The instability of debt:

  George Cooper is a Keynesian who nevertheless provides a cogent explanation of one of the key weaknesses in Keynesian theory and policy. The current credit crunch has put this weakness dramatically on display.
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Even before recovery from one credit crisis, the credit expansion and financial bubbles of the next boom and bust cycle have already begun.

  Business cycle instability is inherent in the U.S. economy, Cooper explains, and central bank efforts to combat that instability only make it worse. (This is something that FUTURECASTS has been explaining for over a decade already.) The capitalist market economic system may be the most efficient available, but it is far from utopian. In the Preface to "The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy," Cooper cogently states his case.
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  Writing in 2008, Cooper begins with an explanation of the two boom and bust cycles of the last decade. These cycles came after more than a decade of the Great Moderation. He asserts that the recent worsening swings in the business cycle are caused by central bank policies that encourage credit expansion - and the inevitably accompanying credit bubbles - when times are good. When the business cycle turns down and the bubbles burst, the central banks energetically attempt to avoid credit contraction.
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  This "asymmetric monetary policy," pursued with increasing vigor by the Federal Reserve System and the U.S. Treasury Department, encourages an acceleration and deepening of the business cycle. Instead of stability, this monetary policy increases instability. Even before recovery from one credit crisis, the credit expansion and financial bubbles of the next boom and bust cycle have already begun.
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Assets that cannot or will not rapidly respond to demand shifts are inherently unstable. Perceived shortages are revealed by rising prices that make them appear like good investments that immediately generate increased demand instead of reduced demand.

  The "Efficient Market Hypothesis" is easily punctured by Cooper. The markets for goods may indeed be efficient enough to avoid major disruptions, but the assertion that this also applies to "factors of production such as labor, land and capital inputs" is unsupported by any evidence. Yet central banks invoke this theory when they refrain from acting against asset price bubbles.

  "Strangely, however, when asset prices begin falling the new lower prices are immediately recognized as being somehow wrong and requiring corrective action on the part of the policy makers."

  The contention that markets are always correctly priced because they always correctly reflect all the information in the market is clearly refuted by two centuries of business cycle swings. "[It] is unsafe to assume that all markets are inherently stable."
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  In particular, Cooper refers to asset price surges and bubbles. Assets that cannot or will not rapidly respond to demand shifts are inherently unstable. Perceived shortages of particular assets are revealed by rising prices that make them appear like good investments that immediately generate increased demand instead of reduced demand. Fine art, company stock, real estate and oil are examples. Moreover, financial markets routinely violate the expectations of Efficient Market theory. Reality thus persistently disproves the premises of monetary policy and financial risk systems.
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Many financial market participants now refer to the moment when boom turns to bust as a "Minsky moment."

The markets on their own cause "waves of credit expansion and asset inflation followed by waves of credit contraction and asset deflation."

Thus, "our risk systems may be designed to work only when they are not required."

  That there are inherent levels of instability in market economies has been recognized by such economists as Irving Fisher in 1933 and John Maynard Keynes in 1936. Irving Minsky presented a cogent explanation in "John Maynard Keynes" (1975), which was initially ignored and is now out of print. However, that book has recently been getting increasing attention. Many financial market participants now refer to the moment when boom turns to bust as a "Minsky moment."
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  Minsky pointed out that the winds of change that constantly cause price swings in financial markets are generated internally by the market itself as well as by external forces. The markets on their own cause "waves of credit expansion and asset inflation followed by waves of credit contraction and asset deflation."

  "The implication of Minsky's suggestion are that financial markets are not self-optimizing, 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 orthodoxy, as did those of Keynes before him."

  Examples of natural destabilizing forces include the instances when demand is driven by supply or by price changes unrelated to consumption. However, credit creation and the banking system inherently generate even more powerful destabilizing forces.
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  Bank runs - including runs on money market funds - are an example of instability that periodically occurs in financial markets. However, quantitative  financial risk systems ignore the public fears generated by past bank runs. Such memory-induced events violate the Efficient Market Hypothesis. Thus, "our risk systems may be designed to work only when they are not required."
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Central Banks:

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  Central banks are a vital part of modern economic systems. How they function explains much of the difference between the economic systems of Europe and that of Zimbabwe. Cooper provides an explanation of the importance of central banks that unfortunately emphasizes the "independence" of those in Europe and the U.S.

  As frequently explained by FUTURECASTS, the independence of the Federal Reserve System is a myth. It is a creature of Congress and can be no more independent than the political support it gets for acting independently.

The Fed's monetary policy can be characterized as one in which policy is used aggressively to prevent or reverse credit contraction or asset price deflation, but is not used to prevent credit expansion or asset inflation.

  The European Central Bank and the U.S. Federal Reserve System - the two most prominent central banks - cannot agree on the proper objectives and methods of their monetary policy. Cooper explains:

  "The U.S. Federal Reserve does not appear to believe that there can be an excessive level of money growth, credit creation or asset inflation. They do, however, believe there can be an unacceptably low level of all these variables. As a result, the Fed's monetary policy can be characterized as one in which policy is used aggressively to prevent or reverse credit contraction or asset price deflation, but is not used to prevent credit expansion or asset inflation. This philosophy has been encapsulated by the idea that asset bubbles cannot be identified until after they burst, and it is only then that the central banks can and should take action.
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  "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. However, there is general reluctance to acknowledge the connection between excessive money supply growth and excessive asset price inflation."

  Can you imagine the political uproar if the Fed acted to burst an asset bubble and could be blamed for the resulting recession? 

