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Free markets have been a tremendous force for progress.  However, they need oversight and regulation.  Lack of appreciation of this point is the fundamental cause of the Great Crunch that the world financial systems recently experienced.  That’s the essential message of the important book by the New Yorker journalist John Cassidy (pictured right), “How markets fail: the logic of economic calamities“.

I call this book “important” because it contains a sweeping but compelling survey of a notion Cassidy dubs “Utopian economics”, before providing layer after layer of decisive critique of that notion.  As such, the book provides a very useful (if occasionally drawn out) guide to the history of economic thinking, covering Adam Smith, Friedrich Hayek, Milton Friedman, John Maynard Keynes, Arthur Pigou, Hyman Minsky, and many, many others.

The key theme in the book is that markets do fail from time to time, potentially in disastrous ways, and that some element of government oversight and intervention is both critical and necessary, to avoid calamity.  This theme is hardly new, but many people resist it, and the book has the merit of marshalling the arguments more comprehensively than I have seen elsewhere.

As Cassidy describes it, “utopian economics” is the widespread view that the self-interest of individuals and agencies, allowed to express itself via a free market economy, will inevitably produce results that are good for the whole economy.  The book starts with eight chapters that sympathetically outline the history of thinking about utopian economics.  Along the way, he regularly points out instances when free market champions nevertheless described cases when government intervention and control was required.  For example, referring to Adam Smith, Cassidy writes:

Smith and his successors … believed that the government had a duty to protect the public from financial swindles and speculative panics, which were both common in 18th and 19th century Britain…

To prevent a recurrence of credit busts, Smith advocated preventing banks from issuing notes to speculative lenders.  “Such regulations may, no doubt, be considered as in some respects a violation of natural liberty”, he wrote.  “But these exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments…  The obligation of building party walls [between adjacent houses], in order to prevent the communication of a fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.”

The book identifies long-time Federal Reserve chairman Alan Greenspan as one of the villains of the Great Crunch.  Near the beginning of the book, Cassidy quotes a reply given by Greenspan to the question “Were you wrong” asked of him in October 2008 by the US House Committee on Oversight and Government Reform:

“I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms…”

Greenspan was far from alone in his belief in the self-correcting power of economies in which self-interest is allowed to flourish.  There were many reasons for people to hold that belief.  It appeared to be justified both theoretically and empirically.  As Greenspan remarked,

“I had been going for forty years, or more, with very considerable evidence that it was working exceptionally well.”

Cassidy devotes another eight chapters to reviewing the history of criticisms of utopian economics.  This part of the book is entitled “Reality-based economics“.  It is full of fascinating and enlightening material, covering topics such as:

• game theory (“the prisoners dilemma”),
• behavioural economics (pioneered by Daniel Kahneman and Amos Tversky) – including disaster myopia,
• problems of spillovers and externalities (such as pollution) – which can only be fully addressed by centralised collective action,
• drawbacks of hidden information and the failure of “price signalling”,
• loss of competiveness when monopoly conditions are approached,
• flaws in banking risk management policies (which drastically under-estimated the consequences of larger deviations from “business as usual”),
• problems with asymmetric bonus structure,
• and the perverse psychology of investment bubbles.

In summary, Cassidy lists four “illusions” of utopian economics:

1. The illusion of harmony: that free markets always generate good outcomes;
2. The illusion of stability: that free market economy is sturdy;
3. The illusion of predictability: that distribution of returns can be foreseen;
4. The illusion of Homo Economicus: that individuals are rational and act on perfect information.

The common theme of this section is that of “rational irrationality”: circumstances in which it is rational for people to choose courses of action that end up producing a bad outcome for society as a whole.  You can read more about “rational irrationality” in a recent online New Yorker article of the same name, written by Cassidy:

A number of explanations have been proposed for the great boom and bust, most of which focus on greed, overconfidence, and downright stupidity on the part of mortgage lenders, investment bankers, and Wall Street C.E.O.s. According to a common narrative, we have lived through a textbook instance of the madness of crowds. If this were all there was to it, we could rest more comfortably: greed can be controlled, with some difficulty, admittedly; overconfidence gets punctured; even stupid people can be educated. Unfortunately, the real causes of the crisis are much scarier and less amenable to reform: they have to do with the inner logic of an economy like ours. The root problem is what might be termed “rational irrationality”—behavior that, on the individual level, is perfectly reasonable but that, when aggregated in the marketplace, produces calamity.

