability Hypothesis, Mandelbrot’s ideas look logical and something to be taken quite seriously.

Between them, the ideas of Minsky and Mandelbrot may help explain why our modern risk management industry finds it so difficult to produce reliable estimates of future return distributions.

If we use the wrong tools, derived from the wrong theories, we should expect to get the wrong answers. As Mandelbrot argues, to get to the right answers we need nothing short of an entirely new statistic, one derived to fit real market behaviour, taking into account the real positive feedback processes operating within these markets.

The prevailing laissez-faire, efficient-market orthodoxy cannot explain the historical pattern of economic progress, nor can it explain the emergence of financial crises, the behaviour of asset markets, the necessity of central banking, or the presence of inflation. In short, our economic theories do not explain how our economies work. The scientific method requires, first and foremost, that theories be constructed to accord with facts. On this count the economic orthodoxy does not qualify as a science

If we are to progress toward an improved, less crisis-prone, system of macroeconomic management, we must first understand how our financial system really works and not how academics would like it to work. This requires the adoption of the scientific method; we must twist the theories to fit the facts, not the other way round. Theories, such as the Efficient Market Hypothesis, which fail to pass this most fundamental of tests, should be cast unceremoniously aside.

Until better ideas come along, we should adopt the Financial Instability Hypothesis as our working assumption of how our financial system really works. We should then use this as a starting point from which to consider how best to reform our macroeconomic policies.

Once we have accepted the wisdom of Minsky’s Financial Instability Hypothesis, it is then only a short step toward understanding that credit cycles require management.

If blame must be laid anywhere it must be placed at the collective feet of those in the academic community who have chosen to continue promoting their flawed theories of efficient self-regulating markets, in the face of overwhelming contradictory evidence, aided and abetted by those who have so disastrously misinterpreted the lessons of the Great Depression. Keynes was correct when he said the world is ruled by little other than the ideas of economists and political philosophers whether right or more recently mostly wrong.

This financial crisis came perilously close to causing a systemic failure of the global financial system. Had this occurred, global trade would have ceased to function within a very short period of time. In these days of just-in-time inventory management, it is sobering to contemplate the consequences of interrupting food supplies to the world’s major cities for even just a few days. The consequences of a run on the banking system would pale into insignificance when compared with the consequences of a run on our supermarkets.

If we do not rise to the challenge of reforming our financial system, history may record the recent bank bailouts as being even more costly than we currently estimate. We may have paid just enough money to temporarily stabilise the system but in so doing have undermined our appetite for reform. If so, we may find ourselves caught in an even more costly future crisis.

The current mix of fiscal and monetary policy looks to be achieving nothing more than shifting and amplifying an unsustainable debt stock from the private sector onto the shoulders of the taxpayer; and in doing so supporting unsustainable industries with unsustainable consumption.

It appears increasingly likely that the current debt-deflation cycle will eventually be addressed through outright monetisation. If we engage in such a monetisation without policymakers having first committed to future monetary policy reform, then we may find ourselves drawn into an open-ended monetisation, leading to an inflationary cycle akin to that which gripped Germany in the 1920s. The social consequences of such an event would be quite devastating.