How Markets Fail:
The Logic of Economic Calamities
By John Cassidy
Farrar, Straus & Giroux; 390 pp.; $28 Economist John Maynard Keynes had a weakness for rhetorical flourishes. At the end of his classic The General Theory of Employment, Interest, and Money, he wrote: "Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist." To author John Cassidy, it's a quote that applies to the practical decision-makers of our own time—and that explains the roots of our own Great Recession.
In his ambitious How Markets Fail: The Logic of Economic Calamities, Cassidy, an economics writer for The New Yorker, offers a powerful argument that the current generation of investors and policymakers has been manacled by what he calls the "utopian" free-market school of economics. In an effort to debunk that "ideology," which he sees as holding sway in academia and among policymakers in recent decades, Cassidy marshals a deep understanding of economic intellectual history, deftly explaining the principal ideas of such towering figures as Adam Smith, Friedrich von Hayek, Léon Walras, Kenneth Arrow, Milton Friedman, and Robert Lucas. This long view allows him to place in context the free marketers' notion that self-interest and competition "equals nirvana." In the author's words: "Between the collapse of communism and the outbreak of the subprime crisis, an understandable and justified respect for market forces mutated into a rigid and unquestioning devotion to a particular, and blatantly unrealistic, adaptation of Adam Smith's invisible hand." And it was this faith, he goes on to say, that led Alan Greenspan, among others, to turn a blind eye to what was happening in the real world of money and business.
Cassidy has his intellectual heroes, too. They are the advocates of what he calls "reality-based economics"—grappling with market failures, disaster myopia, speculative frenzies, and other economic complexities. John Maynard Keynes, the great scholar of economic-crisis management, is one such thinker. So are the experimental psychologists Amos Tversky and Daniel Kahneman, the mathematician Benoit Mandelbrot, and Hyman Minsky, the expert on financial manias. "Reality-based economics ... affords the concept of market failure a central position, recognizing the roles that human interdependence and rational irrationality play in creating it," writes Cassidy. "If further calamities are to be avoided, policymakers need to make a big mental shift and embrace this eminently practical philosophy."
How Markets Fail is a nuanced book. That's a major attraction in an era when shrill commentators bicker crudely about government vs. markets and liberty vs. socialism. Even the portrait of Greenspan, perhaps the closest figure to a villain in Cassidy's account, is drawn with a measure of empathy. Yet this book can provoke angry questions in the mind of the reader. Why did so many smart economists, including Robert Lucas and Eugene Fama, refrain from protesting as their ideas were hijacked and abused by demagogic politicians and messianic think tanks? The scholars knew the exceptions, the qualifications, and the heroic assumptions that lay behind their market models. Why, then, didn't they take issue with the op-ed and cable-TV table-pounders who twisted their thinking?
Cassidy agrees with free-market advocates that the market performs wonders, but he believes its reach is limited. In that spirit, he favors greater government regulation of the financial-services industry. Although he doesn't dwell much on practical ideas for reform, he argues that it's necessary to tame Wall Streetplus or minus now that financiers have learned they can privatize profits during good times and socialize losses in bad. He admires the changes that came out of the Great Depression, such as the Glass-Steagall Act, which separated banking from investment banking. Even if current legislators aren't willing to go that far, banks must be required to keep more capital on hand and be given limits on how much debt they can accumulate, he says. He considers the proposed Financial Product Safety Commission a sensible idea. "The proper role of the financial sector is to support innovation and enterprise elsewhere in the economy," he writes. "But during the past 20 years or so, it has grown into Frankenstein's monster, lumbering around and causing chaos."
The author doesn't offer the reader any juicy bits of gossip. There aren't any vivid recreations of tense negotiations over an investment bank's future. Yet he brings ideas alive. More important, the reader comes away persuaded that reality-based economics can play a critical role in what the 18th century British conservative Edmund Burke called "one of the finest problems in legislation, namely, to determine what the state ought to take upon itself to direct by the public wisdom, and what it ought to leave, with as little interference as possible, to individual exertion."
Let's hope the legislators in Washington share this principled view of their role. Cassidy makes a compelling case that a return to hands-off economics would be a disaster.
Business Exchange: Read, save, and add content on BW's new Web 2.0 topic networkNo Mea CulpaOn his blog, economics writer David Warsh offers a different take on whether some economists must share the blame for the financial meltdown. In contrast to Paul Krugman and others who have argued that economists "got it wrong," Warsh offers evidence that, "broadly speaking, economics has served us well in understanding and managing the crisis."To read Warsh's blog go to http://bx.businessweek.com/economic-analysis/reference/