Publication: Cato Journal
Author: Horwitz, Steven
Date published: April 1, 2011
Language: English
PMID: 17788
ISSN: 02733072
Journal code: CTJ

Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System Kevin Dowd and Martin Hutchinson Chichester, United Kingdom: Wiley, 2010, 432 pp.

The combination of the recession and financial crisis of the last few years has led to quite the outpouring of books by economists purporting to explain what happened and why, and how to avoid a repeat performance. This very crowded field has seen a range of quality, but a good number of these books have been quite well done. Alchemists of Loss by Great Britain's Kevin Dowd and Martin Hutchinson is another very good treatment of the issues. The authors bring a wealth of experience to their book. Dowd has had a long career as an academic, with much of his work focusing on the history and theory of "free banking" and other forms of financial deregulation. Hutchinson is a longtime financial journalist and has worked in the merchant and investment banking industries in Britain. They have written a comprehensive, fairly detailed, and surprisingly entertaining account of the historical context, theoretical framework, and actual events of the crisis.

At over 400 pages, the book is divided into six sections. In section one, the authors examine the history of "pre-modern" finance and prior crises, and in section two they move to a discussion of "modern financial theory." The third section shows how the theory interacted with the real world over the course of the last few decades, and focuses on the way in which this interaction changed the practice and culture of Wall Street and London. Section four deals with the crisis proper, the Fed's easy money policy, and other government policies-including U.S. housing policy-that affected the financial system. In section five, the authors offer a narrative of the unfolding of the crisis, and in the final section they devote four chapters to reform and policy, with suggestions for basic policy reform and for changes in financial practices. As this brief summary suggests, their coverage is expansive, which is a real strength of this book in contrast to their competition.

Like other books on the financial crisis, this book largely faults government intervention for the crisis. However, the authors' expert knowledge of the workings of the financial industry supports a critical look at the role of key players in that industry as well. Dowd and Hutchinson provide sharp criticisms of modern financial theories (from CapM to the Efficient Markets Hypothesis), present a detailed discussion of the shift to the corporate form and "managerial capitalism" (in contrast to the old partnerships that once dominated finance), and identify a number of shortcomings of the financial industry.

The authors' narrative of the crisis-from the fall in housing prices in 2006 through the stimulus package-is particularly good. The more time that passes, the more historians will be able to identify significant elements of the story and fill in details. Dowd and Hutchinson's narrative improves on previous ones and offers some interesting counterfactuals. For example, they argue that allowing Bear Stearns to fail in March of 2008 would have likely initiated a banking crisis at that time, but a much smaller one than eventually did erupt in September. They also argue that allowing it to fail would have sent a clear message about not bailing out failing banks in the future, which would have forced troubled banks to get their acts together sooner. Dowd and Hutchinson are highly critical of the Bush and Obama administrations for the way they handled the crisis, and Greenspan and Bernanke fare no better. The authors note that at the end of 2008, the Fed's balance sheet was more like that of "an extremely large, highly leveraged hedge fund" than a central bank following the traditional rules of central banking.

Dowd and Hutchinson offer a whole range of reforms for the banking system. They would prefer a world like that of the highly competitive and largely unregulated free banking systems of 19th century Scotland and Canada until the 1930s, both of which were notably free of bank failures and financial crises (and inflation). Recognizing that political reality is unlikely to take us there, they also propose some less radical reforms that could prevent future crises. Those include narrowing the Fed's mandate to a single objective of achieving long-run price stability, decentralizing its powers and moving it out of Washington, increasing liability for corporate officers and changing corporate governance (including ending limited liability for shareholders), eliminating deposit insurance (or at least reducing it to give depositors a real stake in knowing the practices of their banks), ending "too big to fail" and the culture of bailouts, and using a "Tobin tax" on "excessive trading" to reduce the size of large banks.

These are all sensible reform steps, with the possible exception of the Tobin tax proposal. In all of their zeal to place blame on bankers and financiers, Dowd and Hutchinson are too willing to see "bigness" as a problem, regardless of the regulatory structure in place. If the other reforms they propose were made, big banks need not be systemically important-that is, their failure would not pose a risk to the overall financial system. Moreover, one should recall that the United States suffered for more than a century with a banking system that was composed of too many small banks. Regulations prevented interstate branching, and thus did not allow risk diversification, which increased U.S. bank failures during the 1930s.

Although this book has some small flaws-including a tendency to make some sweeping and uncharitable generalizations about the motivations of various actors, and to take a generally bearish view of the future-Alchemists of Loss should take its place as one of the more comprehensive and well-informed books on the financial crisis and how to prevent future crises.

Author affiliation:

Steven Horwitz

St. Lawrence University

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