Sunday, January 31, 2010

Cassidy: How Markets Fail

I recently completed How Markets Fail: The Logic of Economic Calamities (2009, 400 p.) by John Cassidy. Last March I recommended Neil Fergusson's The Ascent of Money as the book to read to understand the Great Crash of 2008. Not to take anything away from Fergusson's excellent book, but I now nominate this book for the task.

The crux of Cassidy's argument lies in his distinction between "utopian economics" and "reality-based economics". The Utopians believe strongly in the myth of homo economicus: rational, economic man. Calculating, analyzing, utility maximizing. Based on this model, economics built structures of beautiful mathematical models of how the world works. Some theorists, following the lead of Frederick Hayek, assumed the markets distributed information in the most efficient and rational way. Indeed, in the 1960s and beyond, the idea of "efficient markets" came to the fore, and eventually Allan Greenspan, as head of the Fed, came to think that "the market" would self-correct for anything like greed, myopia, ignorance, and other such imperfections.

It didn't.

Cassidy, after having taken readers through and quick and very informative history of classical and neo-classical economics, and more recent developments in financial theory (once the forgotten relative of economics), then takes us on a history of what he terms "reality-based economics". In this group, we find those who see the imperfections of markets and human behavior, men like Arthur Pigou, John Maynard Keynes, Herbert Simon, and Daniel Kahneman and Amos Tversky. These individuals saw the limits of human behavior, which often proves economically irrational, and the limits of markets, which have their own paradoxes. For instance, Keynes addressed the "rational irrationality" of depressions and recessions. When the economy takes a downturn, people spend less and save more. However, when the economy goes south, someone needs to spend more to get it going again. Hence, for Keynes, we need government spending and intervention. Sound familiar? No wonder Keynes has made a comeback on economics circles (members of the Chicago School thought him a complete has-been). Cassidy addresses this history very deftly and succinctly, without seeming to leave out anything. (I might note here that Cassidy writes for the New Yorker, so you can assume his ability as a writer and expositor.)

In last portion of the book, Cassidy writes in detail about the events of 2007 and 2008, and the proximate causes of the crash. In sum, Wall Street had perverse incentives that in retrospect were certain to lead them to crash and turn our financial bus. For instance, financial risk that was supposed to have been ameliorated by spreading risk around to different holders. However, it turns out to have been only a spreading of ignorance and responsibility. Meanwhile, before the House of Cards fell, Wall Street rewarded itself for its "innovation". Thus the obscene bonuses.

I fear my humble review doesn't do justice to this outstanding book. If you know some economics it helps, but even if you don't, Cassidy is such a fine teacher that I don't think that you'd get lost. In fact, I hope that every member of our national leadership will read this book. (They won't, don't worry.) Cassidy certainly points the way to how we can do better, and how we must recognize where we will continue to fail and need to plan for that failure. Understand this: Cassidy isn't "anti-market" or anti-free enterprise. I deign to think that, like me, he appreciates markets as the primary template for decision-making, since its decentralized process allows for the best flow of information (hats off to Hayek here); however, it's not infallible, and it does not constitute a perpetual motion machine that doesn't need government guidance (not to mention governmental prerequisites). I highly recommend this book.