Freeman

BOOK REVIEW

Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System

OCTOBER 26, 2011 by ROGER W. GARRISON

The subprime crisis and financial meltdown have spawned dozens of books, some aimed at re-enshrining John Maynard Keynes, others at laying him to rest once more; some aimed at praising the Federal Reserve for staving off another Great Depression, others at blaming it for treating the economy to another cyclical episode. In Kevin Dowd and Martin Hutchinson’s reckoning the blame is assigned to government intervention (especially housing policy), fiscal irresponsibility, and interest-rate manipulation, all of which gave scope for short-run profit-taking based on modern finance theory. The incisiveness of this well-integrated tale derives from a mutual leveraging of the coauthors’ perspectives and experiences.

Dowd offers a classical-liberal perspective on macroeconomic policy and specifically central-bank policy. Having written extensively on free banking, he concludes that a thorough decentralization of the banking business is essential to enduring macroeconomic stability. Hutchinson is a seasoned investment banker turned financial journalist. His firsthand, nuts-and-bolts knowledge of modern financial markets undergirds his broader perspective. Together, they provide an enlightening account of the long-run trends and short-sighted policy actions that culminated in the worst financial crisis since the Great Depression.

The “alchemists” in their story are the architects and practitioners of modern finance. Given the perverse regulatory environment, buying and selling derivatives can yield short-run profits to hedge funds and other traders while virtually guaranteeing that in the longer run the owners of the underlying real assets will suffer losses if not bankruptcy. The careful reader will understand that speculation, whether on a long-term or short-term basis, is an essential and healthy feature of a market economy. But, if anything, the authors’ likening of speculation to alchemy when it is based on the techniques of modern finance and carried out in the context of a regulated economy understates the perversity. On reflection we can see that turning future long-run losses (of other people) into current short-run profits (for yourself) is triply more disruptive than trying to turn lead into gold. We can note 1) that lead, unlike long-run losses, has a positive, though modest, value; 2) that it is your own lead; and 3) that given the laws of nature, you’re unable to turn the trick.

But if the laws of nature keep people from turning lead into gold, why don’t the laws of the marketplace preclude the financial alchemy that characterized most of this century’s first decade? The answer, our authors make clear, is government intervention. A toxic mix of interventions (regulatory, fiscal, and monetary) perverted the coordinating market forces by removing considerations of long-run systemic risk. The result was a systemic discoordination whose increasing severity eventually turned systemic risk into a crisis. The laws of the marketplace, if allowed to exert themselves, can preclude financial alchemy (or at least put strict limits on it). But government intervention, including loan guarantees and the too-big-to-fail doctrine, open a window in which short-run profit-taking in financial markets is pitted against long-run viability of the financial institutions.

While the Federal Reserve is recognized as an essential accommodating element in the most recent episode of boom and bust, Dowd and Hutchinson focus on the inherent perversity of modern finance theory in the context of the long-running efforts of the government to redistribute income and to encourage homeownership. Since the 1930s the government has used the tax code to redistribute incomes downward. Over the years the income tax—and over the generations the inheritance tax—has reduced the number of families that oversee their long-run business interests. The old partnerships (Dowd and Hutchinson’s term), which kept the owners’ skins in the game, have been supplanted by limited-liability corporations, which effectively separate management and ownership. This critical separation, which left-leaning authors take to be characteristic of capitalism, is shown by the authors to be a consequence of government systematically overriding the market-governed distribution of income. Whereas we once had business families that were in it for the long run, we now have financial managers and traders in derivatives markets who are in it for the short run, ultimately to the detriment of the financial system and the real economy.

Alchemists of Loss provides a multidimensional account of the nature and magnitude of our long-brewing economic woes. But the book provides us with little hope for the future. The authors’ suggestions for reform range from the radical (reinstating the gold standard and eliminating the central bank) to the not-so-radical (redrafting the Fed’s mandate to exclude concern about unemployment) to the superficial (moving the Fed’s headquarters to St. Louis). Even the casual reader will see that this extends from the virtually impossible to the not-worth-doing, with no promising midrange option. The implicit conclusion is that we should brace ourselves for more booms and busts.

ASSOCIATED ISSUE

November 2011

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