How markets fail: an atlas of economic irrationality
Farrar, Straus and Giroux, New York, (2009)Book review in The Economist: JOHN CASSIDY'S new book is a sequel of sorts. In his previous work, “Dot.Con”, which came out in 2002, he chronicled the follies of the stockmarket bubble of the late 1990s. In “How Markets Fail”, Mr Cassidy, a British writer for the New Yorker, recounts the story of America's housing boom and its devastating bust. It is more than just an account of the failures of regulators and the self-deception of bankers and homebuyers, although these are well covered. For Mr Cassidy, the deeper roots of the crisis lie in the enduring appeal of an idea: that society is always best served when individuals are left to pursue their self-interest in free markets. He calls this “Utopian economics”. This approach turns much of the book into a very good history of economic thought. Mr Cassidy starts in 1776 with Adam Smith and his butchers, brewers and bakers, who supplied their wares as if guided by an unseen hand. Smith's analysis was made richer in the 1940s by Friedrich von Hayek, the Austrian who saw market prices as signals of which goods were scarce and which were abundant. Hayek's idea of the free market as a machine for processing and transmitting information “was one of the great insights of the 20th century,” writes Mr Cassidy. The book gives a detailed account of how the formal “proof” of the efficiency of free markets evolved. The breakthrough was made in the early 1950s by Kenneth Arrow, an American economist, and Gérard Debreu, a French mathematician who died in 2004. Mr Cassidy admires the maths, but points out that their findings rely on some unrealistic assumptions, something the two theorists were quite open about. Arrow and Debreu's “general equilibrium theory” seemed to give the stamp of scientific approval to unfettered markets. And it may have made it harder to challenge the purist free-market views of Alan Greenspan, the Federal Reserve chairman until 2006 whom Mr Cassidy partly blames for the dotcom and housing bubbles. Having set out the tenets of Utopian economics, the author then pokes holes in them. Individual self interest does not always benefit society, he argues, and draws on a deep pool of research (what he calls “reality-based economics”) to support his case. Markets fail if prices send the wrong signals. For instance, an increase in house prices ought to discourage new homebuyers. In practice, however, higher prices are a spur to buyers who hope to benefit from further rises. For would-be homeowners, the signal is that it is time to buy; for banks, that it is time to lend. Those who suspect a bubble face the same dilemma as textbook prisoners: it makes sense to act sensibly only if others do so too. Since that cannot be relied upon, it is safer to go with the herd. The result of such individually rational behaviour is a housing and credit boom, followed inevitably by a nasty bust. Markets also founder when there is hidden information—if sellers know more than buyers, for example—and when the prices paid by individuals do not fully reflect social costs, such as pollution. Such failures were evident in the build-up to the current crisis: dud mortgages were packaged as supposedly safe bonds to investors; banks did not factor in the wider costs of bad debt when making risky loans. Policymakers should have intervened to curb the excesses but were hamstrung by free-market ideology. “How Markets Fail” is an ambitious book, and one that mostly succeeds. Despite its title, it makes rather a good case for market economics; what it rails against is “free market idolatry”. Its call for a better balance between individual autonomy and state oversight might have seemed off-centre just a few years ago. Now its prescription is firmly in the mainstream..Abstract
Behind the alarming headlines about job losses, bank bailouts, and corporate greed is a little-known story of bad ideas. For fifty years or more, economists have been busy developing elegant theories of how markets work—how they facilitate innovation, wealth creation, and an efficient allocation of society's resources. But what about when markets don't work? What about when they lead to stock market bubbles, glaring inequality, polluted rivers, real estate crashes, and credit crunches? In How Markets Fail, John Cassidy describes the rising influence of what he calls utopian economics—thinking that is blind to how real people act and that denies the many ways an unregulated free market can produce disastrous unintended consequences. He then looks to the leading edge of economic theory, including behavioral economics, to offer a new understanding of the economy—one that casts aside the old assumption that people and firms make decisions purely on the basis of rational self-interest. Taking the global financial crisis and current recession as his starting point, Cassidy explores a world in which everybody is connected and social contagion is the norm. In such an environment, he shows, individual behavioral biases and kinks—overconfidence, envy, copycat behavior, and myopia—often give rise to troubling macroeconomic phenomena, such as oil price spikes, CEO greed cycles, and boom-and-bust waves in the housing market. These are the inevitable outcomes of what Cassidy refers to as “rational irrationality”—self-serving behavior in a modern market setting. Combining on-the-ground reporting, clear explanations of esoteric economic theories, and even a little crystal-ball gazing, Cassidy warns that in today's economic crisis, conforming to antiquated orthodoxies isn't just misguided—it's downright dangerous. How Markets Fail offers a new, enlightening way to understand the force of the irrational in our volatile global economy.