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HOW MARKETS FAIL: THE LOGIC OF ECONOMIC CALAMITIES
John Cassidy, 2009, Farrar, Strauss and Giroux, New York, USA, pp. 390
Review*
How Markets Fail, by John Cassidy, is another in a run of books that feed off the corpse of neoliberalism. It is inspired by events pertaining to the current financial crisis. But this book is not just about finance, it also provides a rough overview of trends in the field of economics before concentrating on the theory of finance and on the current financial crisis. The book is divided into three parts – utopian economics or “bad” economics, reality-based or “good” economics and current crisis overview. One drawback of this book is this black and white division of economics, especially since a number of chapters are devoted to a specific economist. Thus, one might infer that this book also provides a list of “good” and “bad” economists. However, a thorough reading shows that the author praises the achievements of a number of “utopians”, including Friedrich August von Hayek. This book is not a tombstone to free markets; it just wants to show that we do not need free markets all the time and in every situation.
In the first part, the author discusses the historical development and rise of utopian economics, a type of economics that works well in theory but somehow fails to perform once put into practice. Cassidy equates utopian economics with self-regulating markets or the free market economy. It is not that this is the only type of utopian economics, but this particular type is the main subject of analysis.
The origins of the free market economy are in the work of Adam Smith. Smith believed that the invisible hand of the market can transform individuals’ selfish acts into socially desirable outcomes. All the state needed to do was to let the markets work its magic, and a few other things. It is well known that Smith did not believe that national defense, the enforcement of laws and public works should be left to the market. But what is less well known is that Smith also did not really trust financial markets and believed the state should actively try to minimize periods of financial hysteria and depression. Therefore, it seems the idea of self-regulating financial markets is of a newer date and cannot be traced back to good old Smith.
* Received: October 26, 2010 Accepted: October 30, 2010
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One of the economists who took Adam Smith’s idea of an invisible hand too far is Friedrich August von Hayek. Hayek was considered more of a political theorist of liber- tarianism than a fully fledged economist. His major contribution to economic theory is that people use market prices to convey information. Now, the information is fragmen- ted (I may know something while others know something else) and the state might have the most information but it cannot have all the information. Therefore, Hayek concluded, the state cannot set prices. Setting wrong prices sends people wrong messages that dis- tort their behavior. But, how do we know that the prices in a free market system send the “right” signals?
Hayek was more of a philosopher than a mathematician and providing the mathematical evidence that market gets prices right was started by Leon Walras and Vilfredo Pareto in the late 19th^ century. But the final touch was provided by Kenneth Arrow and Gerard Debreu much later. Arrow put forward two fundamental theorems of welfare economics. First, all competitive equilibriums are Pareto-efficient. Simply put, this was mathematical proof of the invisible hand. The second theorem deals with equity since some equilibriums involve higher inequalities than others. Arrow managed to prove that government, as long as it performs redistribution in an appropriate manner, can select the most socially desirable Pareto-efficient state and the market will generate the prices needed to support such a state. Interestingly, even though Arrow’s theoretical work was a gospel of free market economics, when he offered policy advice it was mostly interventionist. After constructing his general equilibrium theory, in which prices reflect economic fundamentals in all markets, Arrow moved to explain why economies are not in a state of general equilibrium. The problem of general equilibrium theory is that it has some constraining and unrealistic assumption, like no economies of scale. An even bigger problem is when the economy is struck by an exogenous shock, e.g. September 11th^ or the creation of OPEC and a sudden rise in oil prices. A number of authors proved that in such a scenario, actors following conditions specified in general equilibrium theory can react in a bizarre way. Interestingly, one of these authors was Gerard Debreu himself.
The main populizer of the idea of free markets was Milton Freedman, who used a cunning way to connect his case with American tradition of individualism. Freedman claimed that economic freedoms were necessary to maintain political freedoms, thus connecting deregulation and privatization with fighting communism. Simply put, to further his cause, Freedman used language that the American people could understand and would accept.