  This explanation is admittedly an oversimplification. There are many broad areas of agreement within the two institutions. However, these differences explain much of the instability inherent in today's financial markets. Indeed, the very existence of central banks is an admission that financial markets are not reliably stable
and self-regulating.
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  However, financial markets are not really free in the laissez faire sense. All the major participants are heavily regulated. Central banks and other government agencies are forever pushing and pulling  - expanding the money supply, allocating credit, imposing regulations, some of which are more of a burden than a benefit.

  Private sector participants can also artificially impact individual assets or even entire markets with misinformation, withheld information and/or fraudulent information.

  Milton Friedman took a more rigorous view. He argued that discretionary monetary policy was destabilizing and should be removed by a gold standard or an automatic slow increase in monetary aggregates. Keynes and Minsky argued that markets are inherently unstable and require government management.

  Cooper is not quite accurate, here. Friedman clearly acknowledged the need for some alternative arrangement to deal with occasional panic situations. Keynes didn't just advocate the need for government market management, he advocated the eventual government takeover of all major economic entities. He did not believe in the long run adequacy of mere market stabilization efforts. Both Friedman and Keynes based their ideas on different interpretations of the causes of the Great Depression - both of which are clearly erroneous. See, The Great Deception: Summaries of Great Depression Controversies and Facts," and the six Great Depression Chronology articles beginning with "The Crash of '29," and Friedman and Schwartz, "Monetary History of the U.S., (1867- 1960), Part II, "Roaring Twenties Boom - Great Depression Bust (1921-1933)" and Part III, "The Age of Chronic Inflation ( 1933-1960)."

Laissez faire on the way up, Keynesian on the way down.

England financed many wars and thrived without chronic inflation. However, it did suffer periodic cyclical contractions.

  Unfortunately, central banks today operate as if both concepts are correct, Cooper continues. When markets are expanding they stand back. When they are contracting, they rush to attempt to arrest the decline. Laissez faire on the way up, Keynesian on the way down. (Politically, it is rare when they are able to do anything else.) "Today, the general consensus is that central banks have made mistakes and inadvertently created conditions leading up to the current credit crisis."

  This is partly true. Highly leveraged economic systems are inherently unstable - and government credit allocation, regulatory and tax policies play a big role in that instability. Governments, too, become highly leveraged, and as Cooper points out, "it's the debt that creates financial instability."

  The evolution of money and banking from barter through gold coins through gold depository banks and fractional reserve banking, and the instabilities possible as the banking system became increasingly elaborate, are summarized by Cooper. Credit in the private sector waxed and waned, but price fluctuations were correspondingly cyclical. There could be no chronic inflation - and there was none in England for over three centuries under its gold standard monetary systems. England financed many wars and thrived without chronic inflation. However, it did suffer periodic cyclical contractions.
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The private sector can generate cyclical instability that can become extreme if the financial system contains powerful incentives - "positive feedback effects" - to expand indebtedness during prosperous times and to contract indebtedness during difficult times.

  The private sector can't generate chronic inflation or deflation. However, it can generate cyclical instability that can become extreme if the financial system contains powerful incentives - "positive feedback effects" - to expand indebtedness during prosperous times and to contract indebtedness during difficult times. Only with monetary inflation can price inflation become chronic.

  Low levels of price deflation are actually normal as the pricing benefits of productivity improvements are passed on to the public. This constitutes a healthy increase in the purchasing power of the existing money stock and was typical in the 19th century. Now, these pricing benefits are eaten up for government benefit when government inflates the money supply.

  The monetarist view that overly tight monetary policy in the 1930s was the sole cause of the Great Depression is criticized by Cooper. (This is a blatant overstatement. Monetarists acknowledge the existence of other causes, but insist that monetary tightness was the primary factor.) Ignoring the "excess credit generation in the 1920s" is a fundamental error, Cooper asserts. (Friedman emphatically acknowledges the 12-to-1 record level of expansion generated by the fractional reserve banking system by 1929. See, Friedman & Schwartz, Monetary History of U.S. Part II, "Roaring Twenties Boom - Great Depression Bust," at segment on "High powered money and bank system money.")
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  The fractional reserve banking system thus creates a very unstable credit system, but it also facilitates the economic prosperity that permits entire populations to lift themselves out of poverty. To deal with intermittent financial panics and bank runs, a powerful central bank is needed to support good banks that have good but illiquid collateral get through bank runs, and to conduct orderly liquidation of bad banks to protect the system as a whole. That was the role undertaken by the Bank of England, a privately owned institution with a public purpose. The Bank of England was "the lender of last resort."

  "The original and still primary purpose of central banking is not, as is widely believed today, to fight inflation, rather it is to ensure financial stability of the credit creation system. Financial instability can occur in any credit-dominated system, with or without the gold standard. There are those who argue for a return to a gold standard currency; this move may cure certain problems, but it would not, as some argue, usher in a golden age of financial stability."

  Indeed, the gold standard works through the business cycle. It cannot work without it.

"The banks that could afford to pay the highest rates of interest were likely to be those taking the most risk with depositors' money. The upshot was that the presence of a lender-of-last resort created a rush of money toward the most risky institutions."

Instead of stabilizing the system, a central bank can thus inadvertently destabilize it by increasing the likelihood of even bigger credit panics.

"The movement to a centralized gold-standard paper-currency system made it much easier for a government to expropriate its citizen's wealth through devaluation."

  Central bank support, however, comes with unintended consequences. It's called "moral hazard." 

