How Markets Fail: The Logic of Economic Calamities Paperback – November 23, 2010

"How Markets Fail" by John Cassidy is but one of a growing number of books attempting to explain both the world of finance and its underpinnings and the resulting collapse of the financial markets. The book is exceptionally well written and deals with all of the critical elements of what got us where we are today. Yet it is worth considering the many issues he discusses in light of other factors.The book is divided into three parts as presented by the author in the first Chapter. Part I is a review of the classic economists and up to the present. Part II is the behavioral economists and their influence in understanding herd dynamics and stickiness in the market. Part II focuses on the current crisis.Much of what is written is written well albeit with a strong political bent. For example just out of the box the author states on p. 9 in his introduction of Part I that "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." Now if that quote does not set the stage for all to come nothing else will. It is clear that the author has a strong bias against the free market and denies any personal responsibilities on the part of the individuals. It is a restatement of the victimization approach to economics. He believes that the market, whatever that may be, makes the decision to dump polyphenols from a GE plant into the Hudson. In reality it was the management, the people in GE who did that, not the market. Yet, this theme that capitalism is the forcing function or deus ex machine for all the evils of mankind seems to continue throughout the book.On p.11 he states that "The subprime boom represented a failure of capitalism in the presence of bounded cognition, uncertainty, hidden information, trend following and plentiful credit." That is in part true but it was the legislation and the regulatory environment that stimulated this process and yes the greed and outright dishonesty of many who participated. Greed and capitalism are not a one to one mapping. Greed has existed in every environment, suffice it to say that it is one of the seven deadly sins.On p. 12 he calls the problem that Prince had at Citi as an example of the Prisoner's Dilemma. Frankly it was not even close in a game theoretic sense. It was Rubin along with Prince working with the residual of the Sandy Weill collection of companies in a highly leverage state in a financial downturn that most likely led to their downfall.On pp 17-18 the author speaks towards the issue of having knowledge but not having the ability to conceive of the consequences. He uses Pearl Harbor as an example. Frankly there were many such examples of how this was anticipated ranging from the Navy's War Plan Orange to the well read book by Hector Bywater, The Great Pacific War, detailed in the 1920s the actual plan of the Japanese. In fact the Japanese planning organization actually use the Bywater plan in its own effort. The same types of issues could be said about the attack on 9/11, data was there but "management" was clueless. In fact the collapse of 2008-2009 was presaged by the same market and housing and banking collapse of 1987. Then we had a 25% one day drop in the DOW, a 20-25% drop in housing, and the S&L collapse. The difference was that then people held a reasonable amount of equity in their homes and 401Ks were not as prevalent. The Government took the actions to move from a risky position to a riskier one. Thus it was not the Market but the Government whose hands are dirty. Cassidy seems not to consider that.On p 23 the author starts his use of Galbraithian dicta. This in and of itself sets the tone. Galbraith in his three books for public consumption on his view of economics, American Capitalism, The Affluent Society, and The New Industrial State, makes the assumption that the battle is between the poor defenseless consumer and the massive impenetrable corporations. It requires the use of "countervailing power" to balance the interests and that is where the need is for all benevolent and all knowing Government is seen as the arbiter of fairness and justice in such transactions. Per Galbraith and the author, the Market is both inefficient and lacks a Rawlsian justice in its allocation of what is produced.On p. 38 the author details how Hayek was considered a "right wing nut" when he was a student at Oxford in the early 1980s. Well it was Oxford, what more need be said. Hayek's proposition that markets are aggregators of information was an essential and critical observation as was his understanding that centralized organizations had problems dealing with the division of knowledge (p. 41). In fact one need look no further than to an entrepreneurial company versus a large corporation to see the effect of this gross inefficiency of central planning, and the best example is the old Soviet economy, centrally planned, yet incapable of functioning.On pp 63-68 the author has an interesting and lucid discussion of Arrow's welfare economics. One should remember that Arrow is the uncle of Larry Summers, now in the White House, and once the Treasury Secretary. This discussion is used as a justification of redistribution economics. Namely the basis of the distribution of wealth generated by some is definable by some hypothetical utility function which in turn holds across all people. This utility function has certain mathematical characteristics that are assumed to reflect reality. The net result is that markets, namely free markets, can generate what are termed efficient outcomes, and that efficiency and equity, again a Rawlsian justice schema, can be achieved. Arrow's analysis is just that, and analytical schema. The