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Triumph of hope over experience

The rupture of a market bubble is one of history’s most brutal financial calamities. But the avalanche of its explanation betrays a deep ignorance. 

For example, the banks’ ‘heads I win, tails you lose’ compensation system has been widely cited as the root cause of the 2008 crisis. If only the truth were that simple. 

We ignore the forces that have shaped our world because they cannot be easily pigeon-holed or converted into instant sound bites in today’s 24-hour news cycle. 

“One lesson we learn from history is that we do not learn from history,” observed the Irish playwright George Bernard Shaw.  

For evidence, look no further than this well-researched book. Its painstaking analysis of crises that have roiled investors since modern banking took its earliest form in the Roman Empire makes salutary reading.  

In lucid prose with rich metaphors, Swarup reminds us that financial crises are for us today what natural disasters were for our ancestors. They are endemic to today’s turbo-charged capitalism, rearing their ugly heads on average once every 10 years over the past 400 years in Western Europe alone. 

Their root cause is the instinctive side of human nature. Our rationality does not have an independent identity of its own. It is influenced by experience, emotions and environments that prompt shortcuts that allow us to make quick decisions. But they also foster behavioural biases that fuel a crisis. 

More importantly, these biases are Janus-faced – yes, they promote herd instinct, irrational exuberance and greed, but on the flip side, throughout history, human progress has relied on our capacity for trial and error. 

Speculation may be bad, but giant strides have often resulted from imprudent risks. Millions lost billions in the dot.com bubble. But it also spawned the rise of the internet. This binary view of crises is one of the many insights offered by the book. 

Swarup weaves a colourful tapestry by taking a broad sweep of history and tracing the origin of debt back to the rise of the Roman Empire. Modern banking, as we know it, was born at the start of the first millennium when concepts such as fractional reserve banking, current and deposit accounts flourished to promote growth and sustain the Roman hegemony. 

But the system’s virtues became vices when debt exploded under irrational exuberance and successive emperors were obliged to debase the currency. As in all walks of life, success invited hubris, hubris invited nemesis and the Empire became history.  

Various cognitive biases were at the root of this chain reaction. They were virtues when they helped to promote growth and pioneer new advances. They turned into vices when used in excess in pursuit of greed and fame. They sparked financial contagion and strained societies. As the author observes: “Like sand dunes, our underlying foundations change with the changing winds” (page 67). 

In order to cope with this dynamic world, Swarup offers many recommendations. In my view, the key ones are that we need to counterbalance our instinctive biases in a way that does not limit their benefits and that we need to ensure that regulation does not fight complexity with more complexity.

The book is directed at general readers, so it offers few cautionary words for pension investors. But these are not hard to infer, given its clear-eyed view.

First, the whole investing edifice is based on animal instinct. Standing out from the crowd is often the precursor to being right. Buy-and-hold investing may be no different from buy-and-pray investing. Financial economics is an idea with a great future behind it. 

Second, common sense has to be your best guide. The modern financial system is as stable as an inverted pyramid. It rests on the crutches of excess liquidity from central banks. It is fiendishly complex. The corridors of power are no more than corridors of impotence. Few central banks know what risks are being stoked up by today’s real low yield. Excess liquidity has seeped into cracks they don’t know about. 

Third, don’t believe that regulators will prevent future crises. Regulators are rigorous mostly about the wrong things. After a crisis, they appear to learn a lot in the short term, something in the medium term and nothing in the long term. This book deserves to be read by pension funds. It paints a startling picture of what they are up against when delivering decent retirement pensions.

Prof Amin Rajan is CEO of CREATE-Research

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