How Markets Fail: The Logic of Economic Calamities [Hardcover]

Amid the plethora of books about the credit-crunch (which has become a boom industry in itself), this account stands out for providing the context in which these events occurred. While many others have dealt with the immediate causes of the crisis and its aftermath, Cassidy takes the time to provide a short history of the economic theories that inform these processes - without which any explanation is inadequate.

Running through 200 years of economic theory might not enliven the spirits, but it's a measure of Cassidy's achievement that he makes it both informative and entertaining. And it is only through understanding how beliefs about the free market and economic efficiency serve certain interests, and feed into an ideology that uses circular reasoning to justify its relevance, that the contradictions that have imploded so spectacularly can really be understood - and how a theory which emphasises transparency could result in a system that depends on the kind of asymmetries of information and off-balance-sheet accounting that ensures that markets are so opaque and impenetrable that even the bank's own managers don't understand them.

From myths such as the Efficient Market Hypothesis and the rational individual, to the Prisoner's Dilemma (which ensures that we are condemned to act against our own best interests), Cassidy provides a balanced and thought provoking overview of market behaviour, before rounding it off with an explanation of the current crisis.

An essential read for anyone wishing to grasp the fundamental processes at work.

There has been almost as much comment and media analysis of the credit crisis as there were panicked trades in the markets at its peak. Most comment has taken an aggressive or defensive position around the role of bankers. John Cassidy's outstanding book is a dispassionate but engaging look at the historical, economic, sociological and academic context of the sub-prime crash and its terrible aftermath.

Cassidy does have a message, eloquently argued: the vast majority of economists, bankers and policy makers of the last three decades have been blindly irresponsible in their wholehearted espousal of the unfettered free market. Indeed, he refers to the ideologies of the Chicago school as "Utopian Economics". His arguments are deep, broad and lucid. He shows, quite irrefutably, how the perfect market, enlightened self interest, full information and other such axioms of the Friedman revolution are disastrously simplistic. The evidence of huge areas of hidden information, beauty contest group psychology and the paradoxical force of game theory outcomes is undeniable. The underlying force of markets, "rational self interest" often or even usually works against the mathematics of supply, demand and perfect information. His analysis of the reality of how bubbles happen and how disturbing they are for traditional economic theories of the market is explosively enlightening.

"How Markets Fail" also looks at the agents behind the disaster of the last two years. Cassidy is especially unforgiving of the once God-like Alan Greenspan. The old Fed Chairman's explanation for his arrogant irresponsibility in allowing - indeed encouraging - two major speculative bubbles (dot-com and sub-prime) to explode unchecked was a pathetic "The problem is.. a critical pillar to market competition and free markets did break down...that shocked me. I still do not fully understand why it happened."

Cassidy also looks at the bankers, in particular, the brilliant mathematical minds behind all their risk calculations and the lethal Value at Risk (VAR) model so widely touted as the unsinkable ship for navigating the icebergs of the market. I was shocked to find that these models and, indeed, the bedrock Black-Scholes option pricing formula, are based on long outdated analyses of how markets work, namely the random walk of share prices and a normal distribution curve for market pricing in general. In other words, all that sophisticated, grotesquely overpaid risk analysis edifice was built on an infantile assumption that all trades are independent of each other and traders never follow the herd.

Although there is a good deal of solid economic and financial analysis in this book it is imminently readable, sometimes un-put-down-able. His description of how the sub-prime market came into existence, grew and exploded reads like a thriller.

If, like me, you were once enthralled by the mathematical, organic beauty of the free market, the self correcting forces that would always take us back to a satisfying and essentially good equilibrium, this book is essential reading. John Cassidy's alternative prescription, a plea for "reality based economics" that takes into account how bankers, traders, business managers, house-owners and consumers" act in the real, non-utopian world is powerfully defended and should make us take stock and rethink. After all, what has happened is, fundamentally, a massive intellectual failure, a collapse of an ideology of hubristic wishful thinking. We've had enough of all that Master of the Universe stuff: what we need is rational, modest, realistic wisdom. "How Markets Fail" gives us exactly that.

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 ideologues
The `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 crisis
The 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).

Warning
But 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.