THE END OF ALCHEMY [1/3] – Money, Banking and the Future of the Global Economy

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“Flooding the system with liquidity has been seen by many economists, officials and politicians as the answer to almost any financial crisis. But it is never easy to distinguish between a liquidity and a solvency problem. In only a matter of days, a shortage of liquidity can turn into a solvency question. Banks will always claim that their problems result solely from illiquidity rather than a fall in the value of their assets. And the distinction between liquidity and solvency is one that may be observable only after a detailed examination of a bank’s balance sheet, difficult for the authorities and impossible for investors. In September 2007, the consensus was that the crisis was solely one of liquidity. But it quickly became clear that it was in fact a crisis of solvency, and that a solution would require the combined efforts of central banks and taxpayers. The failure before the crisis was a lapse into hubris – we came to believe that crises created by maturity and risk transformation on a massive scale were problems that no longer applied to modern banking, that they belonged to an era in which people wore top hats. There was an inability to see through the veil of modern finance to the fact that the balance sheets of too many banks were an accident waiting to happen, with levels of leverage on a scale that could not resist even the slightest tremor to confidence about the uncertain value of bank assets. For all the clever innovation in the world of finance, its vulnerability was, and remains, the extraordinary levels of leverage. Pretending that deposits are safe when they are invested in long-term risky assts is an illusion. Without a sufficiently large cushion of equity capital available to absorb losses, or the implicit support of the taxpayer, deposits are inherently risky. The attempt to transform risky assets into riskless liabilities is indeed a form of alchemy.” – What Is a Bank?, Chapter 3. Innocence Lost: Alchemy and Banking


THE END OF ALCHEMY: A GOOD CONTEMPLATION BY A CENTRAL BANKER ON MONEY AND BANKING AND THE FUTURE ECONOMY

Memory fades too soon. Despite the fact that financial crises and market crashes have been happening quite regularly, albeit unexpectedly, it seems we only know how to greet them with fear. We tend to believe normal and stable economic situation is natural and the opposite always rare and unnatural. It’s because we remember only those events we experience during our life time. Short term memory prevails. Hence, we tend to forget that such a significant financial crisis as in 2008 is just one of crises repeated throughout our history since the invention of money and banking. For this reason, if someone audaciously says there will be another big crisis, people won’t be pleased – it’s such a rare and unpleasant experience. Further, if that happens, strangely, what we experience doesn’t really change: Liquidity dries up due to fears and is pumped up by central banks. What repeats is, sadly, taxpayers’ money is used to patch the hole and taxpayers suffer due to crashed economy. Man created money and banking system but same old patterns seem to repeat eternally. Even this mundane job of handling them seems to become more challenging with its severity and frequency in each crisis. What are we missing and what needs to be done?

The revered central bank governor – who stood at the centre of the crisis started in 2008 – wants to discuss about fundamental issues and flaws in our handling of money and banking and the past crisis after his twenty years of time in the Bank of England. Facing on-going challenges of low aggregate demand, a key factor of stagnated growth, that never seems to bounce back to pre-crisis level as well as of the world’s disequilibrium between saving and spending among and within major economies that doesn’t seem to correct by itself, the author tries to look into the world economy in pre- and post-crisis, diagnose the fundamental structural issues in our financial system – money and banking -, opine on what he sees as the cause of the past crisis in 2008, on why the way governments and central banks responded to it was not sufficient and on where current macroeconomic frames are failing and, lastly, suggest what needs to be done in collective level for our future economy.

My summary of the book comprises 7 themes in below order. Due to abundant ideas presented in the book, my writing this time will be separated into three pieces: the summary part I, part II, and the contemplation.

  • Big Questions
  • Pre-Crisis: The World Economy That Lost The Balance
  • Money and Fragile Banking System: Alchemy, Money Creation and Big Banks
  • Radical Uncertainty: A Coping Strategy
  • Reforming Banking: Ending Alchemy through PFAS
  • 2008 Crisis Revisited: The Narrative Revision Downturn and Its Implication to Policy Response
  • Post-Crisis: The World Economy Today and Collective Efforts to Prevent the Coming Crisis

BIG QUESTIONS

According to the author, most sharp economic downturns are followed by sharp recoveries, and the sharper the downturn, the more rapid the recovery. Despite the massive Quantitative Easing made after the sharpest market fallout in 2008, recovery as we expected seems remote. Why? We are getting into almost a decade since the burst of the crisis. What went wrong? What could’ve been better or different? The author poses three big unanswered questions contemplating on pre- and post-crisis.

