Friday, November 30, 2012

How Markets Fail by John Cassidy (review)



How Markets Fail by John Cassidy
            For several decades, economists have been fascinated with developing fancy, complex theories that explain how markets work in what John Cassidy calls, “utopian economics.” Cassidy explores the other side of markets—when they do not work. He stresses that some markets, such as supply and demand for coffee, are straightforward, while others such as financial and labor markets cannot simply be reduced to lines on a graph. Free market theories assume that all consumers act rationally, but it unfortunately does not take into account of reality based issues or “rational irrationality.” In How Markets Fail, first Cassidy discusses the rise of utopian economics, investigates the world of rational irrationality. and lastly, how shortcomings of the market theories can be applied to explain the financial crisis of 2008.
To start, free market ideology is largely based on the rational pursuit of self-interest that each person is looking to make themselves better off. A few notable utopian economists believed this to be true and Cassidy walks the reader through history elaborating on each economist’s contribution to the field. Adam Smith was the forerunner of free market enterprises. Smith believed there was an “invisible hand” that guided the economy and that prices hovered near a natural price. He was also well known for his theories on the division of labor and the idea that maximizing profits was self-evident for all companies. While Smith did not believe in social impacts to the free markets, Friedrich Hayek did. He believed that markets were intricately complex systems and market prices were meant to gather information. It was an idea that looked attractive on paper, but it couldn’t handle “the division of knowledge” or how to utilize knowledge of resources. Hayek mainly focused on price signals, Walras studied supply and demand but Pareto studied preferable outcomes later to be known as the “Pareto effect.” The Pareto effect was that in trade each person would come out of the trade better off even though they may not have gained the most profitable outcome (such as gaining an apple yet giving away two oranges).
            While these contributions helped shape economic thought and view of markets today, other influential students of economics came into popularity that contradicted the traditional free market beliefs. Cassidy mentions several influential economists whose theories can be applied to the financial crisis of 2008, but two that stand out the most are Ackerloff and Keynes. Ackerloff is primarily noted for his research on, “The Market for Lemons,” which uses the used car market to discuss hidden information and its effect on markets. Essentially, the sellers in the used car market have more knowledge about what is wrong with their cars than the potential people buying them do. The same can be applied to health insurance and lenders of loans. A person wanting to buy health insurance in reality knows more than a potential insurer does about their health because they know their lifestyle and diet habits. From a financial standpoint, lenders do not have perfect information about the people applying for loans. The individual knows their income opportunities and spending habits better than the lender. One of Keynes’ most notable theories was the concept of a beauty contest. When a crowd is required to decide who is prettiest, each individual will more likely to choose the outcome the majority will choose rather than basing their choice on personal preferences. Individual opinions become lost and the desire to go with the average opinion becomes stronger. Objections to the Keynes’ Beauty contest were that while going with crowd had benefits in the short term, in the long term true value would prevail, rewarding investors who stuck with the fundamentals and personal choices. However, when applied to the financial sector the opposite proved to be true. Brokers were more likely to expect what their colleague’s moves would be and avoid investing in out of date or unpopular stock options. This scenario can be applied almost perfectly to the boom and crash of the real estate market which eventually led to the financial crisis of 2008.
            Lastly, the 2008 Financial Crisis arguably triggered the worst recession in American history. Cassidy devotes the last part of the book to explain what led up to the crisis and how dangerous it is to conform to ideological beliefs in today’s modern economy. The financial crisis was largely brought on by an increased boom in real estate in the early 2000s. Home prices were at historic highs, but consumers were still purchasing them. Speculations of a housing bubble began to surface but officials such as the Fed chairman at the time, Alan Greenspan, ignored the signs stating that in the free market bubbles are least likely to exist, let alone burst. The housing market seemed stable so not only did consumers purchase more homes, but banks decided to start buying and leveraging mortgages to increase profits. It started to get out of control when the people who were buying homes did not have the credit approval to purchase them. Corporate greed started to become an issue when bank lenders ignored these warnings and approved the credit anyway, simply to make a profit. When these home owners defaulted on the mortgage, which was inevitable, banks quickly tried to sell off these bad assets to someone else. No one wanted to buy them now. With bad assets and revenues beginning to dwindle after a good investment gone badly, several banks were on the verge of filing for bankruptcy. Lehman Brothers did end up going under but investment firms such as Freddie Mac and Fannie Mae were bailed out along with Citigroup and AIG by the government. The idea of “too big to fail” was no longer true when everything came crashing down in the financial sector. Investors and Greenspan were eventually very wrong about the presence of a bubble but it was too late. The substantial trust in the free markets and that everything would correct itself proved, in reality, not as reliable as they thought. The financial crisis on Wall Street in turn set off shocks in other economies around the world and started a global recession. It caused many people to take a step back from the ideological beliefs of the past and form new opinions of how markets truly work and fail.
            In conclusion, John Cassidy gives the reader a well-rounded view of the history of economic thought and how it has shaped economic beliefs today. He also provides a largely unbiased perspective on the causes that led up to the financial crisis and how untrustworthy ideological thinking really is. Behavioral economics is coming into vogue and in regards to the modern economy it should be studied more than classical economics. Free market ideologies are helpful in explaining general economic concepts but when relied on heavily, adverse consequences and financial ruin occur. Cassidy’s book discusses what most mainstream economists will not. His underlying point is that markets in a realistic sense will all fail, but it’s not a matter of if, but when.

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