  "The presence of the central bank therefore created a perverse incentive structure within the banking industry. Depositors would seek out the banks offering the highest rates of interest on their deposits paying no attention to the security of the bank - in the end all money would be repaid by the central bank. However, the banks that could afford to pay the highest rates of interest were likely to be those taking the most risk with depositors' money. The upshot was that the presence of a lender-of-last resort created a rush of money toward the most risky institutions." (See, Moral Hazard and Conflicts of Interest in the Credit Crunch.)

  The U.S. banking system had no shortage of bank failures prior to the establishment of the Federal Reserve System. Banks are an important part of the monetary system and thus their credit standards and financial practices are an inherent responsibility of government. However imperfect, there is no alternative to government regulation of the private components of the government's monetary system.

  The existence of a central bank reduces the size of reserves that must be kept on hand by individual banks. Emergency funds to meet unexpected demands from depositors can always be obtained from the central bank. Instead of stabilizing the system, a central bank can thus inadvertently destabilize it by increasing the likelihood of even bigger credit panics. Cooper notes that this was the case with Northern Rock in England, one of the first major bank failures of the Credit Crunch.
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  The modern central bank has in fact become an arm of government. The central banks centralized monetary gold reserves and thus gained a monopoly on printing money. This permits the government to meet its deficits by devaluing money.

  "All told, the movement to a centralized gold-standard paper-currency system made it much easier for a government to expropriate its citizen's wealth through devaluation."

  The international gold standard began to break down during the period between the world wars and was abandoned during the Great Depression. After WW-II, the world's major currencies were tied to the dollar and the dollar was tied to gold at $35 per ounce. This system broke down in the 1970s, and the world has been on a fiat dollar exchange rate ever since.
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  Cooper considers fixed exchange rates inherently unstable and believes they are the cause of periods of instability. If currencies could freely fluctuate, trade flows would be kept in balance.

  Cooper ignores the role of government budgetary deficits and monetary expansion in undermining fixed exchange rates. He ignores the advantages of fixed exchange rates. In fact, the budgetary and monetary disciplines required for success with fixed exchange rates are very similar to what is required for success with floating rates. Rapid exchange rate fluctuations under floating exchange rates increase commercial risks. Fixed exchange rates impose discipline on government budgets that politicians hate but badly need.

  Without such discipline, it becomes all too easy for governments to resort to monetary inflation that ultimately turns to price inflation at rates sufficient to undermine commerce. This was the experience under floating exchange rates during the last half dozen years of the Great Inflation decade of the 1970s. Both Britain and the U.S. adopted policies of monetary inflation. Price inflation sufficient to undermine commerce and cause stagflation soon followed.

  "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." 

  Inflation was fought primarily by positive real interest rates - high enough above the rate of price inflation to slow economic growth. "An increase in printed money was to be offset by decreasing private sector credit creation." Central bank independence from political control is essential for this role. (As stated above, central bank independence in the U.S. is a fiction.)
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Monetary inflation is a tax. It allows government to draw valuable goods and services from the economy in return for nothing but depreciating fiat dollars.

  However, governments really love inflation. They want as much of it as they can get away with without bringing economic growth to a halt. That inflation rate has been estimated at about 2%, so that is what governments aim for.
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  Monetary inflation is a tax. It allows government to draw valuable goods and services from the economy in return for nothing but depreciating fiat dollars. Price inflation also introduces some pricing flexibility into inflexible aspects of the economy like wage rates. It permits the central bank to drive short term interest rates down to "negative" levels - below the rate of price inflation - to artificially stimulate the economy - especially during election years. Cooper provides an explanation of real interest rates and the impact of inflation on taxation.

  "The move from the gold standard to fiat money made government finances and the central banks unbreakable. This unbreakable quality has its uses, especially during times of crises, but it also removes a key, perhaps the key, financial discipline."

  Cooper quotes the famous explanation by John Maynard Keynes concerning the dangers of substantial rates of inflation. That quote ends with: 

  "Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

  Modern central banks have several - often contradictory - tasks. They underwrite credit markets, act as lender of last resort, control price inflation, and attempt to mitigate or eliminate recessions by maintaining economic demand.
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  Cooper views with great favor the theories of John Maynard Keynes and asserts that deficit spending indeed worked during WW-II to end the Great Depression. (This theory is widely believed and has been frequently debunked in FUTURECASTS articles. See, Great Depression Summaries of Controversies and Facts, at Part J, "The World War II Recovery.") Keynes' intellectual support for deficit spending and monetary expansion has been enthusiastically received by politicians.

  "Both government deficit spending and the lowering of the private sector savings rate have the effect of boosting  spending and therefore demand in the economy."

  This is a blatant Keynesian fallacy. It only applies after periods of severe economic contraction have already been established and has no validity during prosperous times when money markets easily circulate all savings.

The unintended consequence of Keynesian efforts to stabilize the economy is increasing levels of debt and the increasing instability that creates.

  However, budget deficits and monetary inflation have not been limited to periods of depression. Unsurprisingly, once government was freed from all discipline, these policies became chronic. They are now not "reactive" but "proactive." They are used to boost economic activity even before economic contractions begin.
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  Confidence in continuous prosperity encourages debt financing in the private sector and discourages saving. (Persistent levels of price inflation also provide powerful incentives for deficit financing.) The unintended consequence of Keynesian efforts to stabilize the economy is increasing levels of debt and the increasing instability that debt creates. "[As] the debt stock builds it becomes progressively more difficult for the stimulus policies to offset future downturns." Cooper argues that Keynesian stimulus limited to recession periods can work, but preemptive use during prosperous times must fail.

