Excerpts for How Markets Fail : The Logic of Economic Calamities


HOW MARKETS FAIL

THE LOGIC OF ECONOMIC CALAMITIES
By JOHN CASSIDY

FARRAR, STRAUS AND GIROUX

Copyright © 2009 John Cassidy
All right reserved.

ISBN: 978-0-374-17320-3

Contents

Introduction..............................................................3
1. Warnings Ignored and the Conventional Wisdom...........................17
2. Adam Smith's Invisible Hand............................................25
3. Friedrich Hayek's Telecommunications System............................37
4. The Perfect Markets of Lausanne........................................49
5. The Mathematics of Bliss...............................................61
6. The Evangelist.........................................................72
7. The Coin-Tossing View of Finance.......................................85
8. The Triumph of Utopian Economics.......................................97
9. The Prof and the Polar Bears...........................................111
10. A Taxonomy of Failure.................................................125
11. The Prisoner's Dilemma and Rational Irrationality.....................139
12. Hidden Information and the Market for Lemons..........................151
13. Keynes's Beauty Contest...............................................166
14. The Rational Herd.....................................................177
15. Psychology Returns to Economics.......................................192
16. Hyman Minsky and Ponzi Finance........................................205
17. Greenspan Shrugs......................................................221
18. The Lure of Real Estate...............................................235
19. The Subprime Chain....................................................251
20. In the Alphabet Soup..................................................268
21. A Matter of Incentives................................................285
22. London Bridge Is Falling Down.........................................299
23. Socialism in Our Time.................................................317
Conclusion................................................................335
Notes.....................................................................347
Acknowledgments...........................................................371
Index.....................................................................373


Introduction

"I am shocked, shocked, to find that gambling is going on in here!" -Claude Rains as Captain Renault in Casablanca

The old man looked drawn and gray. During the almost two decades he had spent overseeing America's financial system, as chairman of the Federal Reserve, congressmen, cabinet ministers, even presidents had treated him with a deference that bordered on the obsequious. But on this morning-October 23, 2008-Alan Greenspan, who retired from the Fed in January 2006, was back on Capitol Hill under very different circumstances. Since the market for subprime mortgage securities collapsed, in the summer of 2007, leaving many financial institutions saddled with tens of billions of dollars' worth of assets that couldn't be sold at any price, the Democratic congressman Henry Waxman, chairman of the House Committee on Oversight and Government Reform, had held a series of televised hearings, summoning before him Wall Street CEOs, mortgage industry executives, heads of rating agencies, and regulators. Now it was Greenspan's turn at the witness table.

Waxman and many other Americans were looking for somebody to blame. For more than a month following the sudden unraveling of Lehman Brothers, a Wall Street investment bank with substantial holdings of mortgage securities, an unprecedented panic had been roiling the financial markets. Faced with the imminent collapse of American International Group, the largest insurance company in the United States, Ben Bernanke, Greenspan's mild-mannered successor at the Fed, had approved an emergency loan of $85 billion to the company. Federal regulators had seized Washington Mutual, a major mortgage lender, selling off most of its assets to JPMorgan Chase. Wells Fargo, the nation's sixth-biggest bank, had rescued Wachovia, the fourth-biggest. Rumors had circulated about the soundness of other financial institutions, including Citigroup, Morgan Stanley, and even the mighty Goldman Sachs.

Watching this unfold, Americans had clung to their wallets. Sales of autos, furniture, clothes, even books had collapsed, sending the economy into a tailspin. In an effort to restore stability to the financial system, Bernanke and the Treasury secretary, Hank Paulson, had obtained from Congress the authority to spend up to $700 billion in taxpayers' money on a bank bailout. Their original plan had been to buy distressed mortgage securities from banks, but in mid-October, with the financial panic intensifying, they had changed course and opted to invest up to $250 billion directly in bank equity. This decision had calmed the markets somewhat, but the pace of events had been so frantic that few had stopped to consider what it meant: the Bush administration, after eight years of preaching the virtues of free markets, tax cuts, and small government, had turned the U.S. Treasury into part owner and the effective guarantor of every big bank in the country. Struggling to contain the crisis, it had stumbled into the most sweeping extension of state intervention in the economy since the 1930s. (Other governments, including those of Britain, Ireland, and France, had taken similar measures.)

"Dr. Greenspan," Waxman said. "You were the longest-serving chairman of the Federal Reserve in history, and during this period of time you were, perhaps, the leading proponent of deregulation of our financial markets ... You have been a staunch advocate for letting markets regulate themselves. Let me give you a few of your past statements." Waxman read from his notes: "'There's nothing involved in federal regulation which makes it superior to market regulation.' 'There appears to be no need for government regulation of off-exchange derivative transactions.' 'We do not believe a public policy case exists to justify this government intervention.'" Greenspan, dressed, as always, in a dark suit and tie, listened quietly. His face was deeply lined. His chin sagged. He looked all of his eighty-two years. When Waxman had finished reading out Greenspan's words, he turned to him and said: "My question for you is simple: Were you wrong?"

