By Eric Vandenbroeck and co-workers

2008 Financial Crisis

Last year the income of the average American (just under $34,000) went up by at most 5 per cent. (Per data from www.gpoaccess.gov/eop) But the cost of living rose by 4.1 per cent. So in real terms Mr Average actually became just 0.9 per cent better off. Allowing for inflation, the income of the median household in the United States has in fact scarcely changed since 1990, increasing by just 7 per cent in eighteen years,/ Now compare Mr Average's situation with that of Lloyd Blankfein, chief executive officer at Goldman Sachs, the investment bank. In 2007 he received $68.5 million in salary, bonus and stock awards, an increase of 25 per cent on the previous year, and roughly two thousand times more than Joe Public earned.

Then, during the first half of this month of October 2008, sellers sliced more than $10 trillion off global stock- market value, and firms like Goldman Sachs two days ago, announced cuts.

Cause and effect, the riddle of all history, is a particular devil in financial history; and never more so than today, where entire classes of security are collapsing not on public exchanges and stock-tickers but because there are no markets to establish prices this side of nothing.

In rising financial markets, the world is forever new. The bull or optimist has no eyes for past or present, but only for the future, where streams of revenue play in his imagination. In falling markets, there is nothing that has not happened before. The bear or pessimist sees only the past, which imprisons the wretched financial soul in eternal circles of boom and bust and boom again.

Today's financial world however is the result of many years of economic evolution. Money - the crystallized relationship between debtor and creditor - begat banks~ clearing houses for ever larger aggregations of borrowing and lending. From the thirteenth century onwards, government bonds introduced the securitization of streams of interest payments; while bond markets revealed the benefits of regulated public markets for trading and pricing securities. From the seventeenth century, equity in corporations could be bought and sold in similar ways. From the eighteenth century, insurance funds and then pension funds exploited economies of scale and the laws of averages to provide financial protection against calculable risk. From the nineteenth, futures and options offered more specialized and sophisticated instruments: the first derivatives. And, from the twentieth, households were encouraged, for political reasons, to increase leverage and skew their portfolios in favor of real estate.

Economies that combined all these institutional innovations banks, bond markets, stock markets, insurance and property owning democracy - performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning. For this reason, it is not wholly surprising that the Western financial model tended to spread around the world, first in the guise of imperialism, then in the guise of globalization.1 In the words of former Federal Reserve Governor Frederic Mishkin, 'the financial system [is] the brain of the economy ... It acts as a coordinating mechanism that allocates capital, the lifeblood of economic activity, to its most productive uses by businesses and households. If capital goes to the wrong uses or does not flow at all, the economy will operate inefficiently, and ultimately economic growth will be low.'2

But, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes.3 One  study of the available data for gross domestic product and consumption since 1870 has identified 148 crises in which a country experienced a cumulative decline in GDP of at least 10 per cent and eighty-seven crises in which consumption suffered a fall of comparable magnitude, implying a probability of financial disaster of around 3.6 per cent per year.4 Thus, despite the  sophistication of our institutions and instruments, Planet Finance as we have seen this past  weeks, remains as vulnerable as ever to crises. It seems that, for all our ingenuity, we are doomed to be 'fooled by randomness's and surprised by 'black swans,.6 It may even be that we are living through the deflation of a multi-decade 'super bubble'.7

There are three fundamental reasons for this. The first is that s0 much about the future - or, rather, futures, since there is never a singular future -lies in the realm of uncertainty, as opposed to calculable risk. As Frank Knight argued in 1921, 'Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated ... A measurable uncertainty, or "risk" proper ... is so far different from an unmeasurable one that it is not in effect an uncertainty at all.' To put it simply, much of what happens in life isn't like a game of dice. Again and again an event will occur that is 'so entirely unique that there are no others or not a sufficient number to make it possible to tabulate enough like itto form a basis for any inference of value about any real probability ... '8 The same point was brilliantly expressed by Keynes in 1937. 'By "uncertain" knowledge,' he wrote in a response to critics of his General Theory, .. I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty ... The expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or ... the rate of interest twenty years hence ... About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

Keynes went on to hypothesize about the ways in which investors 'manage in such circumstances to behave in a manner which saves our faces as rational, economic men':

(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.

(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects ...

(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average.9

Though it is far from clear that Keynes was correct 1ll his interpretation of investors' behaviour, he was certainly thinking along the right lines. For there is no question that the heuristic biases of individuals playa critical role in generating volatility in financial markets.