  It is the height of stupidity to believe that politicians can limit their appetite for budgetary deficits and monetary expansion to periods of recession.

Deflation - one of the markets most powerful corrective mechanisms - is no longer available to assist in recovery from recessions because of the threat it poses to debt capital. Flexibility has thus been materially reduced - primarily because of government policies.

  The fallaciousness of the Efficient Market Hypothesis is proven, according to Cooper, by the business cycle - and especially the current Credit Crunch. Efficient markets "should be self-optimizing, and therefore should be able to adapt to external shocks without the help of stimulus policies."

  In fact, they do. But adaptation occurs through the business cycle mechanism - unless government interference prevents it, as occurred during the Great Depression. Markets are efficient - but not efficient enough to operate without the business cycle.

  Modern economic markets are far from laissez faire systems, Cooper correctly points out. Both for better or worse, government policies have a big impact. (See, "Government Futurecast.") As Cooper acknowledges, decades of inflation even at low levels have left the system encumbered by highly unstable levels of debt. Deflation - one of the markets most powerful corrective mechanisms - is no longer available to assist in recovery from recessions because of the threat it poses to bloated levels of debt. Flexibility has thus been materially reduced - primarily because of government policies.

  The fundamental causes of particular recessions as a practical matter always include government policies that negatively affect the economy and that are not self-liquidating during market contractions. There are a variety of incentives - many of which flow from government policies - that undermine market stability. Whatever the theoretical strengths of the Efficient Market Hypothesis, it is of limited applicability to a modern U.S. market system that is heavily distorted by government policies. Moreover, as Cooper notes, the Efficient Market Hypothesis is repeatedly refuted by the ongoing business cycle.

  Indeed, the business cycle at some level is a necessary part of an efficient market process because, as Cooper correctly points out, periodic recessions are what generate sufficient caution to limit ambition to prudent levels.

  Cooper is certainly correct that reliance on Efficient Market Theory under the circumstances of current market conditions is intellectually indefensible. However, his reliance on Keynes is itself intellectually indefensible. Keynes' attack on market mechanisms is riddled with "mature economy" fallacies that were the basis of the Marxian stupidity.

  The conflicts between the objectives of modern central banking are explained by Cooper.

  "Supporting demand through interest rate policy means one thing and one thing only: lowering interest charges to encourage more borrowing. However, as explained by the discussion of fractional reserve banking, more borrowing increases bank leverage, which in turn causes the type of financial fragility leading up to events like those of the Bear Stearns and Northern Rock stories. Financial stability therefore requires limiting credit expansion while demand management requires maintaining credit expansion - the two roles do not sit well together, especially if the central bank is of a mindset to prevent any and all credit contractions." (FUTURECASTS could not have said it better.)

  Cooper is certainly correct that central banks cannot ignore credit expansion. To the extent that the Efficient Market Hypothesis is invoked to justify unlimited credit expansion it is not just wrong, it is both dangerous and stupid - and ignores centuries of financial history. Markets are indeed very efficient, but they are far from perfect or utopian. Cooper offers one of the many ways in which excessive debts undermine economic stability and frustrate central bank demand management efforts. It is the objective of price stability that ultimately has to be surrendered.

  "Allowing an economy to free fall into recession from a point of extreme over indebtedness is extremely dangerous, risking a self-reinforcing economic collapse along the lines of that which happened in the Great Depression. The alternative is to simply pay off the debt through the printing press. - - - But of course this inflationary 'get out of jail card' requires the central bank to discard its new role of guardian of price stability."

  Central banks now have an impossible combination of objectives. They must:

• "Restrain credit creation for financial stability;
• Promote credit creation for demand management;
• Restrain monetization to control inflation;
• Promote monetization to avoid economic contractions, after, that is, their policies of promoting credit expansion have been too successful."

  Central banks also differ on their underlying philosophic approaches to policy. Some reject credit creation restraint, some reject demand management, all invoke Keynesian policies in a pinch while rejecting his attack against the Efficient Market Hypothesis that was the basis for his policies. Cooper explains the scope of his objection to the Efficient Market Hypothesis:

  "The thesis of this chapter is that the presence of 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 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."

  This is an unfortunate gross overstatement of a potentially valid point. There is always a limit. The only question is the extent of the swings that will occur. Cooper discusses "destabilizing processes" that serve to widen the swings - but none of them can run on indefinitely unless government or some other outside force is continuously preventing stabilization.

Market instability:

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  The Credit Crunch is presented by Cooper as demonstrating a typical destabilizing force. As assets decline, those that function as collateral on loans will become insufficient and many will be liquidated, causing further asset declines.
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  This process can undermine bank solvency and cause further financial contraction generally - which causes further asset decline. Furthermore, increased risks cause banks to raise interest rates for other lenders who also may thus have to liquidate assets.

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

  Well! A Keynesian explaining the inherent instability of markets heavily dependent on debt funding! Thus, just as FUTURECASTS has been explaining, even domestic debts can be bad after all, if they are not based on a sufficient foundation of equity capital.

  The bust version of this thesis is mirrored by the boom version. Rising asset values permit - and induce - more borrowing to cover acquisition of more assets thus pushing asset values even higher. Credit improves and interest charges are lowered as perceived risks decline. This assists further borrowing.

  As centuries of bubble history demonstrate, these destabilizing processes can run on for surprising lengths of time - but never indefinitely. They are typical aspects of the abuse of credit.