results are just as good as the assumptions, thus one should beware that the assumptions are just that, assumptions.On p 65 the author gives a somewhat backhanded compliment to Johnnie von Neumann, a man who amongst those who know and understand his magnificent contributions consider him one with few if any equals. The author calls him "some sort of genius". He was a genius, not "some sort of". He was brilliant and a true polymath with seminal contributions across the spectra of human knowledge. The author then goes on to characterize von Neumann's life as "loquacious and virulently anti-communist, he drank heavily, told off color jokes, was married twice, and died of cancer..." One is amazed as to the cavalier and heavy handed characterization of the life of a person who has so great respect and has made so great a number of contributions. This one statement is a classic example in my opinion of the less than fair, equitable and knowledgeable writing on the part of the author.On p 78 the author begins to take focus at Friedman and his monetary theory analysis. He states "Friedman liked to invoke the ancient "quantity theory of money" which many of his critics considered hopeless out of date" Frankly the Friedman theory of money was not ancient, it was an new innovation. In fact the theory of money in and of itself was less than ancient, for economists as such had been around at best in some form since the 1650s.On p 81 the author begins his critique of Friedman and uses the example of the elimination of Federal regulators. That was actually the work of Alfred Kahn and was documented in his classic work, The Economics of Regulation. It was in the Carter Administration that the antitrust suits against AT&T and IBM were started and it was Asst Atty General Baxter under Reagan who dismissed one and settled the other. AT&T was a monopoly and it had a strangle hold on the US telecommunications business. The explosion of entrepreneurial spirit and innovation in telecommunications and the information age was the direct and immediate result of its splitting.On p 91 the author speaks of the Black Scholes model. He states: "Some of the mathematics used in these theories is pretty befuddling which explains why there are so many physicists and mathematicians working on Wall Street..." Well let me set the author straight, these equations arose from engineers, from the likes of Norbert Wiener and Rudy Kalman, from Stratonovich in Russia and Ito in Japan, and from my book written in the late 1960s, Stochastic Systems and State Estimation. They were used to model and design estimation and control systems. As engineers, we frequently warned people about the limits of models and the concerns of instabilities. Black and Scholes appear to have taken little heed of those issues resulting most likely in the collapse of Long Term Capital Management. One should note that the "equations" which were the underpinnings of the Black Scholes model were also used by the engineers who designed the navigation and guidance systems for the Apollo space missions. But as ones used by engineers they had engineered into them safety margins to assure against the instabilities of real life. Unlike the engineered solutions of Apollo, the Black Scholes approach were used by bankers who ran them to the edge, to the edge of the envelope if you will, and thus these models when applied suffered from the smallest of perturbations and instabilities and thus collapsed.On p 193 he infers that Volker was the architect of the 19% interest rates. Actually they were the legacy of Nixon and the collapse of gold, Ford and the total lack of confidence, and finally Carter and his gross mishandling of the economy and the final oil crisis. Volker inherited these and then righted them, albeit with high unemployment.On p 115 the author introduces the Pigou Club of Mankiw at Harvard. Simply this is the group which says that you tax the thing you do not want to happen. This is the way the economist thinks. Rather than solving the problem, you tax it. An engineer would try to find a way to remedy it. The result is the engineer's approach is lower cost, social and otherwise. One should wonder why China's senior officials are mostly engineers whereas we in the US have mostly lawyers with economists in the shadows.On pp 118-124 the author tackles the Coase approach to life. Coase looked simply at the problem of unintended consequences, their costs, and the remedies thereto. For example a railroad company has tracks and the grass adjacent to the tracks catches fire and burns the wheat of a farmer. The courts may allow a law suit to be filed and the jury may rule in favor of the farmer who gets paid for the damage. If however the farmer loses the suit he may get together with other farmers and then they may pay the railroad to fix the problem. Either way there is a "free market" solution to the problem, yet the costs may flow one way or the other. The author clearly dislikes Coase and his free market approach. He uses the aforementioned GE and Hudson River example. He then follows Coase with the obligatory Global Warming issue on pp 123-124.On p 128-133 the author starts looking at antitrust issues. Antitrust laws were there to protect competition and not competitors. They were designed to protect the system not the incumbents. The author speaks of Baumol and his view that monopolies did not need to be exposed to competition but the threat of competition. It was Baumol along with Willig who developed the theorem of interconnection pricing, the Baumol-Willing Theorem, which was an ad hoc propiter hoc argument to sustain the AT&T monopoly by allowing the incumbent to collect a "tax" from the