This brings us to the second reason for the inherent instability of the financial system: human behaviour. As we have seen, all financial institutions are at the mercy of our innate inclination to veer from euphoria to despondency; our recurrent inability to protect ourselves against 'tail risk'; our perennial failure to learn from history. In a famous article, Daniel Kahneman and Amos Tversky demonstrated with a series of experiments the tendency that people have to miscalculate probabilities when confronted with simple financial choices. First, they gave their sample group 1,000 Israeli pounds each. Then they offered them a choice between either a) a 50 per cent chance of winning an additional 1,000 pounds or b) a 100 per cent chance of winning an additional 500 pounds. Only 16 per cent of people chose a); everyone else (84 per cent) chose b). Next, they asked the same group to imagine having received 2,000 Israeli pounds each and confronted them with another choice:

between either c) a 50 per cent chance of losing 1,000 pounds or b) a 100 per cent chance of losing 500 pounds. This time the majority (69 per cent) chose a); only 31 per cent chose b). Yet, viewed in terms of their payoffs, the two problems are identical. In both cases you have a choice between a 50 per cent chance of ending up with I,OOO pounds and an equal chance of ending up with 2,000 pounds (a and c) or a certainty of ending up with I,500 pounds (b and d). In this and other experiments, Kahneman and T versky identify a striking asymmetry: risk aversion for positive prospects, but risk seeking for negative ones. A loss has about two and a half times the impact of a gain of the same magnitude.10

This 'failure of invariance' is only one of many heuristic biases (skewed modes of thinking or learning) that distinguish real human beings from the homo oeconomicus of neoclassical economic theory, who is supposed to make his decisions rationally, on the basis of all the available information and his expected utility. Other experiments show that we also succumb too readily to such cognitive traps as:

1.  Availability bias, which causes us to base decisions on information that is more readily available in our memories, rather than the data we really need;

2.  Hindsight bias, which causes us to attach higher probabilities to events after they have happened (ex post) than we did before they happened (ex ante);

3.  The problem of induction, which leads us to formulate general rules on the basis of insufficient information;

4.  The fallacy of conjunction (or disjunction), which means we tend to overestimate the probability that seven events of 90 per cent probability will all occur, while underestimating the probability that at least one of seven events of 10 per cent probability will occur;

5.  Confirmation bias, which inclines us to look for confirming evidence of an initial hypothesis, rather than falsifying evidence that would disprove it;

6.  Contamination effects, whereby we allow irrelevant but proximate information to influence a decision;

7.  The affect heuristic, whereby preconceived value-judgements interfere with our assessment of costs and benefits;

8.  Scope neglect, which prevents us from proportionately adjusting what we should be willing to sacrifice to avoid harms of different orders of magnitude;

9.  Overconfidence in calibration, which leads us to underestimate the confidence intervals within which our estimates will be robust (e.g. to conflate the 'best case' scenario with the 'most probable'); and

10. Bystander apathy, which inclines us to abdicate individual responsibility when in a crowd.11

If you still doubt the hard-wired fallibility of human beings, ask yourself the following question. A bat and ball, together, cost a total of £1.10 and the bat costs £1 more than the ball. How much is the ball? The wrong answer is the one that roughly one in every two people blurts out: 10 pence. The correct answer is 5 pence, since only with a bat worth £ 1.05 and a ball worth 5 pence are both conditions satisfied.12

If any field has the potential to revolutionize our understanding of the way financial markets work, it must surely be the burgeoning discipline of behavioral finance.13 It is far from clear how much of the body of work derived from the efficient markets hypothesis can survive this challenge.14 Those who put their faith in the 'wisdom of crowds' 15 mean no more than that a large group of people is more likely to make a correct assessment than a small group of supposed experts. But that is not saying much. The old joke that 'Macroeconomists have successfully predicted nine of the last five recessions' is not so much a joke as a dispiriting truth about the difficulty of economic forecasting. 16 Meanwhile, serious students of human psychology will expect as much madness as wisdom from large groups of peopleY A case in point must be the near-universal delusion among investors in the first half of 2007 that a major liquidity crisis could not occur (see Introduction). To adapt an elegant summation by Eliezer Yudkowsky:

People may be overconfident and over-optimistic. They may focus on overly specific scenarios for the future, to the exclusion of all others. They may not recall any past [liquidity crises] in memory. They may overestimate the predictability of the past, and hence underestimate the surprise of the future. They may not realize the difficulty of preparing for [liquidity crises] without the benefit of hindsight. They may prefer ... gambles with higher payoff probabilities, neglecting the value of the stakes. They may conflate positive information about the benefits of a technology [e.g. bond insurance] and negative information about its risks. They may be contaminated by movies where the [financial system] ends up being saved ... Or the extremely unpleasant prospect of [a liquidity crisis] may spur them to seek arguments that [liquidity] will not [dry up], without an equally frantic search for reasons why [it should]. But if the question is, specifically, 'Why aren't more people doing something about it?', one possible component is that people are asking that very question - darting their eyes around to see if anyone else is reacting ... meanwhile trying to appear poised and unflustered.18

Most of our cognitive warping is, of course, the result of evolution. The third reason for the erratic path of financial history is also related to the theory of evolution, though by analogy. It is commonly said that finance has a Darwinian quality. 'The survival of the fittest' is a phrase that aggressive traders like to use; as we have seen, investment banks like to hold conferences with titles like 'The Evolution of Excellence'. But the American crisis of 2007 has increased the frequency of such language. US Assistant Secretary of the Treasury Anthony W. Ryan was not the only person to talk in terms of a wave of financial extinctions in the second half of 2007. Andrew Lo, director of the Massachusetts Institute of Technology's Laboratory for Financial Engineering, is in the vanguard of an effort to re-conceptualize markets as adaptive systems.19 A long-run historical analysis of the development of financial services also suggests that evolutionary forces are present in the financial world as much as they are in the natural world.20