First, observing the unsustainable economic path the world economy was proceeding on which was destined to lead to serious problems before the crisis, why did all the players involved – governments, central banks, commercial banks, companies, borrowers and lenders – take no action to change directions? Why were concerns about macroeconomic unsustainability not translated into actions by regulators and policy-makers?

Second, why has so little been done to change the underlying factors that can be seen as the causes of the crisis? The alchemy of our present system of money and banking continues. After arguably the biggest financial crisis in history, nothing much has really changed in terms of either of the fundamental structure of banking or the reliance on central banks to restore macroeconomic prosperity.

Third, why has weak demand become a deep-seated problem, and one that appears immune to further monetary stimulus?

PRE-CRISIS: THE WORLD ECONOMY THAT LOST THE BALANCE

‘What can go wrong?’, one might have asked, during the Great Stability lasted from 1990s until 2008 with unprecedented output and inflation stability.

What preceded the Great Stability were the three bold experiments, embarked from the late 1970s in the western world after getting over the Great Inflation in 1970s, with goals to manage money, exchange rates and the banking system. First, the central bank’s independence with a mandate of inflation targeting: the goal of national price stability. Second, free capital movement across the border encouraging a shift to fixed exchange rates culminating in the creation of EU and China’s pegging the currency to USD: the goal of exchange rate stability. Third, deregulations in the banking and financial system to promote competition allowing banks both to diversify into new products and regions and to expand in size, with the aim of binging stability to a banking system: the goal of financial stability.

The author assesses that these three experiments resulted in the Good, the Bad, and the Ugly.The Good came as the Great Stability. Monetary policy around the world changed radically. Inflation targeting and central bank independence spread to more than thirty countries. And there were significant changes in the dynamics of inflation, which on average became markedly lower, less variable and less persistent. The Bad came as the rise of debt levels. Eliminating exchange rate flexibility in Europe and emerging markets led to growing trade surpluses and deficits. Some countries saved a great deal while others had to borrow to finance their external deficit. As the willingness of the former to save outweighed the willingness of the latter to spend, long-term interest rates in the integrated world capital market began to fall with the effect of rise in the prices of assets across the board. As the values of assets increased, so did the amounts that had to be borrowed. Lastly, the Ugly came as the development of an extremely fragile banking system. Banks diversified and expanded rapidly after deregulation. In continental Europe, so-called universal banks had long been the norm. The assets of large international banks doubled in the five years before 2008. Trading of new and highly complex financial products among banks meant that they became so closely interconnected that a problem in one world spread rapidly to others, magnifying rather than spreading risk. With that rose leverage to extraordinary levels.

The author concludes that by 2008, the Ugly led the Bad to overwhelm the Good and the catastrophic events that unfolded from 2007 and on was the failure of all three experiments. Most of all, he identifies the concealed build-up of a major disequilibrium in the composition of spending during greater stability of output and inflation as the most fundamental problem.

By 2008, the Ugly led the Bad to overwhelm the Good. The crisis – one might say catastrophe – of the events that began to unfold under the gaze of a disbelieving world in 2007 was the failure of all three experiments. Greater stability of output and inflation, although desirable in itself, concealed the build-up of a major disequilibrium in the composition of spending. Some countries were saving too little and borrowing too much to be able to sustain their path of spending in the future, while others saved and lent so much that their consumption was pushed below a sustainable path. Total saving in the world was so high that interest rates, after allowing for inflation, fell to levels incompatible in the long run with a profitable growing market economy. Falling interest rates led to rising asset values and increases in the debt taken out against those more valuable assets. Fixed exchange rates exacerbated the burden of the debts, and in Europe the creation of monetary union in 1999 sapped the strength of many of its economies, as they became increasingly uncompetitive. Large, highly leveraged banks proved unstable and were vulnerable to even a modest loss of confidence, resulting in contagion to other banks and the collapse of the system in 2008. – Economic Experiments, Chapter 1. The Good, the Bad and the Ugly, p24-25

A ‘savings glut’, termed by Ben Bernanke, started as Asian economies who had greater wish to save grew and their volume of saving placed in the world capital market rose. The world economy as a whole had an excess of saving as a result, because the desire to spend in most of the advanced economies was not enough to offset. The consequence was firstly, the fall of long term interest rates around the world and the resulting asset price rise, secondly, the rise of the debt in the West, thirdly, the unnatural uphill capital flow from emerging economies where return on investment is higher to advanced economies where return on investment is lower and lastly, misplaced or bad investment across the board. The disequilibrium or the major macroeconomic imbalance was deepened after all. The explosion of bank balance sheet – the ‘banking glut’, termed by Shin HyeunSeung, former BIS economist – added to it, the result was such a severe crisis in 2008.