competition based upon the premise that AT&T had more customers and that in and of itself had value as some externality. This was in many ways at the heart of the failure of the 1996 Telecom Act whose goal was to allow competition to exist. The author again returns to Galbraith and his book, The New Industrial State, which claims that corporations are dominant controllers of the economy run by technocrats. It is ironic that at most half of the companies Galbraith cites are even in existence today. Their "power" did not keep them from going out of existence. The entrepreneurs, the true engines of growth in the economy, came along and redefined the business under their feet. Consider the telecommunications equipment manufacturers, there is now not a single one in the US, they are just gone. He states Galbraith's claim, "the initiative in deciding what is produced comes not from the sovereign producer, through the market, ... rather, it comes from the great producing organization which reaches forward to control the markets that it is presumed to serve and, beyond, to bend the consumer to its needs..." This was Galbraith's view, and it reflects a 1960's mentality. It however has clearly been shown to have been broken by the mass development of new entrepreneurial businesses, from Microsoft, Apple, and Google.On p 130 he states, "Then there is high technology sector, where monopoly is endemic." That is clearly false by example. The high tech market is very fluid with new entrants changing the landscape day by day. Yet Intel has a hold, but there is Qualcomm and many others who have disintermediated the broad base of semiconductors for uses well beyond just computation. He continues speaking about the concept of "network externalities" which means that having more users one gets to retain position. That is at best questionable. Just look at wireless versus wireline. The wireline side dominated the business until 2004 when wireless took over. This violates the Baumol-Willig Theorem and lets one see that externalities can be shifted again and again. They are not sustainable barriers to entry.On p 137 he speaks of the Internet and uses the term "package switching (sic)" It is "packet switching". This was a seminal disintermediation introduced into the telecommunications world view. The story told by one of the Internet founders is that they tried to get AT&T to work with them but AT&T through its arrogance as a monopoly player wanted to control it all. AT&T did not understand that ARPA could reinvent communications, which it did, and this resulted in the never ending decline of the old AT&T.On pp 158-159 he speaks of insurance and speaks of Arrow stating that the Government should run insurance. That is questionable. Well one should examine the Arrow paper more carefully. He states that health care is a service and as such is different. Ken Arrow, in his well read paper entitled Uncertainty and the Welfare Economics of Health Care, states the following special characteristics of health care in his view:"A. The Nature of Demand The most obvious distinguishing characteristics of an individual's demand for medical services is that it is not steady in origin as, for example, for food or clothing, but irregular and unpredictable..."My simple answer is that there are many people in such a service business, just look at the plumber. Look at the lawyer. Look at the electrician. There are lots of businesses out there that are the same in their demand characteristic as health care. Arrow continues:"B. Expected Behavior of the Physician: It is clear from everyday observation that the behavior expected of sellers of medical care is different from that of business men in general. These expectations are relevant because medical care belongs to the category of commodities for which the product and the activity of production are identical."Consider lawyers, they are service providers. There are hundreds of professions, accountants to name another, where the product and the activity are the same. The definition is the personal services industry, it even has an SIC code! But this was an 1963 article, in the days of Galbraith, where economists viewed the world as large corporations against the common man! Prof Arrow, in my opinion, is in error with this attempt at both generalizing and specializing. Arrow continues in his paper:"C. Product Uncertainty: Uncertainty as to the quality of the product is perhaps more intense here than in any other important commodity. Recovery from disease is as unpredictable as is its incidence. In most commodities, the possibility of learning from one's own experience or that of others is strong because there is an adequate number of trials."One need just go to a civil or criminal trial, especially with a jury, because the practice of law is similar, the outcome is always unpredictable.The author makes many other statements and I chose just a few to counter. The writing is exceptionally good, smooth, and explanatory, but the twist in his presentation is an obvious and transparent attempt to justify his political position. Free markets do work, entrepreneurial behavior is the key element to our success, and the goal of the Government should be to take all actions as is necessary to defend and support that effort. This book seems to ignore that goal. Yet it is worth reading to gain insight, and the book is one of the best out there. My favorite book in this area is the recent one by Donald MacKenzie, An Engine, Not a Camera (MIT Press, 2008) which is a superb tale by a highly respected expert in the field.  An Engine, Not a Camera: How Financial Models Shape Markets (Inside Technology)  The two should be read side by side.