The notion that Darwinian processes may be at work in the economy is not new, of course. Evolutionary economics is in fact a well-established sub-discipline, which has had its own dedicated journal for the past sixteen years.21 Thorstein Veblen first posed the question 'Why is Economics Not an Evolutionary Science?' (implying that it really should be) as long ago as 1898.22 In a famous passage in his Capitalism, Socialism and Democracy, which could equally well apply to finance, Joseph Schumpeter characterized industrial capitalism as 'an evolutionary process':

This evolutionary character ... is not merely due to the fact that economic life goes on in a social and natural environment which changes and by its change alters the data of economic action; this fact is important and these changes (wars, revolutions and so on) often condition industrial change, but they are not its prime movers. Nor is this evolutionary character due to quasi-autonomic increase in population and capital or to the vagaries of monetary systems of which exactly the same thing holds true. The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers' goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates ... The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as US Steel illustrate the same process of industrial mutation - if I may use the biological term - that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.23

A key point that emerges from recent research is just how much destruction goes on in a modern economy. Around one in ten US companies disappears each year. Between 1989 and 1997, to be precise, an average of 611,000 businesses a year vanished out of a total of 5.73 million firms. Ten per cent is the average extinction rate, it should be noted; in some sectors of the economy it can rise as high as 20 per cent in a bad year (as in the District of Columbia's financial sector in 1989, at the height of the Savings and Loans crisis).24 According to the UK Department of Trade 'and Industry, 30 per cent of tax-registered businesses disappear after three years.25 Even if they survive the first few years of existence and go on to enjoy great success, most firms fail eventually. Of the world's 100 largest companies in 1912, 29 were bankrupt by I995, 48 had disappeared, and only 19 were still in the top 100.26 Given that a good deal of what banks and stock markets do is to provide finance to companies, we should not be surprised to find a similar pattern of creative destruction in the financial world. We have already noted the high attrition rate among hedge funds. (The only reason that more banks do not fail, as we shall see, is that they are explicitly and implicitly protected from collapse by governments.)

What are the common features shared by the financial world and a true evolutionary system? Six spring to mind:

- 'Genes', in the sense that certain business practices perform the same role as genes in biology, allowing information to be stored in the 'organizational memory' and passed on from individual to individual or from firm to firm when a new firm is created.

- The potential for spontaneous mutation, usually referred to in the economic world as innovation and primarily, though by no means always, technological.

- Competition between individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist.

- A mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of under-performance, i.e. 'differential survival'.

- Scope for speciation, sustaining biodiversity through the creation of wholly new species of financial institutions.

- Scope for extinction, with species dying out altogether.

Financial history is essentially the result of institutional mutation and natural selection. Random 'drift' (innovations/ mutations that are not promoted by natural selection, but just happen) and 'flow' (innovations/mutations that are caused when, say, American practices are adopted by Chinese banks) playa part. There can also be 'co-evolution', when different financial species work and adapt together (like hedge funds and their prime brokers). But market selection is the main driver. Financial organisms are in competition with one another for finite resources. At certain times and in certain places, certain species may become dominant. But innovations by competitor species, or the emergence of altogether new species, prevent any permanent hierarchy or monoculture from emerging. Broadly speaking, the law of the survival of the fittest applies. Institutions with a 'selfish gene' that is good at self-replication and self-perpetuation will tend to proliferate and endure.27

Note that this may not result in the evolution of the perfect organism. A 'good enough' mutation will achieve dominance if it happens in the right place at the right time, because of the sensitivity of the evolutionary process to initial conditions; that is, an initial slim advantage may translate into a prolonged period of dominance, without necessarily being optimal. It is also worth bearing in mind that in the natural world, evolution is not progressive, as used to be thought (notably by the followers of Herbert Spencer). Primitive financial life-forms like loan sharks are not condemned to oblivion, any more than the microscopic prokaryotes that still account for the majority of earth's species. Evolved complexity protects neither an organism nor a firm against extinction - the fate of most animal and plant species.

The evolutionary analogy is, admittedly, imperfect. When one organism ingests another in the natural world, it is just eating; whereas, in the world of financial services, mergers and acquisitions can lead directly to mutation. Among financial organisms, there is no counterpart to the role of sexual reproduction in the animal world (tho.ugh demotic sexual language is often used to describe certain kinds of financial transaction). Most financial mutation is deliberate, conscious innovation, rather than random change. Indeed, because a firm can adapt within its own lifetime to change going on around it, financial evolution (like cultural evolution) may be more Lamarckian than Darwinian in character. Two other key differences will be discussed below.

Nevertheless, evolution certainly offers a better model for understanding financial change than any other we have.

Ninety years ago, the German socialist Rudolf Hilferding predicted an inexorable movement towards more concentration of ownership in what he termed finance capitaPS The conventional view of financial development does indeed see the process from the vantage point of the big, successful survivor firm. In Citigroup's official family tree, numerous small firms - dating back to the City Bank of New York, founded in 1812 - are seen to converge over time on a common trunk, the present-day conglomerate. However, this is precisely the wrong way to think about financial evolution over the long run, which begins at a common trunk. Periodically, the trunk branches outwards as new kinds of bank and other financial institution evolve. The fact that a particular firm successfully devours smaller firms along the way is more or less irrelevant. In the evolutionary process, animals eat one another, but that is not the driving force behind evolutionary mutation and the emergence of new species and sub-species. The point is that economies of scale and scope are not always the driving force in financial history. More often, the real drivers are the process of speciation - whereby entirely new types of firm are created - and the equally recurrent process of creative destruction, whereby weaker firms die out.