  The supply of shares is another destabilizing factor. The supply of shares does not increase as prices rise or decrease as prices fall. Just the opposite. Investors keep shares off the market as prices rise and throw them onto the market as prices fall. Stock prices are thus notorious for wide swings and sudden reversals as they overshoot their equilibrium levels.

  The volatility of stock market prices is certainly an observable fact, but Cooper's explanation is plainly refuted by history. Rising stock prices bring all sorts of new issues to market, greatly expanding the shares offered for sale. High share prices encourage corporations to issue more shares to raise capital for expansion and acquisitions. Serious bear markets drive speculators out of the market as shares accumulate in the hands of bargain hunter investors who hold them for the long run recovery that will surely come. The process is somewhat "sticky," but clearly exists.

"The combination of debt-financing and mark-to-market accounting conspire to give price movements in the asset markets a fundamentally unstable positive feedback characteristic."

  The impact of "mark-to-market" accounting is explained by Cooper. As prices of assets fluctuate, wealth within the community rises and falls accordingly. When stock markets are rising, collateral available increases and risk management systems indicate the safety of additional loans that fuel additional purchases that push asset values even higher. Ultimately, this all plays in reverse on the way down.

  "The combination of debt-financing and mark-to-market accounting conspire 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."

  Unfortunately, belief in the efficiency of markets has prevented central banks from any effort to manage and moderate asset value swings.
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Markets and financial systems frequently don't produce the information needed to demonstrate that securities are overpriced.

Investment prices that initially seem unjustified by economic fundamentals can be justified by the economic effects of the investment prices. When investment prices are expected to continue to rise or fall, that can cloud expectations concerning expected economic performance.

  Positive feedback mechanisms that can prevent financial markets from achieving equilibrium are identified by Cooper.

  "Bank credit creation, mark-to-market accounting, debt-financed asset markets, cyclical dependence of credit spreads, scarcity driven demand and price-driven demand all provide positive feed back mechanisms with the potential to cause financial markets to behave in a way inconsistent with the theory of efficient markets."

  Unfortunately, Cooper asserts, the countervailing forces are not strong enough to overcome the destabilizing forces. This is not because investors behave irrationally and keep buying securities that they know to be overpriced, but because the markets and financial systems frequently don't produce the information needed to demonstrate that securities are overpriced. Worse, a lot of misinformation circulates during prosperous times that undermines investor ability to properly evaluate risks and potential.
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  The problem is that it is not just the economy that influences the investment markets. The investment markets influence the economy. Rising securities - or housing - prices increase wealth which increases consumption and investment in securities and housing. Thus, investment prices that initially seem unjustified by economic fundamentals can be justified by the economic effects of the investment prices. When investment prices are expected to continue to rise or fall, that can cloud expectations concerning expected economic performance.
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  Because housing prices were rising prior to the Credit Crunch, average household balance sheets were actually improving as the housing bubble progressed. The binge looked indefinitely sustainable - until housing prices began to decline and outstanding mortgage debt was quickly revealed to be excessive. This is true for any investment where debt does not rest on sufficient margin to withstand the value decline of a significant recession.

  Indeed, credit evaluation should always be based on asset worth estimated during a significant recession - as bad as 1980-1982 - rather than on current asset values. Only the stupid - and some Keynesians - think that business contractions can be prevented or substantially mitigated by government policies. The eventual onset of a business contraction must always be expected instead of being doubted or disregarded. Unfortunately, this does not work in the opposite direction. When collateral prices drop below the value of the debts they secure, there is an increasing incentive for the borrowers to walk away from both the collateral and the debt, through bankruptcy if necessary. Moreover, if the contraction is caused predominantly by government policies, recovery may have to await the substantial political abandonment of those policies.

"In predominantly debt-financed asset markets asset prices cannot be considered as an independent metric of sustainable debt levels, nor can debt levels be considered an objective external variable with which to measure asset prices."

The waxing and waning of the use of credit is a powerful factor in the business cycle.

  Mark-to-market accounting powerfully destabilizes balance sheet evaluation in both directions. Unfortunately, while it does not make sense on the upswing, it can make all too much sense on the downswing when it causes the most pain.

  "Balance sheet variables, therefore, do not just fail to inform investors of impending economic problems, they may actively mislead them into believing conditions are safer than they really are. In predominantly debt-financed asset markets asset prices cannot be considered as an independent metric of sustainable debt levels, nor can debt levels be considered an objective external variable with which to measure asset prices."

  The flexibility of credit mechanisms adds to this picture of instability. While Cooper provides a typically fallacious Keynesian explanation, his overall conclusion is clearly correct. The waxing and waning of the use of credit is a powerful factor in the business cycle.

  With modern money markets, savings are never a cause of business cycle turns. Savings rates have long-term implications, as Cooper correctly notes, but it is the "risk averse" and profit inducement factors, not the savings rates, that are the keys to the onset of business cycle turns. They in turn are driven by more fundamental underlying factors.

Minsky:

Higher leverage rates increase profit levels during prosperous times and financial threats during recessions.

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  A key weakness in Keynesian theory was explained by Hyman P. Minsky several decades ago, Cooper points out. Persistent borrowing to combat the business cycle increases the debt load on all economic sectors and increases economic instability. Higher leverage rates increase profit levels during prosperous times and financial threats during recessions. 