The self-regulating market theory in finance is called efficient market theory, which claims that prices in the financial markets are tied to economic fundamentals (e.g., cor- porate profits). In other words, financial markets get prices right. This argument stems from the simple observation that movement of stock prices is difficult to predict. But, the jump from a well grounded claim that the prediction of future prices is difficult to clai- ming these prices must be right extremely dubious. In fact, there is some predictability in the movement of stock prices. More importantly, Gene Grossman and Joseph Stiglitz showed a logical inconsistency in efficient markets theory. Efficient market theory cla- ims that every new piece of information will automatically translate itself into prices. Yet, if this were to be true, Grossman and Stiglitz argued, there would be no incentive for in-
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about its merits, because it is better to fail “conventionally” than “unconventionally”. Furthermore, markets can lead investors to forget about fundamentals. In presence of noise traders, who concentrate on irrelevant information, it makes sense for sophisticated traders, who base their decisions on the fundamentals, to keep the prices rising because noise traders will just keep buying these shares, thus creating a bubble.
Research in psychology has put a serious question mark on investors’ ability to con- centrate on the long-term fundamentals. For instance, Daniel Kahneman and Amos Tver- sky showed that when outcomes are uncertain, people do not rationalize but instead use the rule of thumb. These mental shortcuts include a tendency to generalize on the basis of insufficient evidence (e.g., using small and unrepresentative samples), putting too much weight in one’s own experience and a general inclination to judge things relative to arbi- trary reference points. For instance, in the current debate on the success or failure of Pre- sident Obama’s economic recovery plan, pro-market economists argue that it failed be- cause state intervention is always bound to fail, while the Keynesians argue that it failed because state intervention in the economy was not strong enough.
Still, probably the most devastating critic of efficient market theory was put forward by Hyman Minsky. Minsky argued that peoples’ risk preferences depend on the overall state of the economy. Therefore, during good times, investors tend to be overly brave, taking more and more leverage and making even riskier investments. The end result is a bubble. But, when the bubble bursts, investors become overly cautious, avoiding even good investment options and thus leading the economy into depression. In a nutshell, free market economy’s natural path is from euphoria to depression and then back to euphoria. Capitalism is, thus, inherently unstable, argues Minsky, and the government’s job is to control the cycles of euphoria and depression.
Part three, consisting of seven chapters, is entirely devoted to explaining the causes and events leading to the current financial crisis. Charles Kindelberger argued that every bubble has five stages. It starts with some sort of displacement, in this case drastic reduction in interest rates, which creates a boom. Boom evolves into euphoria and after reaching a peak, the bubble goes bust. But, what made the current financial and property bubble different from previous ones was its geographic spread. While previous bubbles were geographically concentrated, this one was very widely disseminated. On the other hand, what it had in common with previous bubbles was policy-makers being blinded by an illusion of stability; financial innovations, which made speculation easier; and New Era thinking, characterized by overconfidence and disaster myopia.
Fed chairman Alan Greenspan kept interest rates too low for too long because of his belief in the new financial products’ ability to diversify and minimize risk. But these new financial products also distorted incentives for the banks. For instance, securitization of bank debt allowed banks to transfer the risk of bad loans to investors who bought these securities. By doing this, the system created incentives for the banks to give out bad loans. Instead of rewarding prudence, markets began rewarding excessive risk.
Still, if the Fed did a lousy job in the events leading to the crisis, it did an even worse job after the crisis erupted. The main blunder that both Ben Bernanke, the new Fed chairman, and Henry Paulson, Treasury Secretary, shared was their belief that markets
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would somehow correct themselves. Thus, after bailing out Bear Stearns, they let Lehman Brothers crumble in an attempt to send a message to the market that imprudent behavior will not be tolerated. Yet, this decision proved to be catastrophic because it caused panic on the financial markets. Luckily, their commitment to free markets lasted for less than 48 hours, when they bailed out AIG, America’s largest insurer.
In conclusion, John Cassidy argues that current financial crisis was created by utopian economics and its belief that markets are always right. Quite on the contrary, we need to change our understanding of economics and accept that markets are a useful tool but with some important shortcomings, and this is precisely the job of reality-based economics. Unfortunately, it seems that little improvement has been made. The recent struggle to introduce universal and mandatory health care system in the United States showed that people still believe that there is only a choice between liberty (self-regulating markets) and socialism (state intervention). Furthermore, President Obama’s plan does not go far enough in changing the system; it seems more a re-modification of the present system. And John Cassidy firmly believes that the main cause of this crisis was not “bad” bankers but a “bad” system, which distorted incentives and rewarded excessive risk taking over prudence.
Ivan Grgurić