How significant is the role of the disequilibrium? The author stresses the gradual build-up of this disequilibrium in spending and saving during the Great Stability is what is holding back the demand today. The imbalance in savings and spending between major economies that morphed into the imbalance within economies resulted in low spending that hinders production and growth of the economy.

The factors holding back demand are not just temporary phenomena that will disappear of their own accord but the result of a gradual build-up of a disequilibrium in spending and saving, both within and between countries, which must be corrected before we can return to a strong and sustainable recovery. From its origins in an imbalance between high- and low-saving countries, the disequilibrium has morphed into an internal imbalance of even greater significance between saving and spending within economies. Desired spending is too low to absorb the capacity of our economies to produce goods and services. The result is weak growth and high unemployment(the euro area), falls in productivity growth(US and UK) and potentially large trade surpluses at full employment(Germany, Japan, and China). Policy faces much bigger challenges than responding to temporary shocks to demand; it must move the economy to a new equilibrium. – Disequilibrium in the World Economy, Chapter 1. The Good, the Bad and the Ugly, p45-46

The question of ‘What can go wrong?’ then must have been answered by optimism that the Great Stability could continue indefinitely. Important thing is, despite the stable inflation and output, this imbalance in the form of saving and spending was far from sustainable. The author argues the belief that stability would be sustained indefinitely encouraged people to bring more spending forward from the future to the present because of their assessment of future long-term incomes. So when the crisis hit, they corrected this belief and reduced spending based on their future assessment of bleaker future long-term incomes. What they realised was previous spending was unrealistically too high. This explains a lot for extended, weak spending today and seemingly ineffective policy response to it.

The impact of the crisis was to make debtors and creditors – households, companies and governments – uncomfortably aware that their previous spending paths had been based on unrealistic assessments of future long-term incomes. So they reduced spending. And central banks then had to cut interest rates yet again to bring more spending forward from the future to the present, and to create more money by purchasing large quantities of assets from the private sector – the practice known as QE(quantitative easing). There is in fact nothing unconventional about such a practice – so-called QE was long regarded as a standard tool of monetary policy – but the scale on which it has been implemented is unprecedented. Even so, it has become more and more difficult to persuade households and businesses to bring spending forward once again from an ever bleaker future. After a point, monetary policy confronts diminishing returns. We have reached that point. The ‘headwinds’ that the major economies are facing today are not the result of a temporary downward shock to aggregate demand, but of an underlying weakness caused by the earlier bringing forward of spending. Stagnation has resulted from the realisation that domestic spending before the crisis was too high. … The fact that the recovery is far weaker than we expected, even with the extraordinary monetary stimulus that we have in fact put in place, suggests that something is amiss. We need to tackle the underlying disequilibrium. Easy monetary policy is necessary but is not sufficient for a sustained recovery. – Disequilibrium in the World Economy, Chapter 1. The Good, the Bad and the Ugly, p48

MONEY AND FRAGILE BANKING SYSTEM: ALCHEMY, MONEY CREATION AND BIG BANKS

The author claims the financial crisis of 2007-9 was not the fault of particular individuals or economic policies but, rather, merely the latest manifestation of our collective failure to manage the relationship between finance – the structure of money and banking – and a capitalist system. What peculiar characteristics do we have to see in money and banking system in this regard?

For this, the author starts with a question of ‘What’s money?’ followed by ‘What’ a bank?’ and further develops on how banking has changed from its traditional model to a splendid banking model with its fragility.

What’s Money?: Three Roles of Money

The author defines the role of money in three criteria: Acceptability, Stability, and Trust.

Firstly, money has to be accepted as medium of exchange in good and bad times. While the importance of acceptability in transactions for ‘stuff’ – purchase of goods and services – has been stressed through history, today, its significance is expanded in the acceptability in financial transactions, including the making or repaying of loans, or the buying and selling of financial assets.