"Partially," Greenspan replied. He went on: "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms ... The problem here is something which looked to be a very solid edifice, and, indeed, a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and, obviously, to the extent that I figure out what happened and why, I will change my views."

Waxman, whose populist leanings belie the fact that he represents some of the wealthiest precincts in the country-Beverly Hills, Bel Air, Malibu-asked Greenspan whether he felt any personal responsibility for what had happened. Greenspan didn't reply directly. Waxman returned to his notes and started reading again. "'I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We have tried regulations. None meaningfully worked.'" Waxman looked at Greenspan. "That was your quote," he said. "You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Now our whole economy is paying the price. Do you feel that your ideology pushed you to make decisions that you wish you had not made?"

Greenspan stared through his thick spectacles. Behind his mournful gaze lurked a savvy, self-made New Yorker. He grew up during the Great Depression in Washington Heights, a working-class neighborhood in upper Manhattan. After graduating from high school, he played saxophone in a Times Square swing band, and then turned to the study of economics, which was coming to be dominated by the ideas of John Maynard Keynes. After initially embracing Keynes's suggestion that the government should actively manage the economy, Greenspan turned strongly against it. In the 1950s, he became a friend and acolyte of Ayn Rand, the libertarian philosopher and novelist, who referred to him as "the undertaker." (In his youth, too, he was lugubrious.) He became a successful economic consultant, advising many big corporations, including Alcoa, J.P. Morgan, and U.S. Steel. In 1968, he advised Richard Nixon during his successful run for the presidency, and under Gerald Ford he acted as chairman of the White House Council of Economic Advisers. In 1987, he returned to Washington, this time permanently, to head the Fed and personify the triumph of free market economics.

Now Greenspan was on the defensive. An ideology is just a conceptual framework for dealing with reality, he said to Waxman. "To exist, you need an ideology. The question is whether it is accurate or not. What I am saying to you is, yes, I found a fl aw. I don't know how significant or permanent it is, but I have been very distressed by that fact." Waxman interrupted him. "You found a fl aw?" he demanded. Greenspan nodded. "I found a fl aw in the model that I perceived as the critical functioning structure that defines how the world works, so to speak," he said.

Waxman had elicited enough already to provide headlines for the following day's newspapers-the Financial Times: "'I made a mistake,' admits Greenspan"-but he wasn't finished. "In other words, you found that your view of the world, your ideology, was not right," he said. "It was not working?"

"Precisely," Greenspan replied. "That's precisely the reason I was shocked. Because I had been going for forty years, or more, with very considerable evidence that it was working exceptionally well."

This book traces the rise and fall of free market ideology, which, as Greenspan said, is more than a set of opinions: it is a well-developed and all-encompassing way of thinking about the world. I have tried to combine a history of ideas, a narrative of the financial crisis, and a call to arms. It is my contention that you cannot comprehend recent events without taking into account the intellectual and historical context in which they unfolded. For those who want one, the first chapter and last third of the book contain a reasonably comprehensive account of the credit crunch of 2007-2009. But unlike other books on the subject, this one doesn't focus on the firms and characters involved: my aim is to explore the underlying economics of the crisis and to explain how the rational pursuit of self-interest, which is the basis of free market economics, created and prolonged it.

Greenspan isn't the only one to whom the collapse of the subprime mortgage market and ensuing global slump came as a rude shock. In the summer of 2007, the vast majority of analysts, including the Fed chairman, Bernanke, thought worries of a recession were greatly overblown. In many parts of the country, home prices had started falling, and the number of families defaulting on their mortgages was rising sharply. But among economists there was still a deep and pervasive faith in the vitality of American capitalism, and the ideals it represented.

For decades now, economists have been insisting that the best way to ensure prosperity is to scale back government involvement in the economy and let the private sector take over. In the late 1970s, when Margaret Thatcher and Ronald Reagan launched the conservative counterrevolution, the intellectuals who initially pushed this line of reasoning-Friedrich Hayek, Milton Friedman, Arthur Laffer, Sir Keith Joseph-were widely seen as right-wing cranks. By the 1990s, Bill Clinton, Tony Blair, and many other progressive politicians had adopted the language of the right. They didn't have much choice. With the collapse of communism and the ascendancy of conservative parties on both sides of the Atlantic, a positive attitude to markets became a badge of political respectability. Governments around the world dismantled welfare programs, privatized state-run firms, and deregulated industries that previously had been subjected to government supervision.