I gave this book four stars because the book did indeed do a good job showing how markets fail. I kept off that last star because the implicit assumption throughout the book (and sometimes made explicit) is that more government regulation would improve markets. He certainly did not show this, and often provided evidence to the contrary. I was impressed by the understanding of a journalist for economics, a much better understanding than most journalists (such as Naomi Klein). But he did have the blind spot in not understanding that to show regulation is in order he must not only show that the free market can fail but that regulation will make this less likely. It is in the latter case that he failed miserably. I gave as many stars as I did only because government regulation wasn't what the book was about.He had three convincing ideas showing how markets may not achieve maximum efficiency:1) Rational irrationality. This is a strange label for the situation when what benefits individuals doesn't always benefit society. Thus in a pure market society with no FDIC insurance, it may make sense for individuals to make a run on the bank to protect the individual investment even though it hurts others that lose their investment when the bank runs out of cash. Also, it may be rational for individuals to contribute to an investment bubble, even though the ultimate crash is bad for everyone.2) Externalities. This is the free market failing that is always brought up, and is agreed to by every serious economist, despite Cassidy's denial. An example of an externality is pollution -- a free market will despoil common property if there are no regulations to stop it.3) Disaster myopia. This is the tendency of people to underestimate the possibility of disaster if it hasn't happened for awhile. Of course this is as true of government regulators as for business people, so it certainly is not an argument for regulation.Rational irrationality is the main crux of Cassidy's argument showing how markets failed, causing the recent financial collapse. But this is one area in which Cassidy does not understand the free market. He made the point that the CEOs of financial institutions have incentives to continue a financial bubble, so they need regulation to keep them in line. But it isn't the CEOs that are the free market regulatory mechanism, it is the holders of the inflated assets. They are the ones that get hurt when the bubble bursts, so they are the ones that should be holding the CEOs in check. That is how the markets failed, and so that is where we need to look to fix it.Which brings me to the causes of the financial collapse. The causes of the collapse, based mostly on Cassidy's diagnosis, but adjusted by my own knowledge and beliefs:1) There was too much interlocking debt, so that when one financial institution went down, it brought down all the others. In my opinion, our society has too much debt, period, and this is what made the economy so vulnerable. If we had a whole lot less debt, pricking of the bubble might have destroyed some institutions, but the economy as a whole would've been alright.2) All the financial experts (both in industry and in government) didn't understand the risk of so much sub-prime debt. They thought that any collapse of a real estate bubble would be regional, so it wouldn't bring down the whole economy, or even severely effect any sub-prime securities that covered the whole country.3) The rating agencies simply didn't do their job of downgrading very risky debt4) Disaster myopia.5) Lack of information. The holders of sub-prime debt didn't know how likely the mortgage holders were to default.So the question is, how would greater regulation have avoided this result, and can it help in the future?1) Debt. Government has been mostly encouraging more debt, especially mortgage debt, so that more people can own homes. It might be useful for government to somehow encourage less debt in the future. But currently it is the federal government that is making the economy more vulnerable, as it greatly increases its own debt, and is strongly encouraging corporations to spend their cash hoards. It is the private companies who have these cash hoards that are doing the most to avoid another catastrophe. A good example of regulation worsening the situation.2) Risk of sub-prime debt. One of the main causes of the Great Recession was that most financial experts thought that diversity of geographic holdings would protect security holders. Regulation would not have helped here, because the financial experts in the government had the same misconception as industry experts. Regulation doesn't help now, because both sides now realize the danger.3) Rating agencies. The big problem here is that there are only such few rating agencies. However, this is something the government caused, since they don't allow additional agencies. This was definitely a failure of government, not the market.4) Disaster myopia. As with #2, this was a failure on both sides. Hindsight