Secondly, the value – the purchasing power in terms of goods and services – of money has to be stable. The author illustrates gold and paper money system as examples. Gold, compared to paper money regime, has its own advantage and drawback in this regard. Sharp changes in the balance between the demand for and supply of liquidity can cause havoc in the economy. Due to its limited supply, gold has stable value and doesn’t cause hyper-inflation, but in times of crisis as it cannot create required liquidity, it cause depression as historical cases proved. Paper money, on the other hand, is prone to political motivation of printing money that can also lead to hyper-inflation, but it has advantage in dealing with liquidity freeze in times of crisis. Also, during the Great Stability, paper money regime has shown a stable inflation management.

Lastly, money has to embody trust. The author emphasises that trust is what leads to economic efficiency. Trust in others can make it possible for one party to deliver goods and services to another at one date and receive an agreed delivery of other goods and services at a later date. The role of money is to embody and cement that trust.

What’s a Bank?: Money Creator and Alchemist

The author asserts that, in a crisis, only central bank money has to be the ultimate means of both payment and store of value. Two types of money make a good case for his assertion. Gold is a store of wealth that is universally acceptable as of today, but it is unlikely to regain its position in their acceptability function – payment. Bank deposits, likewise, that function well in normal times as money, may become illiquid as a result of a loss of confidence in their acceptability. This raises an important case for argument. The fact that bank deposits comprise more than ninety percent of money today and they fail to function as money during the crisis throws us the question why and how our system has been built as such, exposing us vulnerable in every crisis.

The author stresses, firstly, that governments allowed the creation of money to become the by-product of the process of credit creation during the twentieth century and, secondly, the fact that most money today is created by private sector institutions – banks – are the most serious fault line in the management of money in our societies today. Also, he argues that it was that ‘financial alchemy’ that led to their downfall. Money and banking proved to be not a form of alchemy, but the Achilles heel of capitalism – a point of weakness that threatens havoc on a scale that drains the life out of a capitalist economy.

What’s financial alchemy? The author defines it as the idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments. This alchemy came into its own with the Industrial Revolution in the eighteenth century but the pursuit of it has brought about a series of economic disasters – from hyperinflations to banking collapses.

To understand how banks functioned as alchemists in the past and is functioning today, we need to look at history of banks. The author illustrates how money and credit system that started from as early as Roman times has evolved into the banking practice – illiquid assets financed by liquid deposits or banknotes – and how money was created by private hands.

As early as Roman times, and despite the prevalence of coins, money and credit existed in the form of loan contracts. Wealthy individuals acted as banks by extending loans, with the bank’s owner often exploiting personal knowledge of his customers, and those claims on the borrowers were used by the owner to make payments because the recipients could in turn pass them on to pay for their own purchases. The claims met the criterion of acceptability. In medieval Europe, banknotes evolved out of promissory notes – pieces of paper issued as receipts for gold bullion deposited with goldsmiths and other merchants. The paper money so created was backed by the bullion held by the goldsmith. The holder of the paper claim knew that at any time it could be exchanged for gold. As it became clear that most notes were not in fact immediately converted into bullion but were kept in circulation to finance transactions, merchants started to issue notes that were backed by assets other than gold, such as the value of loans made by the merchants to their customers. Provided the holders of the paper notes were content to carry on circulating them, the assets backing those notes could themselves be illiquid, that is, not suitable for conversion quickly or reliably into money. From this practice emerged the system of banking we see today – illiquid assets financed by liquid deposits or banknotes. – Chapter 2. Good and Evil: In Money We Trust, p59

What is a bank? What makes banks special? What are the key features that keeps money and banking system the same as it was despite numerous banking collapses through major financial crises? Three features can be noted.

First, bank deposits are protected. The emergence of a central bank to regulate private banks’ issuing banknotes and deposit insurance (FDIC in the US) to protect ordinary depositors that suffer from bank runs or such failures of banking, not only transferred the risk to the taxpayers but also cemented the role of banks as the main creators of money in the form of bank deposits, with banknotes issued solely by government.

Second, banks are the main source of money creation. Banks are at the heart of the alchemy of our financial system. They create deposits as a by-product of making loans to risky borrowers. Those deposits are used as money. Banks are able to transform short-term liabilities into long-term assets; in essence, they borrow short and lend long. They are, therefore, vulnerable to any crisis of confidence, real or imagined. The author claims that the notion banks can offer safe returns on deposits and can be withdrawn at any time is false. However, people’s belief in the alchemy persists despite innumerable banking failures.