In the United States, deregulation started out modestly, with the Carter administration's abolition of restrictions on airline routes. The policy was then expanded to many other parts of the economy, including telecommunications, media, and financial services. In 1999, Clinton signed into law the Gramm-Leach-Bliley Act (aka the Financial Services Modernization Act), which allowed commercial banks and investment banks to combine and form vast financial supermarkets. Lawrence Summers, a leading Harvard economist who was then serving as Treasury secretary, helped shepherd the bill through Congress. (Today, Summers is Barack Obama's top economic adviser.)

Some proponents of financial deregulation-lobbyists for big financial firms, analysts at Washington research institutes funded by corporations, congressmen representing financial districts-were simply doing the bidding of their paymasters. Others, such as Greenspan and Summers, were sincere in their belief that Wall Street could, to a large extent, regulate itself. Financial markets, after all, are full of well-paid and highly educated people competing with one another to make money. Unlike in some other parts of the economy, no single firm can corner the market or determine the market price. In such circumstances, according to economic orthodoxy, the invisible hand of the market transmutes individual acts of selfishness into socially desirable collective outcomes.

If this argument didn't contain an important element of truth, the conservative movement wouldn't have enjoyed the success it did. Properly functioning markets reward hard work, innovation, and the provision of well-made, affordable products; they punish firms and workers who supply overpriced or shoddy goods. This carrot-and-stick mechanism ensures that resources are allocated to productive uses, making market economies more efficient and dynamic than other systems, such as communism and feudalism, which lack an effective incentive structure. Nothing in this book should be taken as an argument for returning to the land or reconstituting the Soviets' Gosplan. But to claim that free markets always generate good outcomes is to fall victim to one of three illusions I identify: the illusion of harmony.

In Part I, I trace the story of what I call utopian economics, taking it from Adam Smith to Alan Greenspan. Rather than confining myself to expounding the arguments of Friedrich Hayek, Milton Friedman, and their fellow members of the "Chicago School," I have also included an account of the formal theory of the free market, which economists refer to as general equilibrium theory. Friedman's brand of utopian economics is much better known, but it is the mathematical exposition, associated with names like Léon Walras, Vilfredo Pareto, and Kenneth Arrow, that explains the respect, nay, awe with which many professional economists view the free market. Even today, many books about economics give the impression that general equilibrium theory provides "scientific" support for the idea of the economy as a stable and self-correcting mechanism. In fact, the theory does nothing of the kind. I refer to the idea that a free market economy is sturdy and well grounded as the illusion of stability.

The period of conservative dominance culminated in the Greenspan Bubble Era, which lasted from about 1997 to 2007. During that decade, there were three separate speculative bubbles-in technology stocks, real estate, and physical commodities, such as oil. In each case, investors rushed in to make quick profits, and prices rose vertiginously before crashing. A decade ago, bubbles were widely regarded as aberrations. Some free market economists expressed skepticism about the very possibility of them occurring. Today, such arguments are rarely heard; even Greenspan, after much prevarication, has accepted the existence of the housing bubble.

Once a bubble begins, free markets can no longer be relied on to allocate resources sensibly or efficiently. By holding out the prospect of quick and effortless profits, they provide incentives for individuals and firms to act in ways that are individually rational but immensely damaging-to themselves and others. The problem of distorted incentives is, perhaps, most acute in financial markets, but it crops up throughout the economy. Markets encourage power companies to despoil the environment and cause global warming; health insurers to exclude sick people from coverage; computer makers to force customers to buy software programs they don't need; and CEOs to stuff their own pockets at the expense of their stockholders. These are all examples of "market failure," a concept that recurs throughout the book and gives it its title. Market failure isn't an intellectual curiosity. In many areas of the economy, such as health care, high technology, and finance, it is endemic.

The previous sentence might come as news to the editorial writers of The Wall Street Journal, but it isn't saying anything controversial. For the past thirty or forty years, many of the brightest minds in economics have been busy examining how markets function when the unrealistic assumptions of the free market model don't apply. For some reason, the economics of market failure has received a lot less attention than the economics of market success. Perhaps the word "failure" has such negative connotations that it offends the American psyche. For whatever reason, "market failure economics" never took off as a catchphrase. Some textbooks refer to the "economics of information," or the "economics of incomplete markets." Recently, the term "behavioral economics" has come into vogue. For myself, I prefer the phrase "reality-based economics," which is the title of Part II.

Reality-based economics is less unified than utopian economics: because the modern economy is labyrinthine and complicated, it encompasses many different theories, each applying to a particular market failure. These theories aren't as general as the invisible hand, but they are more useful. Once you start to think about the world in terms of some of the concepts I outline, such as the beauty contest, disaster myopia, and the market for lemons, you may well wonder how you ever got along without them.

(Continues...)



Excerpted from HOW MARKETS FAIL by JOHN CASSIDY Copyright © 2009 by John Cassidy. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.



----------------------