Friday, July 23, 2010

A Trio of Books that Help Explain the Recent Crisis

I recently posted about an excellent book on the financial crisis--Gary Gorton's SLAPPED BY THE INVISIBLE HAND. I now have two additional books to recommend. The first is by Carmen M. Reinhart & Kenneth S. Rogoff, THIS TIME IS DIFFERENT: EIGHT CENTURIES OF FINANCIAL FOLLY, and hte second is by Raghuram G. Rajan, FAULT LINES: HOW HIDDEN FRACTURES STILL THREATEN THE WORLD ECONOMY. One can get a good understanding of the causes of the crisis by reading these three books.

Reinhart & Rogoff look at eight centuries of data concerning financial crises. The information is sobering on at least two accounts--the frequency of the crises and the severity of the recession following a banking crisis. They also not that crises often follow a period when the belief at the time is that "this time is different" and complacency or hubris leads to problems. It is interesting to note that for many of the crises, a run-up of housing prices preceeded the collapse.

Gorton shows how much what happened can be described as a bank run in the shadow banking sector. Since I wrote on it previously, I won't add more here. Rajan's book tries to be the most comprehensive regarding the recent crisis. He pins the blame on the places I have suggested in the past--policymakers, the financial firms, the global saving glut, and poor regulation. He also discusses the problems caused by policymakers responding to a downturn given that the safety net in American society is less secure than in Europe. He notes a key pointsthat I think has not received adequate attention. Low interest rates have two negative effects--it reduces incomes of savers and it encourages people who want more return to take on more risk by increased leverage.

I highly recommend all three books for a greater understanding of the crisis. Hopefully, a better understanding can aid in determing how best to encourage a sustainable recovery.