CFA Institute

Modern Financial Macroeconomics: Panics, Crashes, and Crises by Todd A. KnoopReview by: Martin S. FridsonFinancial Analysts Journal, Vol. 65, No. 2 (Mar. - Apr., 2009), pp. 85-86Published by: CFA InstituteStable URL: http://www.jstor.org/stable/40390355 .

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Martin S. Fridson, CFA Editor For more critiques of books that are relevant to practitioner work, please visit our Book Review service at www.cfapubs.org.

Modern Financial Macroeconomics: Panics, Crashes, and Crises. 2008. By Todd A. Knoop. Blackwell Publishing, (877) 762-2974, www.blackwellpublishing.com. 288 pages, $84.95.

Reviewed by Martin S. Fridson, CFA.

Identifying the sources of cyclical downturns and ultimately learning how to mitigate them are key aspirations of economists. To individuals reared on popular perceptions of the Great Depression, stock market excesses figure prominently in the debate. Most major schools of economics, however, stead- fastly refuse to consider the independent role of financial markets.

Classical and neoclassical models, for example, assume that by cutting interest rates, central bank- ers can always induce lenders to resume lending and thereby jump-start a recovery. In reality, reces- sions cause lenders to focus acutely on the risk of not getting repaid. They know that they are at an informational disadvantage vis-à-vis loan appli- cants regarding the applicants' creditworthiness and that the riskiest borrowers are the ones most likely to seek loans. Consequently, opening the credit spigot often fails to provide the stimulus that policymakers expect.

Author Todd A. Knoop of Modern Financial Macroeconomics: Panics, Crashes, and Crises points out that the founder of another major school of econom- ics, John Maynard Keynes, linked speculative excesses to swings in investment and, ultimately, the production of goods and services. Knoop, a Cornell College economist, notes, however, that the Keynesians did not follow Keynes in this respect. They emphasized consumption volatility over investment volatility. The Keynesians' chief oppo- nents of the 1950s and 1960s, the Monetarists, simi- larly minimized the role of imperfect financial intermediation in producing economic shocks. They blamed, instead, inept central bankers.

Martin S. Fridson, CFA, is CEO of Fridson Investment Advisors, New York City.

Knoop deftly details how the models that give short shrift to financial systems fail to explain eco- nomic fluctuations as a function of the traditional channels of monetary transmission - interest rates, exchange rates, and the wealth effect.1 For instance, the U.S. Federal Reserve Board controls only the overnight lending rate, yet long-term interest rates are what truly determine the financing costs of investment and consumption. Furthermore, numer- ous studies have found little correlation between interest rates and levels of investment - especially fixed business investment. Neither has empirical evidence emerged that monetary policy creates wealth effects large enough to influence real eco- nomic activity materially nor has research shown that exchange rates, given that international trade represents a small portion of GDP in the United States and other large economies, play more than a minor role. Despite this sorry record for traditional monetary mechanisms in influencing the economy, Knoop notes that they "are so widely accepted among economists, the public, and the media as to be almost accepted as law."

In light of such pervasive misapprehensions, investors would do well to familiarize themselves with New Institutional Economics (as a part of New Institutional Theory), which is finally giving financial markets their due. These modes of eco- nomic thought focus on balance sheet channels of monetary transmission: Monetary policy affects borrowers' and lenders' financial conditions, which, in turn, influences default risk, thereby causing financial intermediaries to increase or decrease their activity - and that is what produces swings in aggregate output.

Knoop expertly applies New Institutional Economics analysis to such topics as the Basel Accord of 1988, the Asian Financial Crisis of 1997, the 2007 credit crunch, and the operations of the International Monetary Fund. He meticulously documents his arguments with recent research that challenges conventional wisdom across a broad front. (Too bad for ideologues for whom it is an article of faith that the Smoot-Hawley tariff triggered the Great Depression!)

"Book Reviews" is a regular feature of the Financial Analysts Journal. The views expressed herein reflect those of the reviewer and do not represent the official views of the FAJ or CFA Institute.

March/April 2009 www.cfapubs.org 85

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Financial Analysts Journal

Considering the book's important insights, it is regrettable that the publisher did not take time to edit it more carefully. The author mischaracterizes the infamous Dutch "tulip mania" by stating that prices soared on the flowers themselves rather than on bulbs. The bulbs, in fact, had considerable value by virtue of their ability to propagate exotic variet- ies. Knoop also incorrectly credits economist Irving Fisher (1867-1947) with the invention of the rotary card file known by the trademark Rolodex. It was actually invented more than a decade after his death by Arnold Neustadter, although Fisher became wealthy by patenting a forerunner device in 1912.

Misspellings risk undercutting the text's credi- bility (e.g., "Paul Volker" for "Paul Volcker," the "Glass-Stegal Act," and "Arthur Anderson" for "Arthur Andersen"). Other stylistic flaws include redundant phrasing ("help facilitate," "new innova-

tions"), together with numerous subject-verb dis- agreements ("legal systems that protects") and antecedent-appositive conflicts (the plural pronoun "they" referring to singular nouns, such as "central bank" and "the public").

One hopes that most readers will fight their way through such imperfections. We are not overstating the case to assert that Modern Financial Macroeconom- ics will revolutionize the thinking of readers condi- tioned to view business cycles through the lens provided by Wall Street economists, politicians, and the financial media. Knoop and the New Institu- tional economists make a compelling case that the TV talking heads who agonize over the Fed's next move on interest rates are missing the point.

- M.S.F.

Notes 1 . The wealth effect is the tendency of consumers to feel richer

when the prices of such assets as stocks and real estate rise and, therefore, to step up spending in response to such rises.

Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently. 2007. By Riccardo Rebonato. Princeton University Press, +1 (609) 258-4900, www.press.princeton.edu. 272 pages, $35.00.

Reviewed by James Jackson.

In his preface, Riccardo Rebonato states, "financial risk management is in a state of confusion." He expands this assertion by noting that managers spend too much time measuring risk and develop- ing risk metrics and not enough time making actual decisions based on the results of the risk models.

In response to this situation, Rebonato has developed what he considers a radical critique of risk management methodology. In Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently, Rebonato analyzes and offers solutions to problems related to quantitative risk management strategies and the value-at-risk (VAR) methodology currently used by financial managers. Through stories, examples, theory, and practical methods, he first provides a critical review of the current state of affairs in investment risk management. Then, he proposes how we

James Jackson is a lecturer of finance at the University of Illinois at Urbana-Champaign.

should "revisit our ideas about probability in financial risk management" and "put decision making back at center stage."

Plight of the Fortune Tellers is logically organized by themes into three main segments: the history of quantitative decision making and risk measure- ment, a critique of current VAR methods and the decision-making process, and suggestions for investment managers and market regulators about how to improve the risk management process.

To begin, Rebonato provides a brief history of the development of risk measurement techniques that is reminiscent of Peter Bernstein's book Against the Gods: The Remarkable Story of Risk (1996, reviewed in the March/ April 1997 FAJ). He reminds readers of the work of Daniel Bernoulli and Thomas Bayes and the success of such researchers as Harry Markowitz in developing decision-making tech- niques in a world of uncertainty. He points out, however, that much of the research developed in the last half-century or so seems to have been lost on practitioners in the present quantitative world of risk management.

With this problem acknowledged and using his risk management proposals, Rebonato presents theoretical and practical suggestions to improve the decision-making process in risk management on the basis of the simple, but sometimes over- looked, concept of expected return as measured by a combination of risk, return, and probability.

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