is 20-20, but it doesn't argue for more regulation.5) Information. The regulators didn't know any more than the security holders.It would have been nice to see a similar discussion of the failures of government, with the perhaps the following list:1) Rent seeking of lobbyists seeking and often getting a mis-allocation of resources in the direction of their clients2) Incentives of government aren't to create the best results for society, but instead the best results for those who can help them get re-elected3) Governments don't go out of business when they fail, they merely ask for more resources4) Politics determines who gets the most resources, as well as the distribution of resources, not the desires of those receiving the resources, as is the case in a free market5) The free market has an automatic regulation in that those with the most to lose will struggle the hardest to keep things on an even keel. Government needs to build in these regulations manually, and they simply don't work as well and are more prone to failure.Towards the end of Chapter 11, Cassidy bemoans the "blind reliance on self-interest" by advocates of the market. Although Cassidy understands the free market pretty well, this is one place he shows his ignorance. It isn't that free market advocates promote untethered markets because self interest works so well, although it mostly does work well. It's that it is human nature to do whatever is in each person's self interest to do. The incentives of the free market usually harness that self interest towards the benefit of society. This is less likely to be the case for those in government.I hope John Cassidy's next book is "How Governments Fail." He does a good job documenting the problems. With such a book we'd really have something to discuss.

John Cassidy explains brilliantly the rise and fall of the free market ideology. Its application ended in the most sweeping extension of State intervention in the economies all over the world since the 1930s. The recent financial panic could have brought down any number of financial firms worldwide, which meant the total collapse of capitalism.The Free Market and its ideologuesThe `free market' ideology (laissez-faire) is an all-compassing way of thinking about the world and about man (the perfect homo aeconomicus) with markets as divine efficient and self-regulating processes.Its prominent ideologues were A. Smith (the invisible hand of self-interest), F. Hayek (a system of price signals), V. Pareto (an efficient economy), K. Arrow and G. Debreu (the combination of efficiency and social equity), M. Friedman (monetarism), E. Fama (efficient stock markets) and R. Lucas (governmental intervention in the economy is counter-productive).Criticism (no market nirvana)For its critics, a free market economy is utopian, based on illusions of stability (bubbles are not aberrations), of rational irrationalities (124 banking crises in the last 40 years) and of predictability (markets don't follow regular patterns).The prominent critics were J.M. Keynes (governmental intervention is needed in recessions), A. Pigou (no spontaneous coordination of private and social interests), F. Bator (oligo (mono)-polies destroy free markets, no markets for public goods), G. Akerlof and J. Stiglitz (market prices don't reveal all information) and H. Minsky (free market capitalism is inherently unstable).Current crisisThe actual housing and financial crisis was an outcome of deregulation (abolition of the Glass-Steagall Act), too long and too low interest rates, criminality at the top, greed (in the face of monumental risk), incentive-based compensation of officers, stupidity (NINJA loans, no income, no job, no assets), lax oversight of the banking system (SIVs off balance sheets), the incest between rating agencies and Wall Street firms, moral hazard (privatizing gains for a tiny oligarchy of extremely wealthy people, and socializing losses) and the mind-boggling amounts of money involved ($ 42.6 trillion CDSs).WarningBut the `special interests' are back downplaying the massive (5 % of GDP) governmental bailout. The author gives a stiff warning: if those special interests can block meaningful reform, crony capitalism of the few will rule again at the cost of the many.Milton Friedman's monumental blunder (the Fed is not a branch of government)His comment about the Great Depression is as follows: `The Great Depression was produced by governmental mismanagement rather than by any inherent instability of the private economy. A governmentally established agency, the Federal Reserve System, exercised its responsibilities so ineptly...'The comment should have been as follows: `The Great Depression was produced by private mismanagement. A private established agency, the FRS, exercised its responsibilities so ineptly ...'The blunder destroys his whole theory.John Cassidy wrote a formidable overview of essential economic theories and practises. His book is a must read for all those who want to understand the world we live in.