  "The additional borrowing associated with an asset price boom will likely flow back into additional asset purchases, but part will also be converted into higher debt-financed spending; in the recent housing market bubble this process was referred to as home equity withdrawal. As a result higher borrowing produces both higher profits and higher asset prices, while falling levels of borrowing cuts both profit and asset prices. At the aggregate level corporate earnings do not always provide a reliable measure to the true 'value' of the stock market."

"Over time, a policy of always maximizing economic activity implies a constantly increasing debt stock and progressively more fragile financial system."

  Our reliance on price/earnings ratios, revenue growth and other money flow variables can thus be deceiving about the risk/reward ratio of an asset and its true value. These errors tend to increase the virulence of the business cycle.

  "The upshot of all of these linkages is that asset inflation and credit expansion flow back into the real economy, generating self-ratifying stronger economic data. Unfortunately the converse is also true; credit contraction undermines profits, reduces investment spending, weakens employment, cuts consumption, and therefore creates conditions ripe for still more credit contraction - Keynes' paradox of thrift."

  Asset prices don't just reflect economic conditions. They clearly have a positive feedback into economic conditions during both phases of the business cycle. Each time the central bank tries to facilitate credit expansion, the system becomes increasingly unstable. "Over time, a policy of always maximizing economic activity implies a constantly increasing debt stock and progressively more fragile financial system."
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  Cooper thus comes to a very ordinary, common sense conclusion - something disparaged by most Keynesians. Debt - domestic as well as foreign - can increase instability. His primary method of evaluating the levels of credit expansion is simple but impractical. "What would the economic variables look like without credit."

  There is no way to actually calculate this. Even the most sophisticated macroeconomic models provide grossly inaccurate results. Nor is it reasonable, since credit use at some reasonable level is both healthy and essential for a broadly prosperous economy.

  Other methods suggested are far more practical. By observing lending activity and asset price inflation, you can tell if credit creation is running ahead of economic growth. Debt increasing as a fraction of economic activity and the increase of debt servicing expenses as a fraction of the income employed to service that debt are good macroeconomic indicators. More important is the evaluation of debt service burdens in the event of a significant recession. The extent of leverage is always an important indicator for private entities and government entities alike.

  These are far more straightforward methods for the analysis of the viability of credit expansion. The continuation of the business cycle must be accepted, not disparaged, and 1980-1982 provides a close approximation of maximum severity in the absence of government policy madness such as generated decade-long economic disruptions during the 1930s and 1970s. The housing bubble could not have been ignored, and the dangers of government allocation of credit would have been clearly revealed, with such analyses.

Monetary policy:

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 The stabilization of inherently unstable economies is a primary objective of central banking. Unfortunately, belief in the extreme version of the efficient market theory has created doubts as to whether credit creation can ever be excessive.
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The Fed's heavy handed effort to persistently inflate credit growth with low interest rates ultimately increases the instability of the economy. It encourages all manner of credit bubbles which ultimately cannot be prevented from bursting destructively.

  Thus, central banks have been too slow to step on the brakes as the economy heats up. They keep actively stimulating the economy too long after it begins to recover. They are too easily influenced by the growth indications that are the result of the credit expansion.
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  Even worse is the explosive reaction of the U.S. Federal Reserve to any economic contraction. The Federal Reserve attempts to keep the economy permanently growing - an impossible task. This heavy handed effort to persistently inflate credit growth with low interest rates ultimately increases the instability of the economy. It encourages all manner of credit bubbles which ultimately cannot be prevented from bursting destructively.
 &
  Cooper then demonstrates a degree of naïveté. He suggests that central banks should occasionally tighten unexpectedly just to test the sustainability of an expansion. These periodic unexpected moves might beneficially induce practical levels of caution in the more adventurous speculators. 

  "At present we are attempting to control consumer price inflation, whereas the instability of the system arises through asset price inflation. In addition to which some central banks are willfully ignoring credit creation (money growth), which is the most valuable control signal, and focusing instead on other variables that tend to give misleading signals." 

  Cooper is apparently ignorant of the history of the Federal Reserve and the vicious criticism it received - and still receives - for efforts to control the booms prior to the depression of 1920-1921, the Crash of '29, and the relapse of 1937-1938. See, the three articles on Meltzer, "A History of the Federal Reserve (1913-1951)," vol. 1, beginning with Part I, "The Search for Monetary Stability (1913-1923)." As a political matter, the Fed cannot withstand such criticism. Only the staunch support of Pres. Reagan permitted Paul Volcker to maintain an austere monetary policy through the 1980-1982 depression to suppress the Great Inflation of the 1970s.

Risk management systems:

&

  Quantitative risk management systems for banking, asset management and regulatory systems presume market efficiency. On that basis, it is possible "to determine reliable probability distributions for future asset price returns." Unfortunately, Cooper points out, Northern Rock and Bear Stearns demonstrate that "the risk distributions predicted by these systems frequently underestimate real world scenarios."
 &

These risk management systems are reliable only under quiescent  market conditions - when they are not needed.

Over reliance on invalid risk management systems encourages assumption of behaviors that turn out to be dangerous.

  Minsky's Financial Instability Hypothesis correlates far better with actual market outcomes than the Efficient Market Hypothesis. Unstable financial markets mean that previous market behavior is not a reliable guide for generating future return distributions. Calculations during expanding cycles differ from those of contracting cycles, and "the entire probability distribution" will tend to shift at the point when the cycle shifts - at the "Minsky Moment" - precisely when reliable risk management is most needed. 
 &
  Thus, these risk management systems are reliable only under quiescent  market conditions - when they are not needed. For bankers, investors and regulators, risk management systems serve to increase confidence to inappropriate levels. The risk management systems do not know what they claim to know.