Take the case of retail and commercial banking, where there remains considerable biodiversity. Although giants like Citigroup and Bank of America exist, North America and some European markets still have relatively fragmented retail banking sectors. The cooperative banking sector has seen the most change in recent years, with high levels of consolidation (especially following the Savings and Loans crisis of the I98os), and most institutions moving to shareholder ownership. But the only species that is now close to extinction in the developed world is the state-owned bank, as privatization has swept the world (though the nationalization of Northern Rock suggests the species could make a comeback). In other respects, the story is one of speciation, the proliferation of new types of financial institution, which is just what we would expect in a truly evolutionary system. Many new 'mono-line' financial services firms have emerged, especially in consumer finance (for example, Capital One). A number of new 'boutiques' now exist to cater to the private banking market. Direct banking (telephone and Internet) is another relatively recent and growing phenomenon. Likewise, even as giants have formed in the realm of investment banking, new and nimbler species such as hedge funds and private equity partnerships have evolved and proliferated. The rapidly accruing hard currency reserves of exporters of manufactured goods and energy are producing a new generation of sovereign wealth funds.

Not only are new forms of financial firm proliferating; so too are new forms of financial asset and service. In recent years, investors' appetite has grown dramatically for mortgage-backed and other asset-backed securities. The use of derivatives has also increased enormously, with the majority being bought and sold 'over the counter', on a one-to-one bespoke basis, rather than through public exchanges.

In evolutionary terms, then, the financial services sector appears to have passed through a twenty-year Cambrian explosion, with existing species flourishing and new species increasing in number. As in the natural world, the existence of giants has not precluded the evolution and continued existence of smaller species. Size isn't everything, in finance as in nature. Indeed, the very difficulties that arise as publicly owned firms become larger and more complex - the diseconomies of scale associated with bureaucracy, the pressures associated with quarterly reporting - give opportunities to new forms of private firm. What matters in evolution is not your size or (beyond a certain level) your complexity. All that matters is that you are good at surviving and reproducing your genes. The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model.

In the financial world, mutation and speciation have usually been evolved responses to the environment and competition, with natural selection determining which new traits become widely disseminated. Sometimes, as in the natural world, the evolutionary process has been subject to big disruptions in the form of geopolitical shocks and financial crises. The difference is, of course, that whereas giant asteroids (like the one that eliminated 85 per cent of species at the end of the Cretaceous period) are exogenous shocks, financial crises are endogenous to the financial system. The Great Depression of the 1930S and the Great Inflation of the 1970s stand out as times of major discontinuity, with 'mass extinctions' such as the bank panics of the 1930S and the Savings and Loans failures of the 1980s.

Could something similar be happening in our time? Certainly, the sharp deterioration in credit conditions in the summer of 2007 created acute problems for many hedge funds, leaving them vulnerable to redemptions by investors. But a more important feature of the recent credit crunch has been the pressure on banks and insurance companies. Losses on asset-backed securities and other forms of risky debt are thought likely to be in excess of $1 trillion. At the time of writing (May 2008), around $318 billion of write-downs (booked losses) have been acknowledged, which means that more than $600 billion of losses have yet to come to light. Since the onset of the crisis, financial institutions have raised around $225 billion of new capital, leaving a shortfall of slightly less than $100 billion. Since banks typically target a constant capital/assets ratio of less than 10 per cent, that implies that balance sheets may need to be shrunk by as much as $1 trillion. However, the collapse of the so-called shadow banking system of off-balance-sheet entities such as structured investment vehicles and conduits is making that contraction very difficult indeed.

It is doubtful whether the major Western banks can navigate their way through this crisis without a fundamental change to the international accords (Basel I and II) governing capital adequacy.

Under the Basel I rules agreed in 1988, assets of banks are divided into five categories according to credit risk, carrying risk weights ranging from zero (for example, home country government bonds) to 100 per cent (corporate debt). International banks a~ required to hold capital equal to 8 per cent of their risk-weighted assets. Basel II, first published in 2004 but only gradually being adopted around the world, sets out more complex rules, distinguishing between credit risk, operational risk and market risk, the last of which mandates the use of value at risk (VaR) models. Ironically, in the light of 2007-8, liquidity risk is combined with other risks under the heading 'residual risk'. Such rules inevitably conflict with the incentive all banks have to minimize their capital and hence raise their return on equity.

