[This book review appeared in the Summer 2010 issue of The Journal of Social, Political and Economic Studies, pp. 279-282.] 


Book Review 

The Road to Financial Ruin: Warnings, Consequences, Reforms

Henry Kaufman

John Wiley & Sons, 2009 

          Henry Kaufman has so extensive a resume after a lifetime of financial practice and writing that it hardly does him justice simply to mention that he obtained his doctorate in banking and finance from New York University; worked for more than a quarter-century in several top capacities at the Wall Street investment bank Salomon Brothers, Inc.; most recently is the president of his own consulting firm; and writes often for major publications in the United States and Great Britain.

          His book should dispel any notion that “nobody saw the crisis [the world’s recent financial debacle] coming” or failed to warn against it.  Kaufman was one of those who long stood, if you will, in the train’s engine repeatedly telling the engineers that the train was running amok.  His and similar voices were largely ignored in the context of “the uninhibited market can do no wrong” mania that swept the mainstream.  “My warnings went unheeded, as did my recommendations.”  Four early chapters in a section on “Neglected Early Warnings” are in fact reprints of talks Kaufman gave at the annual U. S. Federal Reserve’s Jackson Hole conferences and to other influential audiences in the 1980s pointing to the on-rushing systemic problems.

          A persistent theme in his talks was a call for the creation of both a United States and an international oversight authority to possess comprehensive regulatory jurisdiction over the rapidly changing world of finance.  In his Foreword, Harvard professor Niall Ferguson says “Kaufman regularly voiced his unease about the inadequacy of financial regulation.  As early as 1985 he called for a National Board of Overseers of Financial Institutions and Markets, with a counterpart entity operating at the international level.”

          When we recall how pivotal the violations of trust by the credit rating agencies were to the debacle, we should note that Kaufman was early in noting their conflicts of interest.  He advocated giving the role “of rating the credit of institutions and financial instruments” to the oversight authority, in place of those private agencies.

          Two major themes in his warnings were the growth of huge financial conglomerates and the vast expansion of public and private debt.  He called for separating lending, underwriting and equity investing.  Ferguson says Kaufman “staunchly opposed the repeal of the 1933 Glass-Steagall Act, which had separated commercial and investment banking.” (Contrary to Kaufman’s advice, the Act was repealed in 1999.)  And since the political situation is such that large institutions will not be allowed to fail, there needs to be regulatory “standards that prevent them from moving to the precipice of failure.”  When he looked at the intricate new financial instruments flooding the world market, he warned that regulatory authorities weren’t ready to deal with them effectively. 

          A point that Kaufman makes that has rarely been articulated in the financial literature we have reviewed is that “a serious financial crisis holds the potential of transforming our [the U.S.] society from an imperfect economic democracy into a socialist system.”  Many years ago, this reviewer went to New York University to study under the Austrian economist Ludwig von Mises for precisely this reason: that if there were a recurrence of the Great Depression, capitalism would be struck a mortal blow.  To those such as myself who opposed socialism, this made a solution to the trade cycle imperative for a society that hoped to retain a market economy.

          Kaufman’s analysis of the causes of the current crisis differs very little from the analysis made by many others (and stated at length in our earlier reviews).  This has led us to look for aspects to which he gives particular emphasis.  One of these is the attention he brings to the U. S. monetary authorities’ lack of grasp, going into the crisis, of the deleterious web that had been woven by the changes in the global financial system, which had seen a Gargantuan credit explosion based on securitization, derivatives and conglomerates.  Indeed, he goes so far as to say that “the main failure of the Federal Reserve and others was to fully understand what the implications would be for the financial markets from the structural changes” (emphasis added).  We saw this failure to comprehend the broader picture when a series of stop-gap expedients were resorted to with the successive bailouts in and after the fall of 2008. 

          There has been much criticism of the economic modeling that has played a central role in modern finance, and Kaufman seconds it.  He points out how widely the models are used: “Quantification and modeling have only grown thicker in the economic profession… [and speaks of] economists enamored with their own techniques.”  In most colleges of business, “anything having to do with the qualitative side of business practice – ethics, business culture, history, and the like – was subordinated or eliminated.”  Within the huge financial conglomerates, “senior managers became increasingly dependent on middle managers, many of whom are highly skilled at econometric techniques and motivated to take increasing risks to achieve higher compensation for themselves.”  Among the deficiencies: “The models rely on historical data but fail to take into account the profound impact of structural changes.”  Factors the models can’t quantify include such potentially earth-shaking developments as war, pandemic flu and terrorist attacks.  And he observes that “most models… lose their predictive power during times of financial euphoria or panic.”

          What reforms does Kaufman favor for the financial system?  First, it is worth noting that he admonishes that “there is no quick fix.”  The problems are too numerous for that.  Indeed, he believes the world’s monetary authorities “do not possess a clear vision of how to proceed toward more effective financial supervision.”   What is needed, he thinks, is a “new economic philosopher… with an integrated economic and financial approach.”    He rues the fact that little reform had been accomplished by the time his book went to press. 

          Here are some of his specific proposals:

          .  As we’ve seen, he has long favored the creation of a National Board of Overseers and an international one.  These agencies should, among other things, supervise risk taking, set down uniform minimum capital rules, establish codes of conduct, monitor performance, and rate quality.

          .  He supports nationwide banking.

          .  Deposit insurance, he feels, should cover all deposits without regard to size or number of accounts.

          .  There should be greater transparency about profits and the true financial condition of banks and other institutions.

          .  A financial institution in “weakened” condition should be “resolved… while it still has some tangible net worth.”

          .  Increased regulation should extend to management practices, the declaring of dividends when capital is weak, and the payment of bonuses.

          .  Kaufman strongly supports the Sarbanes-Oxley Act of 2002, passed to correct abuses that were made apparent by the Enron, Tyco, Adelphia, World Com and other scandals.  The Act established a Public Company Accounting Oversight Board and provided for rules about auditor independence, the governance of public corporations, the assessment of internal controls, and strengthened financial disclosure.

          .  It is significant that he is critical of the core of modern accounting – the GAAP and GAAS rules[1] – as not giving “an accurate picture of an institution’s true profits and financial situation.” 

          .  We saw earlier that he thinks the Federal Reserve’s failure to grasp the intricacies of the rapidly changing financial system was “the main failure.”  We see the enormity of the responsibility he assigns to the Fed when he adds that “the Fed has not responded with alacrity by tightening policy [after a credit expansion].  In the long run, this failure is perhaps more dangerous to the long-term well-being of our economy than any of the private sector financial malpractices…” [emphasis added].  When we consider the extent of those malpractices, this is saying a lot.

          These reforms are all premised on an overall acceptance of the global financial system that has come into being, subject to important prescriptions about how it should be regulated.  Kaufman favors “globalization.”  He doesn’t seem to sense the vital issues of American deindustrialization, the displacement of labor, and the long-term social, political and economic effects of an increasingly automated technology.  This means he isn’t “the new economic philosopher” who he says is needed.  But, taken within what are nevertheless its own rather broad confines, his book is a valuable contribution to the literature. 

                                                                                                                                                                                            Dwight D. Murphey


[1]   “GAAP” is the acronym for “Generally Accepted Accounting Principles” and “GAAS” stands for “Generally Accepted Auditing Standards.”