What is it that makes banks special? The distinguishing feature of a bank is that its assets are mostly long-term, illiquid and risky, whereas its liabilities are short-term, liquid and perceived as safe. Returns on risky long-term assets are normally much higher than the returns which the bank has to offer on its safe short-term liabilities. So banking is highly profitable. Unfortunately, the notion that a bank can offer safe returns on deposits that can be withdrawn at a moment’s notice by using them to finance long-term illiquid risky investments is, as common sense would suggest, generally false. The transformation of short-term liabilities into long-term assets-borrowing short to lend long-is known as maturity transformation. And the creation of deposits, which are regarded by the depositors as safe, into loans which, by their nature, are inherently risky constitutes risk transformation. Banks combine maturity and risk transformation. This is what makes them special. Moreover, when a bank makes a loan, it creates a deposit of equal value in the account of the borrower. That deposit can be withdrawn on demand and used to make payments. It is money. As explained in Chapter 2, most money today comprises bank deposits. – What is a Bank?, Chapter 3. Innocence Lost: Alchemy and Banking, p104

Third, banking is at the heart of the ‘payments system’. Without a banking system our economy would grind to a halt with people unable to receive wages and salaries, pay bills, services loans and make other transactions. Because of its critical role in the infrastructure of the economy, markets correctly believed that no government could let a bank fail, since that would cause immense disruption to everyone’s ability to make and receive payments.

The belief that they are too important to fail and will be guaranteed by governments and taxpayers at any event brought a moral hazard and made banks freely extend their risk takings and that continues till today. Along with the deregulation in 1980s, the extent was further deepened.

Big Banks: Deregulations, Derivatives and Fragility

Along with banks’ ride on implicit public subsidy stated as above, a combination of deregulation and derivatives brought about two features: exploded balance sheet in financial sector and banks’ change of focus into trading from making loans.

Whereas traditional lending is limited by the amount of business and households’ borrowing, newly invented complex financial products such as derivatives didn’t have limit on the size of the transactions, resulting in the size of the balance sheets exploded in unprecedented level without proper measure to calculate the size nor regulate it. Also, the emergence of universal banks made growing the size of the bank as ultimate objective and the size provided an incentive to borrow more at a cheaper funding such as wholesale funding with even shorter terms creating an even higher mismatch between shorter term funding at liability side and longer term risky investments at assets side.

A massive expansion of trading in new and complex financial instruments among big banks deepened interconnectedness in the banking sector with ever higher leverage level. With a growing proportion of bank activity deriving from the trading of complex instruments, it was difficult to work out how big the risks actually were. Also, not enough resources were devoted to assessing the riskiness of the balance sheet as a whole.

What made the financial system so fragile after all? The deepened interconnectedness in the financial system made it vulnerable to any problems that arise playing havoc with services vital to the operation of the economy – the payments system, the role of money and the provision of working capital to industry. The belief in the financial alchemy, moral hazards based on implicit public subsidy and lastly, untamed risk-taking and expansion all made the financial system fragile that’s vulnerable to a crisis.

RADICAL UNCERTAINTY: A COPING STRATEGY

Optimising Model versus Coping Strategy

Are we really capable of expecting the unexpected? How do we understand the uncertainty of unknown future? The author addresses the limitations of modern macroeconomics for their attempt to calculate unknown uncertainty in mathematical certainty of known probabilities, as Long Term Capital Management(LTCM)’s failure proves. Borrowing the American economist Frank Knight’s distinction between risk and uncertainty, the author emphasises that uncertainty, in contrast to risks, concerns events where it is not possible to define, or even imagine, all possible future outcomes, and to which probabilities cannot therefore be assigned.

In a world of pure risk where possible future events are listed and probabilities attached to them, the traditional stance, especially by neoclassic economics, on rational behaviour is ‘optimising’ model. Individuals evaluate each possible future outcome, calculate and choose their actions to reach the highest level of ‘expected utility’.

In a world of radical uncertainty, however, it is not only possible to compute the ‘expected utility’ of an action but also there is no such thing as optimising behaviour. The author quotes John Maynard Keynes who was convinced that radical uncertainty was the driving force behind the behaviour of a capitalist economy: ‘About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.’

Then how do people behave under radical uncertainty? If people don’t behave rationally as in the optimisation model, do they behave irrationally as behavioural economics claim? The author presents a ‘coping strategy’ as a new model that can replace these two explanations and emphasises that people are not irrational but make a rational choice in trying to cope with the new environment – i.e. the radical uncertainty. He adds that emotions help us to cope with an unknowable future and should not be seen as ‘irrational’.