In Europe, for example, average bank capital is now equivalent to significantly less than 10 per cent of assets (perhaps as little as 4), compared with around 25 per cent towards the beginning of the twentieth century. The 2007 crisis has dashed the hopes of those who believed that the separation of risk origination and balance sheet management would distribute risk optimally throughout the financial system. It seems inconceivable that this crisis will pass without further mergers and acquisitions, as the relatively strong devour the relatively weak. Bond insurance companies seem destined to disappear. Some hedge funds, by contrast, are likely to thrive on the return of volatility.  It also seems likely that new forms of financial institution will spring up in the aftermath of the crisis. As Andrew Lo has suggested: 'As with past forest fires in the markets, we're likely to see incredible flora and fauna springing up in its wake.'29

There is another big difference between nature and finance. Whereas evolution in biology takes place in the natural environment, where change is essentially random (hence Richard Dawkins's image of the blind watchmaker), evolution in financial services occurs within a regulatory framework where - to borrow a phrase from anti-Darwinian creationists - 'intelligent design' plays a part. Sudden changes to the regulatory environment are rather different from sudden changes in the macroeconomic environment, which are analogous to environmental changes in the natural world. The difference is once again that there is an element of endogeneity in regulatory changes, since those responsible are often poachers turned gamekeepers, with a good insight into the way that the private sector works. The net effect, however, is similar to climate change on biological evolution. New rules and regulations can make previously good traits suddenly disadvantageous. The rise and fall of Savings and Loans, for example, was due in large measure to changes in the regulatory environment in the United States. Regulatory changes in the wake of the 2007 crisis may have comparably unforeseen consequences.

The stated intention of most regulators is to maintain stability within the financial services sector, thereby protecting the consumers whom banks serve and the 'real' economy which the industry supports. Companies in non-financial industries are seen as less systemically important to the economy as a whole and less critical to the livelihood of the consumer. The collapse of a major financial institution, in which retail customers lose their deposits, is therefore an event which any regulator (and politician) wishes to avoid at all costs. An old question that has raised its head since August 2007 is how far implicit guarantees to bailout banks create a problem of moral hazard, encouraging excessive risktaking on the assumption that the state will intervene to avert illiquidity and even insolvency if an institution is considered too big to fail - meaning too politically sensitive or too likely to bring a lot of other firms down with it. From an evolutionary perspective, however, the problem looks slightly different. It may, in fact, be undesirable to have any institutions in the category of 'too big to fail', because without occasional bouts of creative destruction the evolutionary process will be thwarted. The experience of Japan in the 1990S stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite underperformance, and bad debts are not written off.

Every shock to the financial system must result in casualties. Left to itself, natural selection should work fast to eliminate the weakest institutions in the market, which typically are gobbled up by the successful. But most crises also usher in new rules and regulations, as legislators and regulators rush to stabilize the financial systeIj and to protect the consumer/voter. The critical point is that the possibility of extinction cannot and should ~not be removed by excessively precautionary rules. As Joseph Schumpeter wrote more than seventy years ago, 'This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted.' This meant, in his view, nothing less than the disappearance of 'those firms which are unfit to live'.30

 However, when we withdraw banknotes from automated telling machines, or. invest portions of our monthly salaries in bonds and stocks, or insure our cars, or remortgage our homes, or renounce home bias in favour of emerging markets, we are entering into transactions with many historical antecedents.
And until we fully understand the origin of financial species, we shall never understand the fundamental truth about money: that, far from being 'a monster that must be put back in its place', as the German president recently complained,31 financial markets are like the mirror of mankind, revealing every hour of every working day the way we value ourselves and the resources of the world around us.

Here Selwyn Parker's book is a good account of the Wall Street crash of 1929 and the resulting worldwide depression as banks failed, credit contracted, tariff barriers were erected and the volume of world trade fell by two-thirds. His narrative takes us to out of the way places somewhat ignored in the standard accounts of those events, most notably JK Galbraith's The Great Crash: 1929 (1955). Here are not just New Zealand and Australia, but Newfoundland, Sweden, the Netherlands, Hawaii, Bengal, Scotland. Unfortunately, what we really rather badly need to know this week is not the price of jute in Calcutta in 1931 but the precise chain of events that caused 10,000 bank failures in the US between 1929 and 1933 (much better in Ferguson) and the success or not of the depression-era precursor of the Paulson plan, the Reconstruction Finance Corporation. Parker was not to know that.

The contention of The Gods that Failed in turn is the failure of the West’s politicians to take on the New Olympians spells disaster, and their book is devoted to explaining why.

The bankers and financiers, chained up after the second world war by exchange control, high and selective taxation, bank regulation and social parsimony, gradually broke their bounds. They were secretly assisted by a lurid and deep-laid conspiracy of philosophers such as Friedrich Hayek and Milton Friedman and, in a most interesting dialectical twist, by the breakdown of traditional authority in the social movements of 1968.

In essence the authors argue that our political leaders have done everything they can to support the liberalization of finance in order to stimulate wealth and growth. But this growth has not been beneficial to the majority of us. While Wall Street and City bonuses have soared there has been no particular effect on the general rates of growth of the economy, on wage levels or on the security of the lives of ordinary people. Worse, market liberalization is making our lives more insecure not only effecting the well being and opportunities of the working class but now of the middle class as well. In essence they argue that many of our professional institutions that have served us well - and which are the bedrock of many local communities - stand to be transformed in the coming years as local assets are stripped, services depersonalized and profits sucked from local communities to bolster even more the coffers of international corporations.