  "As with mark-to-market accounting, the modern risk management system was introduced to help make the financial system safer and more stable, but may have helped to add to its instability."

  Here again, a process designed to increase financial stability instead increases financial instability. Over reliance on invalid risk management systems encourages behaviors that turn out to be dangerous.
 &
  Indeed, Cooper asserts, these risk management systems themselves constitute another destabilizing positive feedback mechanism. After an asset crashes, they increase their assessment of risk - although it is apparent that an asset has to be less risky at a lower price than it was at the higher price.

  "While we continue to base our risk models, our regulatory regimes, our investment decisions and our macroeconomic policy on the mild randomness of efficient markets we will remain perpetually unprepared for the shocks thrown at us by the financial markets."

  The laissez faire philosophy of market competition is viewed unfavorably and as less solidly based than Darwin's evolution concepts. The latter are in evidence everywhere, Cooper asserts, while market competition has produced prosperity rarely and until recently for only a few.

  Cooper neglects to mention that the disappointing economic results are always associated with political and economic systems that constrain market competition. Indeed, Adam Smith's "The Wealth of Nations" was written precisely to explain the noxious impacts of political and private constraints on markets. See, Adam Smith, "The Wealth of Nations," Part I, "Market Mechanisms," and Adam Smith, "The Wealth of Nations," Part II, "Economic Policy." In this, Smith has been proven every bit as accurate as Darwin.

  Then, Cooper invokes the "science" propaganda ploy. 

  "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 behavior 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."

  This is actually an accurate statement, but is nevertheless misleading in its incompleteness. The "prevailing" theories - both Keynesian and the extreme monetarist and efficient market concepts - are indeed at odds with reality. Cooper himself accepts much of the Keynesian stupidity. To understand competitive markets, you have to unlearn a lot of macroeconomics that have been taught at Harvard and Yale and MIT and similar institutions of alleged higher learning during the last six decades.
 &
  First, economics is not and can never be a "science." The "science" propaganda ploy is used by propagandists to cloak themselves with a level of intellectual authority that they do not deserve - and to deflect objections to their concepts that they cannot answer. The "science" propaganda ploy has been used by Marxists and Keynesians for decades and should not be repeated by Cooper or anyone else. The same could be said for social "science" and political "science," etc., but we won't get into that. Indeed, Keynesians have even given up trying to provide forecasts - an essential ingredient in testing scientific hypotheses. They now only provide "projections" that are invariably proven false by every turn in the business cycle.
 &
  Economics is a profession. Economists provide only "professional opinions." From a skilled professional, these can be very good, indeed, but they are not statements of scientific truth, which are as close to absolute truth as human analytical methods can provide. Economists do have a few tools that can be part of scientific inquiry, but they do not have broad access to repeatable, controlled experiments, and Keynesian economists admit they cannot provide reliable forecasts with which to test their hypotheses.
 &
  The concept of laissez faire has itself been turned into a propaganda ploy and is widely misused. The result is broad misunderstanding and frequent mischaracterization, which are primary objectives of propaganda ploys. Cooper in this book is responsible for further obfuscation. See, Future Economic Myths at segment on "The 'Laissez Faire' Straw Man." Every debate about some level of regulatory policy is instantly turned into a misleading debate about the benefits and weaknesses of mythical versions of laissez faire policy. The use of this ploy often succeeds in blocking consideration of the actual merits and burdens of the policy.
 &
  Cooper adequately makes his case against the absurd absolutist versions of the efficient market theory without having to descend to the level of the propagandists. Macroeconomic system management does NOT require "adoption of the scientific method." It requires a well-developed professional understanding about how the economic system actually works. The "scientific method" is not really available for the study of macroeconomics.

  Minsky's Financial Instability Hypothesis - that financial markets flip between self-reinforcing expansions and contractions - is viewed by Cooper as explaining "real financial markets behavior."

  Cooper explains why self-reinforcing expansions flip over into contraction, but fails to even indicate why a self-reinforcing contraction should ever flip over into an expansion. Yet, before Keynes, there was a whole century of examples of self-limiting contractions. The Great Depression was not self-limiting precisely because government policies rather than economic weaknesses were the fundamental causes at work.
 &
  As Cooper correctly explains, after seven decades of Keynesian and monetarist economic policy, the U.S. economy is so heavily laden with debt that it is indeed inherently unstable. However, this is a function of the debts - made worse by heavy reliance on monetary inflation - it is not inherent in the economic system.

  Credit cycle management:

 Thus, " credit cycles require management," Cooper correctly concludes.
 &

  However, his prescription suffers from a high degree of political naïveté. He asserts correctly that monetary policies designed to combat all contractions and spur recoveries tend to "over-govern" the system, "leading to wild destructive swings in activity." Instead, he counsels "a minimalist approach to macroeconomic and monetary policies."

  "For a system as inherently unstable as the financial markets, we should not seek to achieve perfect stability; arguably it is this objective that has led to today's problems. A more sustainable strategy would involve permitting, and at times encouraging, greater short-term cyclicality, using smaller, more-frequent downturns to purge the system of excesses. In this way it may be possible to avoid the wrenching crises of the type we find ourselves currently in. To achieve this policy would require recognition of the importance of curtailing both excessive credit creation and excessive credit destruction, and a reappraisal of our attitude to central bank policy and economic cycles. Ideally we should move beyond considering all economic contractions as symptomatic of policy failure, viewing them instead as a normal part of the operation of a healthy vibrant economy." (Isn't that what we had under the gold standard?)

