Today I had a delightful lunch with an old friend with whom I chatted about the Scottish Enlightenment, amongst other things, and in particular what big fans we both are of David Hume. Adam Smith owed a great intellectual debt to Hume, as Nicholas Phillipson's recent biography Adam Smith: An Enlightened Life (reviewed by me in the New Statesman) makes clear. Not all that many people realise that Hume did write about economics. When I got back to my desk I looked up his classic essay 'Of the Balance of Trade' from Essays Moral, Political and Literary of 1752. This is the essay that sets out the famous price-specie flow mechanism. Hume was the first to point out that capital and current accounts have to balance, ex post. He wrote:

“There still prevails, even in nations well acquainted with commerce, a strong jealousy with regard to the balance of trade, and a fear that all their gold and silver may be leaving them….. I should as soon dread that all our springs and rivers should be exhausted, as that money should abandon a kingdom where there are people and industry.”

He goes on to point out the equilibrating adjustments to monetary shocks that occur via the exchange rate and discusses the adverse effects of accumulating reserves and trying to prevent the addition to the money supply from affecting prices. He would be unimpressed with China's exchange rate policy, but equally unimpressed by concern about US sales of financial assets to foreigners. For as the essay concludes:

“A government has great reason to preserve with care its people and its manufactures. Its money, it may safely trust to the course of human affairs, without fear or jealousy. Of it it ever give attention to this latter circumstance, it ought only to be so far as it affects the former.”

I think one has to describe Hume as a monetarist with a Keynesian heart.

You might think I should really get a life, but I've spent part of this Sunday afternoon reading the December 2010 Financial Stability Report from the Bank of England. This is not the world's most exciting or raciest document but it's not just one for finance nerds either.

To give just one example as we head into bank bonus season, chart 5.9 on page 52 tells me that the four major UK banks received a subsidy amounting to £100bn in 2009 from access to cheap funds via the Bank of England. Chart 4.3 on page 38 tells me that their profits in that year were £40bn and 2010 profits are likely to be a little higher. The Bank's Special Liquidity Scheme, providing cheap funding, continues until January 2012. Looking at these two charts, I ask myself where the profits which are supposed to justify a return to bonuses actually come from?

I just devoured the UK paperback edition of The Big Short, which author Michael Lewis has been here publicising this past week. It's one of the popular classics of the Great Crash, managing to be both a page turner and a clear explanation of the financial instruments at the heart of the financial meltdown. (Having said that, every time I thought I'd understood the CDOs and CDSs, I forgot, and had to go back and remind myself. In the end Lewis's phrase 'pile of shit' seemed a perfectly adequate synonym.)

Lewis is a terrific story teller, and he recounts the origins and unfolding of the sub-prime crisis through interwoven stories about a handful of characters who were amongst the only investors to foresee the crash. Hence they shorted the financial derivatives on sub-prime mortgages – the infamous CDOs, sometimes using the CDSs which were bets on them. Intriguingly, all turn out to be in various ways misfits, loners or eccentrics. It took a distinctive character to stand against the crowd – Lewis successfully brings these people to life. As for the crowd, the Goldmans, Bear Stearns etc traders and bosses, they made the sub-prime derivatives complex to fool their clients and ended up fooling themselves. Once they kept some of them on their own books rather than shuffling all of it onto AIG and the like, disaster was only a matter of time.

Once the sub-prime market got going, after 2005, almost all the mortgages originated were bound to go belly up. In 2005 alone, half a trillion dollars worth of mortgages were extended to non-creditworthy borrowers; the figures got bigger in successive years. There was no way loans on this scale could be repaid by low income borrowers. Nevertheless, the Wall Street machine wanted the mortgages created because the margins from fees on the bonds and derivatives spun on top of them were so juicy.

But throughout the second half of the noughties, the rising incidence of default and fraud was clear in the statistics. Wall Street managed to ignore the implications because the ratings agencies meekly rated almost all the CDOs as triple-A, even those which were created out of the riskier tranches of previous CDOs. The eagerness of investment banks to screw their clients, and the inadequacy of the ratings agencies are two key elements in this story, along with the denseness of a few individuals who just did not understand the risk they were taking. (This includes the CEOs of the investment banks.)

Lewis is also very clear about the wider purpose of the sub-prime machine, to allow poor people to spend as if they were rich, and paper over the yawning inequality in the United States. In this he agrees with Raghuram Rajan's Fault Lines. While more than 2 million people lost their homes, the losers on Wall Street walked away with millions or tens of millions in payoffs. Equally, he points out forcefully that Goldman Sachs managed to transfer around $20bn directly from the taxpayer (bailing out AIG) to itself at the height of the crisis, and suffered hardly at all for its own greed and misjudgement. In this he echoes Matt Taibi's Griftopia (Taibi has a detailed account of the negotiations between Goldmans and the authorities at the time).

So The Big Short joins my list of gripping and accessible reads about the crisis – along with Whoops! by John Lanchester as well. The behaviour of the Wall Streeters defies belief in retrospect – as does their continuing insistence that they can go back now to business as normal. I think not.

The terrific David Levine – game theorist and expert on intellectual property issues –  is publishing on his website under a Creative Commons Licence, a new book, Is Behavioural Economics Doomed? He writes:

“Those who have read
about –
and who has not? – the current economic crisis may wonder just how
rational economic man or woman is. Behavioral economics has become the
modern rage. So is rational economic man – homo economicus –  dead? Has
the economics profession moved on to recognize the true irrationality
of humankind? Read on.“

The intro and chapter one are currently available. The whole book will be published by Open Book Publishers, about whom I've blogged in the past. Chapter One is an exploration of what 'homo economicus' actually means. Behavioural economics makes much of experimental results that seem to overturn what conventional economics assumes by way of human behaviour. Levine describes the equally prevalent experimental results which uphold the conventional approach, and concludes:

“[C]ompetitive equilibrium predicts the outcome of market experiments with a high degree of accuracy, with experimental markets converging quickly to approximately the competitive price.”

One of my old colleagues, and one of the UK's most experienced financial journalists, Robert Cole, has just published a handy pocket-sized book stuffed with advice about investment that's both sensible and amusing: The Unwritten Laws of Finance and Investment. A rare combination in this genre.

Some of the headings offer basic economic insights, including “There's no such thing as a free lunch.” Some draw on findings from behavioural finance, such as the warning not to be tempted by gimmicky offers such as free air miles – which of us has not fallen for buying an extra pot of face cream to get the 'free gift' of samples, or bought a bar of chocolate at the till for £1 when we went into the store for a magazine?

The book's the ideal length for a tube journey and filled with common sense cover to cover. I'd pair it with John Kay's 2009 book, The Long and the Short of It. One gives the general principles in a completely painless way, the other more detail on how to. Between them, they provide a realistic and thorough guide to investment for non-experts.