Consider the [lending] freeze that started in August of 2007. Each bank was adopting a prudent course by turning away questionable borrowers and holding on to its capital. But the results were mutually ruinous: once credit stopped flowing, many financial firms—the banks included—were forced to sell off assets in order to raise cash. This round of selling caused stocks, bonds, and other assets to decline in value, which generated a new round of losses.

A similar feedback loop was at work during the boom stage of the cycle, when many mortgage companies extended home loans to low- and middle-income applicants who couldn’t afford to repay them. In hindsight, that looks like reckless lending. It didn’t at the time. In most cases, lenders had no intention of holding on to the mortgages they issued. After taking a generous fee for originating the loans, they planned to sell them to Wall Street banks, such as Merrill Lynch and Goldman Sachs, which were in the business of pooling mortgages and using the monthly payments they generated to issue mortgage bonds. When a borrower whose home loan has been “securitized” in this way defaults on his payments, it is the buyer of the mortgage bond who suffers a loss, not the issuer of the mortgage.

This was the climate that produced business successes like New Century Financial Corporation, of Orange County, which originated $51.6 billion in subprime mortgages in 2006, making it the second-largest subprime lender in the United States…

The book then provides a seven chapter blow-by-blow run through of the events of the Great Crunch itself.  Much of this material is familiar from recent news coverage and from other books, but the context provided by the prior discussion of utopian economics and reality-based economics provides new insight into the individual tosses and turns of the unfolding crisis.  It becomes clear that the roots of the crunch go back much further than the “subprime mortgage crisis”.

The more worrying conclusion is that many of the conditions responsible for the Great Crunch remain in place:

In the world of utopian economics, the latest crisis of capitalism is always a blip.

As memories of September 2008 fade, revisionism and disaster myopia will become increasingly common.  Many will say that the Great Crunch wasn’t so bad, downplaying the government intervention that prevented a much, much worse outcome.  Incentives for excessive risk-taking will revive, and so will the lobbying power of banks and other financial firms.  If these special interests succeed in blocking meaningful reform, we could well end up with the worst of all worlds.

As Cassidy explains:

It won’t be as easy to deal with the bouts of instability to which our financial system is prone. But the first step is simply to recognize that they aren’t aberrations; they are the inevitable result of individuals going about their normal business in a relatively unfettered marketplace. Our system of oversight fails to account for how sensible individual choices can add up to collective disaster. Rather than blaming the pedestrians for swarming the footway, governments need to reinforce the foundations of the structure, by installing more stabilizers. “Our system failed in basic fundamental ways,” Treasury Secretary Timothy Geithner acknowledged earlier this year. “To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game.”

Despite this radical statement of intent, serious doubts remain over whether the Obama Administration’s proposed regulatory overhaul goes far enough in dealing with the problem of rational irrationality…

In his final chapter, addressing the question “What is to be done?“, Cassidy advocates a few specific proposals, ranging from the specific to the over-arching:

• Banks that create and distribute mortgage securities should be forced to keep some of them on their books (perhaps as much as a fifth) – to make them monitor more closely the types of loan they purchase;
• Mortgage brokers and mortgage lenders should be regulated at the federal level;
• The government should outlaw stated-income loans, and enforce the existing fraud laws for mortgage applicants, which make it a crime to misrepresent your personal finances;
• Wall Street needs taming … the more systemic risk an institution poses, the more tightly it should be controlled;
• The Federal Reserve should set rules for Wall Street compensation and bonuses that all firms would have to follow … the aim must be to prevent rationally irrational behaviour.  Unless some restrictions are placed on people’s actions, they will inevitably revert to it.

Footnote: For more by John Cassidy, see his online blog.