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How Markets Fail by John Cassidy

In How Markets Fail, John Cassidy has set out a very readable history of Economic theory and practice and how they created the conditions for the 2007-2008 Credit Crunch.

History and Analysis of Financial Theory, Practice and Failure

How Markets Fail explores the history of economic theory and the development of the conventional economic, psychological and financial “wisdom” of the late 20th and early 21st century. He shows how the resulting behaviours almost inevitably led to the Credit Crunch or would have produced some other form of financial collapse.

Cassidy divides How Markets Fail up into three sections that develop the logic that led to the calamity of the Credit Crunch and describes how the behaviour of regulators could , and should, have prevented the collapse of 2007. The warnings were there.

Utopian Economics

History of Economic Theory

The opening section covers the history of economic theory from Adam Smith to the present day. It shows how working economists and teachers lagged behind the theory and so were trying to apply theory that had been shown to be flawed. By the beginning of the 21st century free markets were deemed to be more efficient in using and sharing information than central control.

But those free market theories ignored or did not understand the implications of social and other "externalities".

Reality-based Economics

Mismatch Between Theory and the Real World Behaviours and Drivers

Cassidy argues that whilst deregulated free markets as advocated by people such as Friedman and Greenspan may work well up to a point at an individual level they do not work reliably at the macro level. They do not work so well, or at all, for many social needs such as health care or the environments. Similarly the theory fails when the parties are of significantly different size or power, for example large corporate or the state and the individual.

According to How Markets Fail since the 19th century much economic theory had also ignored the psychology of real human behaviour and its impact on the performance of markets. Economic theory during that period assumed rational choices would be made by the individual. Psychological experiments during the second half of the 20th century have shown that decision making was not rational – often illustrated by the Prisoners’ Dilemma. Cassidy therefore introduces his concept of "rational irrationality".

As a result a new branch of behavioural economics had been developed but it was overtaken by quantitative methods. At the end of the 20th century Cassidy explains mathematics had become a major component of risk management. It led to a combination of ignoring history of previous disasters and creating a false rationalisation about the risk mitigation of the new financial products.

However managers and regulators ignored the signs, some as early as 1997, and even direct warnings from highly-regarded figures went unheeded. Warren Buffet was unequivocal about the impending problem in 2006.

The Great Crunch

Financial Collapse and the Credit Crunch

The final section pulls together the theory and reality to show how the financial markets were on an inevitable slide into collapse. It also explores how decisions by those in power, regulators and managers, failed to heed warnings and prevent or mitigate the consequences until it was too late.

The Federal Reserve Bank, and especially Alan Greenspan the Governor, comes in for specific criticism as Cassidy argues that the behaviour of the central banks and other regulators could and should, have taken action much sooner. Their belief in the efficacy of free, unregulated, markets prevented them taking action that could have mitigated the consequences much earlier.

Clear Description of the Inevitability of Financial Failure

How Markets Fail, The Logic of Economic Calamities is one of the most readable economic studies that has been spawned by the Credit Crunch. The interested lay reader will have no difficulty following the ideas as explained by Cassidy who does not need to resort to the mathematics that gave the authorities false comfort that everything was under control.

How Markets Fail is a clear and insightful analysis of economic history and the failures of the financial markets in 2007 and 2008. Unlike some books on the subjective it does not come from particular dogmatic standpoint so it is not a polemic but a carefully considered analysis of history.

How Markets Fail, The Logic of Economic Calamities (2009, ISBN:9781784643007) by John Cassidy is published in hardback by Allen Lane at £25.

 

First seen on Suite101

 


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