This volume is extremely topical, engaging and entertaining, and is highly pertinent to the Eurozone sovereign credit and banking crisis. The bulk of the book concerns itself with credit bubbles, banking (financial) crises, and the role of the lender of last resort. The sixth edition has been updated to cover the burst of the subprime mortgage credit bubble and subsequent Lehman Brothers implosion, and also some of the developments taking place in Europe (e.g. Greek government debt). When I first read this book (the fourth or fifth edition) around 2000, when the dot-com bubble had burst, I was more interested in the model described in the text explaining how bubbles grow and eventually burst, and the implications for stock markets. Re-read in November 2011, I realise that its focus is much wider.
The authors first explain how manias, panics and crisis start - through pro-cyclical changes in the supply in credit. In short, asset bubbles result from the rapid growth in the supply of credit. A stylised model of credit expansion, speculation (manias), financial distress and panic is presented. Easy credit, fuelled by the apparently easy gains to be had through rising property prices and speculation, fuels the bubbles.
International financial contagion is covered in depth. Aliber makes the case that there is something special about the four waves of crisis in the last 30 years (Latin America in the 1980s, Japan in the late 1980s and early 1990s), South East Asia in the late 1990s and the current US subprime/Lehman andEuropean sovereign credit crisis.) He explores the interactions between these events and the contagion from one country to another. If bubbles appear in multiple countries at the same time, it is highly likely that there are common origins. In fact, the authors major on financial contagion, showing that it nothing new and there have been successive instances of a banking panic spreading from one country to another. In particular, Aliber explores the modern role of large capital flows in triggering expansions in credit supply - the phenomenon of `hot money' sparking a bubble and augmenting economic imbalances and volatility, and comes to the conclusion that these flows are excessive and should be curbed.
How to deal with crises, through a lender of last resort, is the third large block in the book. The authors detail at length how this role has come about, who has performed it different historical situations, whether there should be such a lender (i.e., the risks of moral hazard), and how it should operate. They further extend their analysis, initially from a domestic context to the international arena, and highlight the problems in attempting to ensure global economic and monetary stability. The authors conclude that an international lender of last resort, if it had existed, would not have prevented the current crisis.
The authors rightly point out that an increase in credit supply (say banks more willing to lend) is matched with its concomitant rising demand for credit-linked securities. However, they fail to discuss adequately how this demand increases. Who were the new providers of credit and why were they so keen to lend? Why were they happy to lend to banks (or to buy securities issued by banks)? Why did German investors buy peripheral European government and private mortgage debt? Why was there an appetite for higher-yielding securities? Who wanted to buy the new AAA-rated subprime mortgage-backed paper? And why were China, Japan and other Asian economies buying US treasuries and agency bonds? In fact, I find it a great omission that the book does not cover the accumulation of reserves post Asian crisis. For example, China is only mentioned four times in the index, and only one refers to the accumulation of trade surpluses.
Two final topics I would flag are structure and the final words. The book's structure and editing repeats certain ideas again and again, and occasionally you get full sentences and paragraphs reproduced twice. In the epilogue, Aliber warns that regulatory reform in the US to prevent a repeat of the 2007-08 financial crisis is likely to be ineffective and result in another property-led crisis by 2020. He doesn't go further into examining whether the next financial crisis could happen elsewhere, in a different geography or asset class. This, however, does not detract from the overall quality and message of the book.
I would also recommend reading this book in conjunction with Reinhart and Rogoff's This Time Is Different: Eight Centuries of Financial Folly
(focusing more on the aftermath of crises and on sovereign defaults), and El-Erian's When Markets Collide: Investment Strategies for the Age of Global Economic Change
(majoring in the changes in the global economic and institutional changes and the implications for investors' portfolios).