  There is nothing wrong with this view, except for the political criticism that will be directed at "failed economic policies" during contractions and "jobless recoveries" during recoveries. Once invited to indulge in budgetary deficits and monetary inflation during contractions, does Cooper really expect politicians to regain budgetary and monetary discipline during a recovery?  Unemployment, after all, is a lagging indicator, and the opposition party is always in the wings promising to "get the economy moving again."

The existence of instability and self-reinforcing tendencies in our debt-laden economic system must be acknowledge and included in market analysis and financial risk assessment.

It is debt - both private and public - that drives the "Inflation Monster."

It is debt - both private and public - that drives the "Inflation Monster."

Central banks must govern aggregate credit creation - not just consumer prices and narrow monetary aggregates.

  Cooper counsels more realistic and disciplined use of credit in the private sector. He is correct that credit-driven profit growth should be viewed with suspicion, and that the central bank should acknowledge that asset inflation is a real and dangerous form of inflation that it will have to act against. This should help concentrate minds and at least dispel the varieties of "new financial era" myths that periodically circulate in both stock markets and real estate markets.
 &
  In short, the existence of instability and self-reinforcing tendencies in our debt-laden economic system must be acknowledged and included in market analysis and financial risk assessment. The chronic inflation bias of central bank monetary policy must also be acknowledged and dealt with.

  "Today's inflationary pressures do not stem from an innate inflationary bias of the fiat money system per se, rather it stems from the political imperative to avoid the damaging economic consequences of any contracting credit cycle. It is our inability to stomach even the most modest of economic downturns that feeds the Inflation Monster." (There are in fact many reasons why fiat money systems are inherently inflationary.)

  It is debt - both private and public - that drives the "Inflation Monster." (For a Keynesian, this is incredible insight.) Even Keynes, prior to the Great Depression and his 1936 "General Theory," argued for administered limits on the credit system to reduce instability. Some means of limiting excessive reliance on debt is essential. Cooper believes that this is yet another task for a central bank. Central banks must govern aggregate credit creation - not just consumer prices and narrow monetary aggregates. He acknowledges the difficulty of determining just what the limits should be.

  The Federal Reserve has not exactly reliably achieved the objectives it already has. Its various objectives, as Cooper notes, are already inherently contradictory.

"The central bank would be moving its focus from the management of inherently stable goods markets to inherently unstable capital markets   - if we are going to have a governor we can at least attach it to that part of the machine whose motion requires governing."

  Cooper notes the weaknesses of consumer price targeting. The targeting of consumer prices is often in conflict with the management of credit cycles. The central bank after all is going to have to "preemptively prick asset bubbles" before there is any sign of price inflation.

  "The conflict between consumer price targeting and the management of credit can be easily resolved by dispensing with consumer price targeting altogether. As discussed, if excess credit and monetization is avoided, inflation will look after itself. In practical terms this move would mean shifting our central bank's mandate from targeting consumer price inflation to that of targeting asset price inflation. Put differently, the central bank would be moving its focus from the management of inherently stable goods markets to inherently unstable capital markets -- if we are going to have a governor we can at least attach it to that part of the machine whose motion requires governing."

    To repeat, Cooper should review Federal Reserve history. See, the three articles on Meltzer, "A History of the Federal Reserve (1913-1951)," vol. 1, beginning with Part I, "The Search for Monetary Stability (1913-1923)." The Federal Reserve came under intense criticism and political pressure as it fought the asset bubble of the 1928-1929 stock market boom. Agricultural and labor and main street commercial interests complained bitterly about having to suffer from high interest rates just because Wall Street couldn't control itself. The political pressure grew to paralyzing proportions. Cooper's policy recommendations require a degree of independence, and financial deftness, that the Fed has never exhibited. Interest rate movements are truly a blunt instrument - too blunt for such a delicate task.

  Even worse, Cooper then descends into a political Never-Never Land. He proposes that the central bank - an unelected creature of Congress lacking any standing under the Constitution - should have powers to restrain the exercise of the power of the purse that is the Constitutional foundation of Congressional authority. (Good Luck!) Yet he realistically notes that the lack of budget discipline in Congress forces the central bank to engage in the monetization of public debt that leads to destabilizing degrees of monetary inflation. 

  If Congress proved unwilling to submit to the market disciplines of the gold standard, what makes Cooper believe it will submit to discipline from its creature, the central bank?

Credit Crunch remedies:

&

  There are three methods of dealing with the current Credit Crunch, Cooper points out. None of them are very palatable.

1. The market can be allowed to "purge the rottenness," but this would result in a very deep contraction indeed.
2. Government policy could encourage the expansion of another credit bubble big enough to reverse the current contraction of the Credit Crunch bubbles. This is what it did after the "dot-com" bubble, however, and led to the current Credit Crunch.
3. The government could unleash monetary inflation - to monetize enough dodgy loans and excessive credit expansion to permit recovery. A weak dollar and price inflation significant enough to unfairly redistribute wealth from the prudent to the imprudent and threaten further economic disruption thereafter would be the result.

  Cooper believes that this latter choice is the best available. (In fact, all three processes are at work.) Cooper hopes that monetary inflation is not permitted to regenerate the "cavalier conduct" that led to the Credit Crunch, and that a more disciplined monetary and budgetary strategy can thereafter be implemented. (Not by the spendthrift forces currently dominant in both the Republican and Democratic parties!)