How Markets Fail by John Cassidy provides a detailed review of economic theories relating to the operations of markets and illustrates the power of ideas; sometimes - bad ideas.Cassidy provides the reader with a highly relevant historical journey that weaves the development of economic theories (particularly in finance and macroeconomics) with their practice in the real world leading up to the breaking of the financial crash of 2008-2009 centred on the US housing bubble. Key characters include economists from both sides of the spectrum together with pivotal policy makers.This is definitely one of the better books I have read on the financial crisis since Cassidy illustrates how we came to be in this dreadful place through a combination of factors. Grounded in a fair representation of the conflicting theories of finance and macroeconomic policy this books avoids the kind of ranting witnessed in certain other publications on the subject.Perhaps most valuable in this book is the way in which Cassidy traces the thinking of theoreticians about how markets operate from the classical to the contemporary period and illustrates how these various theories were adopted by politicans and financiers in the real world. Sometimes with disastrous results.Hence whilst the book goes to some lenghts to explain the relevant theoretical constructs of the economics community, it is complemented by an equal consideration of the psychology and political economics at play amongst some of the key players.As recorded in other publications on the financial crisis the book reinforces the sense that the demise of millions of people results from the games played by a relatively small number of players at the top of the power pyramid.Sadly, although the conclusion of the book offers up some suggestions on how the crisis might be turned into an opportunity for significant reform in banking (particularly investment banking), the intervening three years since the book was published witness very little has been changed. A seriously missed opportunity.At its heart this is a book that revisits the intellectual struggle by top economists from Adam Smith to Friedrich Hayek and Milton Friedman, from the ideas of Karl Marx to the insights of John Maynard Keynes. But it also includes some less well known figures whose contributions have greatly enriched our understanding of how people behave in market situations, in particular Daniel Kahneman and Amos Tversky in their contributions from psychology and Hyman Minsky's grasp of reality of how markets really work.It reminds us that as students of political economics, there are two sides to consider; namely, the political (in particular the use of power) and the economic. The same can be said of financial economics, where there are the increasingly mathematically based models to consider, but there are also the psychological and political elements of the players. At its heart, this book reads as a review of the ideological battle between those (both theorists and practitioners) who believe in the efficiencies of the market and the need to minimise government intervention, versus those who take a more pragmatic approach that acknowledges the realities of market failure and the need to insulate society from its excesses. It is of course a conflict that continues to this day.

This superb book gives not only a wonderfully comprehensive and readable insight into the 2007/8 financial crisis in the U.S., but also a lucid and articulate look into the world of economic theory, which is especially important given the Federal Reserve's totally misguided (some might describe it as downright negligent) attitude towards Wall Street during the Alan Greenspan regime.If, by any chance, you believe that something called the Efficient Market Hypothesis has any validity in modern-day financial markets, then this book will surely demonstrate to you the error of your ways.The book is extraordinarily detailed but never gets bogged down.Amongst other things, the book enables us to stand back and see how the legislative protections put in place after the Great Depression (in order to avoid a repeat, naturally) were unceremoniously dismantled, particularly over the ten years or so leading up to 2007. We can only guess at the motivations that drove certain Senators and Congressmen to press for the dismantling of this protective framework which had helped to preserve a certain amount of sanity in the financial markets in all of those decades since the Depression.And with the facts laid out so clearly in front of us, we can at least see who was supplying the matches before the house burnt down. Step forward Alan Greenspan, the revered (at least up to 2007/8) Chairman of the Fed, who now looks like a one-trick bull market pony, who not only exercised atrociously poor judgement when it came to understanding where the out-of-control bull markets were heading, but seemed hell-bent on wiping out all forms of regulation for U.S. financial institutions and markets as soon as was humanly possible.Yes, we know lots of other individuals and entities were also culpable, but when the man at the top of the Fed seemed to spend most of his time opening all of the doors, we shouldn't be surprised when the fire burns the whole house down.The author deserves a big pat on the back for weaving the various strands of this very involved story into one coherent body of work.Economics students could do far worse than ditch their degree course and just read this book instead.

Pretty much what I expected. Solid analysis of radical free market cowboy insanity...but written clearly and calmly.

Very readable, very persuasive; but I'll withhold judgement until I've read Mervyn King's book "The End of Alchemy".