Thus the authors, Elliott and Atkinson sticks pins into the usual pin-cushions, from Greenspan to the Davos conference and the geniuses at LTCM. I was less clear as to precisely how the City is responsible for the closing of sub post-offices, the government's project for identity cards, city-centre CCTV, council equality officers, disruption in the National Health Service, restrictions on the smoking of tobacco in public and the general form of government the authors call "nagocracy". Middle Britain may well have been conned, as Elliott and Atkinson claim, but surely it is not only by the financial interest. I suppose this is is how the Guardian can drink with Mail on Sunday without coming to blows.

"The Trillion Dollar Meltdown," and “Bad Money,” in turn are two of the best books about the American credit crunch. And report that over the last three decades, financial services have expanded from 11% of America's gross domestic product to a record 21%, while manufacturing has declined from 25% to 13%. The author rejects the notion that this shift simply reflects a healthy adaptation to a "post-industrial" economy. Instead, he argues that the emergence of hedge funds and ever-more exotic bundles of financial derivatives amounts to a "financialization" of the American economy that has facilitated a ruinous expansion of private, as well as public, debt. Failed energy policies -- or rather, the avoidance of any policy -- have made the United States vulnerable to what may be the coming peak in oil production, thereby further weakening the dollar, which is essentially backed by the global petroleum economy.

Thus behind each phenomenon there lies a financial secret.  For example in the past, the Renaissance created such a boom in the market for art and architecture because Italian bankers like the Medici made fortunes by applying Oriental mathematics to money. The Dutch Republic prevailed over the Habsburg Empire because having the world's first modern stock market was financially preferable to having the world's biggest silver mine. The problems of the French monarchy could not be resolved without a revolution because a convicted Scots murderer had wrecked the French, financial system by unleashing the first stock market bubble and bust. It was Nathan Rothschild as much as the Duke of Wellington who defeated Napoleon at Waterloo. It was financial folly, a self-destructive cycle of defaults and devaluations, that turned Argentina from the world's sixth-richest country in the 1880s into the inflation-ridden basket case of the 1980s.

New institutions, too, have proliferated. The first hedge fund was set up in the I940S and, as recently as 1990, there were just 610 of them, with $38 billion under management. There are now over seven thousand, with $1.9 trillion under management. Private equity partnerships have also multiplied, as well as a veritable shadow banking system of 'conduits' and 'structured investment vehicles' (SIVs), designed to keep risky assets off bank balance sheets. If the last four millennia witnessed the ascent of man the thinker, we now seem to be living through the ascent of man the banker.

In 1947 the total value added by the financial sector to US gross domestic product was 2.3 per cent; by 2005 its contribution had risen to 7.7 per cent of GDP. In other words, approximately $I of every $13 paid to employees in the United States now goes to people working in finance.5 Finance is even more important in Britain, where it accounted for 9.4 per cent of GDP in 2006. The financial sector has also become the most powerful magnet in the world for academic talent. Back in 1970 only around 5 per cent of the men graduating from Harvard, where I teach, went into finance. By 1990 that figure had risen to 15 per cent.  Last year the proportion was even higher. According to the Harvard Crimson, more than 20 per cent of the men in the Class of 2007, and 10 per cent of the women, expected their first jobs to be at banks. And who could blame them? In recent years, the pay packages ip finance have been nearly three times the salaries earned by Ivy League graduates in other sectors of the economy.

At the time the Class of 2007 graduated, it certainly seemed as if nothing could halt the rise and rise of global finance. Not terrorist attacks on New York and London. Not raging war in the Middle East. Certainly not global climate change. Despite the destruction of the World Trade Center, the invasions of Afghanistan and Iraq, and a spike in extreme meteorological events, the period from late 2001 until mid 2007 was characterized by sustained financial expansion. True, in the immediate aftermath of 9/11, the Dow Jones Industrial Average declined by as much as 14 per cent. Within just over two months, however, it had regained its pre-9/II level. Moreover, although 2002 was a disappointing year for US equity investors, the market surged ahead thereafter, exceeding its previous peak (at the height of the 'dot com' mania) in the autumn of 2006. By early October 2007 the Dow stood at nearly double the level it had reached in the trough of five years before. Nor was the US stock market's performance exceptional. In the five years to 3 I July 2007, all but two of the world's equity markets delivered double-digit returns on an annualized basis. Emerging market bonds also rose strongly and real estate markets, especially in the English-speaking world, saw remarkable capital appreciation. Whether they put their money into commodities, works of art, vintage wine or exotic asset-backed securities, investors made money.

How were these wonders to be explained? According to one school of thought, the latest financial innovations had brought about a fundamental improvement in the efficiency of the global capital market, allowing risk to be allocated to those best able to bear it. Enthusiasts spoke of the death of volatility. Self-satisfied bankers held conferences with titles like 'The Evolution of Excellence'.

