Why Financial Crises and Crashes Happen.

By Charles R. Morris.

297 pp. New York:

Times Business/Random House. $25.

A CENTRAL question of economics concerns the relationship between what we call the »real economy» and financial markets. The real economy is production, wages, profits, incomes, employment and living standards. Financial markets run the gamut from stocks, bonds and banks to more obscure investment instruments like mortgage-backed securities and options. The two worlds intersect, but until recently the consensus among economists was that financial markets were a sideshow. We could explain economic cycles mainly through shifts in purchasing power, technology and management methods. Well, maybe not.

Almost everywhere you look, financial markets seem crucial to economic fortune and misfortune. Japan’s economic stagnation in the 1990’s is intertwined with a banking crisis that may involve up to $1 trillion in bad loans. Asia’s banking and currency collapses — beginning in mid-1997 — plunged many of the region’s countries into deep slumps from which they are just beginning to recover. On a cheerier note (so far), the United States’ boom has drawn strength from a headstrong stock market that has left people feeling richer and consuming more.

»The financial sector,» Charles R. Morris writes, »is the economy’s plumbing system. A company’s failure, even a big one like I.B.M.’s, is like a broken sink, but a failure in the financial sector threatens the entire water supply.» Just so, and in »Money, Greed, and Risk» Morris seeks to demystify the murky relationship between finance and the real economy. To this task he brings rare qualifications. He’s both a market player and a first-rate writer. In the 1980’s, he advised several LBO funds (for »leveraged buyout,» meaning the funds bought companies with borrowed money). His previous books have covered subjects as varied as American Catholicism and computers.

Finance’s main contribution to economic progress, Morris shows, has been to permit specialization and investment. Money itself (usually precious metals like silver and gold) represented an enormous advance because it liberated people from barter. The creation of »bills of exchange» — used by the 15th-century Italians and further perfected by the 18th-century Dutch — did the same for trade, sparing merchants from carting scarce coin around the world. Trade flourished.

In time, finance underwrote investments — roads, canals, railroads, ships and factories — that could presumably repay the original sums and then some. Accumulated wealth could be employed, not hoarded. At its best, this process confers huge social benefits. Thirty years ago, for example, most home mortgage loans were made by local savings associations and banks. Since then, mortgages have been widely »securitized,» meaning they’re bundled together in bonds and sold to institutional investors (pension funds, insurance companies, investment houses). The investors receive homeowners’ principal and interest payments, a development that has cut interest rates on home loans relative to other investments and saved homeowners billions in monthly payments.

The rub, of course, is that the process doesn’t always work well. Financial markets traffic in risk. Dutch banking houses that issued bills of exchange had to know whether merchants could cover the credits. If too many bills were issued, they might finance a shaky boom that would collapse. Not surprisingly, this happened. Similarly, savings channeled into unproductive investments can create losses for individual investors, and — if the amounts are great enough — destabilize entire economies. The crises in Japan and Asia exemplify this. Banks overlent for unneeded projects, from office buildings to factories. As more borrowers couldn’t repay, lending (and the associated spending and jobs) imploded.

The paradox of finance is that a usually farsighted and constructive process routinely descends into frenzied, shortsighted and self-destructive binges. Greed, fear, hope and ignorance reign. Almost everyone plays for a quick killing — or aims to escape a slaughter. To explain the paradox, Morris argues that finance regularly follows a cycle of »innovation, crisis and consolidation.» Greater trade required paper credits; expanding railroads needed to sell more public stocks and bonds. The financial innovation meets the need, but its novelty also »triggers a period of greatly increased risk and instability, until institutions catch up.»

Up to a point, this is convincing. Financial innovations initially involve huge profits that attract imitators until too many investors are chasing too few good opportunities. Crashes and losses ensue. Sooner or later, institutions adapt. Governments impose regulations, markets evaluate risk better — or both. Morris provides much evidence for his theory, from British bond investments in American railroads in the 19th century to junk bonds in the 1980’s. But in the end, the theory is not completely satisfying. Many financial crises stem from plain old excess. Markets go to extremes. Investors and traders get caught in fits of excitement or gloom. Morris ignores episodes that don’t fit his theory. Except for passing references, for instance, he doesn’t discuss Japan’s banking crisis. After banks overlent, government regulators turned a blind eye to weak loans in the (vain) hope that prosperity would transform bad credits into good.

And while the financial breakdowns that he does explore — from the collapse of the Bank of the United States in the 1830’s to the savings and loan crisis of the 1980’s — are well told, the whole is less than the sum of the parts. What really concerns us is the world’s financial plumbing. Are we dealing only with some leaky faucets? Or is the whole system in jeopardy? Some big crises — take the savings and loan debacle — haven’t derailed prosperity. But there are ominous trends. Financial markets increasingly deal in instruments — options, derivatives — that can confuse even professionals. Moreover, financial markets have gone global. Morris argues that regulation can provide safeguards. Financial institutions can have ample capital to protect against losses; disclosure requirements may prevent some stupid investments. All this is true. But bad regulation also worsened some crises — the S.&L. and Japanese banking meltdowns, for instance.

So, is the plumbing safe? Morris never says. Perhaps no one can.

Robert J. Samuelson, a columnist for Newsweek and The Washington Post Writers Group, is also the author of »The Good Life and Its Discontents: The American Dream in the Age of Entitlement.»