The language of optimisation is seductive. But humans do not optimise; they cope. They respond and adapt to new surroundings, new stimuli and new challenges. The concept of coping behaviour does not, however, mean that people are irrational. On the contrary, coping is an entirely rational response to the recognition that the world is uncertain. There is no need to abandon the conventional assumptions of economists that people prefer more consumption, or profit, to less, and that their choices display a degree of consistency. The strength of economics as a social science is the belief that people will attempt to behave rationally. The challenge is to work out how a rational person might cope with radical uncertainty. People aren’t dumb. It is just that in a world of radical uncertainty even smart people do not find it easy to know what it means to behave in a smart manner. – Coping Strategies As Rational Behaviour under Uncertainty, Chapter 4. Radical Uncertainty: The Purpose of Financial Markets, p131

What does the author mean being ‘rational’ in a world of radical uncertainty in a coping strategy? The author claims that ‘heuristics’ as ‘rules of thumb’ are seen as rational ways to cope with an unknowable future. He defines a heuristic and being rational as below.

A heuristic is a decision rule that deliberately ignores information. It does so not just because humans are not computers, but because it is rational to ignore information when we do not understand how the world works. As is clear from the example of trying to explain and then predict the stock market, getting lost in the thickets of the past conceals the big picture. Ignoring information is rational when it is likely to be of little help in solving the problem we confront-sometimes less is more. Heuristics are not deviations from the true optimal solution but essential parts of a toolkit to cope with the unknown. … Humans are not pre-programmed to solve complex mathematical optimising problems, because it is impossible to know in advance which problems they will need to solve. But they are programmed to learn and to adapt. Coping strategies are the natural, even perhaps genetic response to the need to adapt to an uncertain world. They are, in Gigerenzer’s phrase, ‘ecologically rational’; that is, they are decision processes that are well suited to the environment in which they are used. In that sense, in a world of radical uncertainty they are more rational than the economists’ assumption of optimising behaviour. – Coping Strategies As Rational Behaviour under Uncertainty, Chapter 4. Radical Uncertainty: The Purpose of Financial Markets, p136

Financial Markets and Coping Strategies

How well does the modern macroeconomics explain the unknown future, especially the swings of the market? Are they successful? The answer seems no. The author states that radical uncertainty is the key to understanding not just money and banks but financial markets in general. Also, he considers that coping strategies are especially important in financial markets because these markets are a link between the present and the future.

The author regards two aspects of financial markets as illusions: derivatives and liquidity. On derivatives, he points out that, even if they perform functions of reducing risk if carefully used, the very complexity and obscurity can mislead the unwary into thinking that they are hedging risks while in fact they remain exposed to great uncertainty and huge potential losses in the event of even a small change in underlying asset prices. Also, the belief that financial markets are always liquid is misleading, as can be found from historical cases where market makers altogether disappeared under radical uncertainty. Financial alchemy fails due to the fact that the underlying assets are usually illiquid, and continuing supply of liquid is disrupted in radical uncertainty.

Then how do investors and market participants behave under the radical uncertainty? He argues that investors are simply people trying to cope with an unknowable future and behave, as we all do in such situations, sometimes cautiously sometimes erratically, but always in a fog of uncertainty. And he warns on the belief that uncertainty has been turned into calculable risk.

Under radical uncertainty, investors make judgements, perhaps based on a coping strategy, and with the benefit of hindsight these are sometimes described as ‘mistakes’. But beliefs change, and who is to know which beliefs are correct? The valuations in financial markets are for the moment. They change quickly, and sometimes violently, reflecting uncertain knowledge of the future. Investors are simply people trying to cope with an unknowable future and behave, as we all do in such situations, sometimes cautiously sometimes erratically, but always in a fog of uncertainty. … Finance should support, not overshadow, the real economy. Financial markets can help us to cope with an uncertain future provided we do not succumb to the danger of believing that uncertainty has been turned into calculable risk. Central to a capitalist economy is the fact that the future cannot be seen as a game of chance in which the only source of uncertainty is on which number the wheel of fortune will come to rest. The future is simply unknowable. And in a capitalist economy, money, banking and financial markets are institutions that have evolved to provide a way of coping with an unpredictable future. They are the real-world substitute for the economic theorist’s concept of a grand auction. – The Illusion of Liquidity, Chapter 4. Radical Uncertainty: The Purpose of Financial Markets, p155

(To be continued at Part II)

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