But while much less severe than the current worldwide crises, the minor financial crisis that struck the Western world in the summer of 2007 already, provided a timely reminder of one of the perennial truths of financial history. Sooner or later every bubble bursts. Sooner or later the bearish sellers outnumber the bullish buyers. Sooner or later greed turns to fear. And in the early months of 2008, it was already becomming clear that the US economy might suffer a recession. Was this because American companies had got worse at designing new products? Had the pace of technological innovation suddenly slackened? No. The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a spasm in the credit markets caused by mounting defaults on a species of debt known euphemistically as subprime mortgages. So intricate has our global financial system become, that relatively poor families in states from Alabama to Wisconsin had been able to buy or remortgage their homes with often complex loans that (unbeknown to them) were then bundled together with other, similar loans, repackaged as collateralized debt obligations (CDOs) and sold by banks in New York and London to (among others) German regional banks and Norwegian municipal authorities, who thereby became the effective mortgage lenders. These CDOs had been so sliced and diced that it was possible to claim that a tier of the interest payments from the original borrowers was as dependable a stream of income as the interest on a ten-year US Treasury bond, and therefore worthy of a coveted triple-A rating.

However, when the original mortgages reset at higher interest rates after their one- or two-year 'teaser' periods expired, the borrowers began to default on their payments. This in turn signaled that the bubble in US real estate was bursting, triggering the sharpest fall in house prices since the 1930s. What followed resembled a slow but ultimately devastating chain reaction. All kinds of asset-backed securities, including many instruments not in fact backed with subprime mortgages, slumped in value. Institutions like conduits and structured investment vehicles, which had been set up by banks to hold these securities off the banks' balance sheets, found themselves in severe difficulties. As the banks took over the securities, the ratios between their capital and their assets lurched down towards their regulatory minima. Central banks in the United States and Europe sought to alleviate the pressure on the banks with interest rate cuts and offers of funds through special 'term auction facilities'. Yet, at the time of writing (May 2008), the rates at which banks could borrow money, whether by issuing commercial paper, selling bonds or borrowing from each other, remained substantially above the official Federal funds target rate, the minimum lending rate in the US economy. Loans that were originally intended to finance purchases of corporations by private equity partnerships were also only saleable at significant discounts. Having suffered enormous losses, many of the best-known American and European banks had to turn not only to Western central banks for short term assistance to rebuild their reserves but also to Asian and Middle Eastern sovereign wealth funds for equity injections in order to rebuild their capital bases.

All of this may seem arcane to some readers. Yet the ratio of a bank's capital to its assets, technical though it may sound, is of more than merely academic interest. After all, a 'great contraction' in the US banking system has convincingly been blamed for the outbreak and course of the Great Depression between 1929 and 1933, the worst economic disaster of modern history.32 If US banks have lost significantly more than the $255 billion to which they have so far admitted as a result of the subprime mortgage crisis and credit crunch, there is a real danger that a much larger - perhaps tenfold larger - contraction in credit may be necessary to shrink the banks' balance sheets in proportion to the decline in their capital. If the shadow banking system of securitized debt and off-balance-sheet institutions is to be swept away completely by this crisis, the contraction could be still more severe.

This has implications not just for the United States but for the world as a whole, since American output presently accounts for more than a quarter of total world production, while many European and Asian economies in particular are still heavily reliant on the United States as a market for their exports. Europe already seems destined to experience a slowdown comparable with that of the United States, particularly in those countries (such as Britain and Spain) that have gone through similar housing bubbles. The extent to which Asia can ride out an American recession, in the way that America rode out the Asian crisis of 1997-8, remains uncertain. What is certain is that the efforts of the Federal Reserve to mitigate the credit crunch by cutting interest rates and targeting liquidity at the US banking system have put severe downward pressure on the external value of the dollar. The coincidence of a dollar slide and continuing Asian industrial growth has caused a spike in commodity prices comparable not merely with the 1970s but with the 1940s. It is not too much to say that in mid-2008 we witnessed the inflationary symptoms of a world war without the war itself.

It seems reasonable to assume that only a handful of those polled would have been able to explain the difference between a 'put' and a 'call' option, for example, much less the difference between a CDO and a CDS.

Politicians, central bankers and businessmen regularly lament the extent of public ignorance about money, and with good reason. A society that expects most individuals to take responsibility for the management of their own expenditure and income after tax, that expects most adults to own their own homes and that leaves it to the individual to determine how much to save for retirement and whether or not to take out health insurance, is surely storing up trouble for the future by leaving its citizens so ill-equipped to make wise financial decisions.

The first step towards understanding the complexities of modern financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present-day role much easier to grasp. When did money stop being metal and mutate into paper, before vanishing altogether? Is it true that, by setting long-term interest rates, the bond market rules the world? What is the role played by central banks in stock market bubbles and busts? Why is insurance not necessarily the best way to protect yourself from risk? Do people exaggerate the benefits of investing in real estate? And is the economic inter-dependence of China and America the key to global financial stability, or a mere chimera?

Maybe we could start with three suggestions, the first is that probably, poverty is not the result of rapacious financiers exploiting the poor. It has much more to do with the lack of financial institutions, with the absence of banks, not their presence. Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks, and only when savers can deposit their money in reliable banks can it be channeled from the idle rich to the industrious poor. This point applies not just to the poor countries of the world. It can also be said of the poorest neighborhoods in supposedly developed countries - the 'Africas within.'

A second suggestion or starting point, has to do with equality and its absence. If the financial system has a defect, it is that it reflects and magnifies what we human beings are like. As we are learning from a growing volume of research in the field of behavioral finance, money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. Booms and busts are products, at root, of our emotional volatility. But finance also exaggerates the differences between us, enriching the lucky and the smart, impoverishing the unlucky and not-so-smart. The world can no longer be divided neatly into rich developed countries and poor less-developed countries.

And the third is that few things are harder to predict accurately than the timing and magnitude of financial crises, because the financial system is so genuinely complex and so many of the relationships within it are non-linear, even chaotic as we are very well seeing this month.
 

1.     For some fascinating insights into the limits of globalization, see Panka (Ghemawat, Redefining Global Strategy: Crossing Borders in a World Where Differences Still Matter (Boston, 2007).

2.    Frederic Mishkin, Weissman Center Distinguished Lecture, Baruch College, New York (12 October 2006).

3.    Larry Neal, 'A Shocking View of Economic History', Journal of Economic History, 60, 2 (2000), pp. 317-34.

4.     Robert J. Barro and Jose F. Ursua, 'Macroeconomic Crises since 1870" Brookings Papers on Economic Activity (forthcoming). See also Robert J. Barro, 'Rare Disasters and Asset Markets in the Twentieth Century', Harvard University Working Paper (4 December 2005).

5.    Nassim Nicholas Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets (2nd edn., New York, 2005)

6.    Idem, The Black Swan: The Impact of the Highly Improbable (London, 2007).

7.    Georges Soros, The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means, (New York, 2008), pp. 91 ff.

8.    See Frank H. Knight, Risk, Uncertainty and Profit (Boston, 1921).

9.    John Maynard Keynes, 'The General Theory of Employment', Economic Journal, 51, 2 (1937), p. 214.

10.   Daniel Kahneman and Amos Tversky, 'Prospect Theory: An Analysis of Decision under Risk', Econometrica, 47, 2 (March 1979), p. 273.

11.   Eliezer Yudkowsky, 'Cognitive Biases Potentially Affecting Judgment of Global Risks', in Nick Bostrom and Milan Cirkovic (eds.), Global Catastrophic Risks (Oxford University Press, 2008), pp. 91-119. See also MichaelJ. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places (New York / Chichester, 2006).

12.    Mark Buchanan, The Social Atom: Why the Rich Get Richer, Cheaters Get Caught, and Your Neighbor Usually Looks Like You (New York, 2007), p. 54.

13.    For an introduction, see Andrei Shleifer, Inefficient Markets: An Introduction to Behavioral Finance (Oxford, 2000). For some practical applications see Richard H. Thaler and Cass R. Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven, 2008).

14.    See Peter Bernstein, Capital Ideas Evolving (New York, 2007).

15.    See for example James Surowiecki, The Wisdom of Crowds (New York, 2005); Ian Ayres, Supercrunchers: How Anything Can Be Predicted (London, 2007).

16.    Daniel Gross, 'The Forecast for Forecasters is Dismal', New York Times, 4 March 2007.

17 The classic work, first published in 1841, is Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds (New York, 2003 [1841]).

18.    Yudkowsky, 'Cognitive Biases', pp. II of.

19.    For an introduction to La's work, see Bernstein, Capital Ideas Evolving, ch. 4. See also John Authers, 'Quants Adapting to a Darwinian Analysis', Financial Times, 19 May 2008.

20.    The following is partly derived from Niall Ferguson and Oliver Wyman, The Evolution of Financial Services: Making Sense of the Past, Preparing for the Future (London / New York, 2007).

21.    The Journal of Evolutionary Economics. Seminal works in the field are A. A. Alchian, 'Uncertainty, Evolution and Economic Theory', Journal of Political Economy, 58 (1950), pp. 2II-22, and R. R. Nelson and S. G. Winter, An Evolutionary Theory of Economic Change (Cambridge, MA, 1982).

22.    Thorstein Veblen, 'Why is Economics Not an Evolutionary Science?' Quarterly Journal of Economics, 12 (1898), pp. 373-97.

23.    Joseph A. Schumpeter, Capitalism, Socialism and Democracy (London, 1987 [1943]), pp. 80-4.

24.    Paul Ormerod, Why Most Things Fail: Evolution, Extinction and Economics (London, 2005), pp. 180ff.

25.    Jonathan Guthrie, 'How the Old Corporate Tortoise Wins the Race', Financial Times, IS February 2007.

26.    Leslie Hannah, 'Marshall's "Trees" and the Global "Forest": Were "Giant Redwoods" Different?', in N. R. Lamoreaux, D. M. G. Raff and P. Temin (eds.), Learning by Doing in Markets, Firms and Countries (Cambridge, MA, 1999), pp. 253-94.

27.    The allusion is of course to Richard Dawkins, The Selfish Gene (2nd edn., Oxford, 1989).

28.    Rudolf Hilferding, Finance Capital: A Study of the Latest Phase of i Capitalist Development (London, 2006 [1919]).

29.    'F~ar and Loathing, and a Hint of Hope', The Economist, 16 February 2008.

30.    Joseph Schumpeter, The Theory of Economic Development (Cambridge, MA, 1934), p. 253.

31.    Bertrand Benoit and James Wilson, 'German President Complains of Financial Markets "Monster", Financial Times, 15 May 2008.

32.    Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (Princeton, 1963).

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