"How Markets Fail" Review by James Pressley
Dec. 10 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke delivered the wrong speech this week at the Economic Club of Washington. The correct script appears in How Markets Fail, an admirably lucid account of how utopian economics drove us to disaster.
In an ideal world, Ben Bernanke would give a speech acknowledging the Feds failures and blunders in which he was complicit, and pledge to return the Fed to its traditional role, writes the author, John Cassidy of the New Yorker.
This is a book about how flawed ideas, and the people who promoted them, tipped us into the worst financial crisis since the Great Depression. Its high time, Cassidy says, for the Fed to repudiate the Greenspan Doctrine, the former Fed chiefs argument that modern markets -- so efficient, so rational -- can be counted on to disperse risk and police themselves. There was no point in trying to prick asset bubbles, Alan Greenspan argued, because they cant be detected until they burst.
The chances of Bernanke giving that speech are as low as the Fed Funds rate today: effectively zero. If U.S. senators are sincere about fixing the Fed, they should oblige him to read this book before confirming his second term.
How Markets Fail is three books in one. The first traces the rise of free-market theory, taking us from Adam Smiths invisible hand (and highly visible nose) through Friedrich Hayeks description of price signals as a system of telecommunications and on to Greenspans bubbles.
Rational Irrationality
The second explores what Cassidy calls reality-based economics. Humans dont really behave like homo economicus, calculating pros and cons with the speed of a Roadrunner supercomputer. The messiness of life tends to gum up the elegant models of the efficient market hypothesis.
We rely on instinct, apply rules of thumb and often run with the herd. Pursuing our own self-interest, we are hemmed in by mental limitations and circumstances that force us to act amid partial information, uncertainty and confusing signals. The result can be resolute yet self-defeating behavior, which Cassidy terms rational irrationality.
Game theorists, for example, have demonstrated that humans can fall into logical traps. Charles Prince of Citigroup Inc. discovered this in 2007, when he felt constrained to keep lending amid turmoil in the U.S. subprime mortgage market.
As long as the music is playing, youve got to get up and dance, Prince told the Financial Times that July. Were still dancing.
Minsky Moment
The hero of this section is Hyman Minsky, whose Financial Instability Hypothesis argues that capitalist economies trigger waves of first credit expansion and asset inflation and then credit contraction and asset deflation. Stability, in this view, is destabilizing. Mainstream economists paid scant attention to his argument until the subprime crisis roiled markets in 2007. That was the Minsky moment, when credit dried up.
In the third section of the book, Cassidy shows how rational irrationality pumped up the housing bubble and wrecked the financial system. This is a compelling synthesis that derives most of its narrative energy from the authors clarity of thought and exposition.
Cassidy plays down character issues, saying that Wall Street executives were neither sociopaths nor idiots nor felons. They were, rather, men competing in an environment that provided them with no incentive to pull back. He has far less sympathy for the former Fed chairman.
Libertarian Instincts
Greenspans claim that the market economy was innately stable was an absurdity, Cassidy says. Here was a man of libertarian, antigovernment instincts who for almost two decades headed an institution that was designed to save financial capitalism from itself. One might have expected Greenspan to call for the abolition of the Fed and to argue that troubled banks should be allowed to fail.
This he never did, Cassidy writes. Instead, he helped make it easier for financiers to take on extra leverage and risk while pursuing a monetary policy that often seemed designed to protect them from their mistakes.
All the while, big financial firms enjoyed a safety net that included deposit insurance, a Fed able to print money and a Congress that could authorize bailouts.
In such an environment, pursuing a policy of easy money plus deregulation doesnt amount to free market economics, Cassidy writes. It is a form of crony capitalism.
Is Ben Bernanke ready to give the right speech now?
How Markets Fail: The Logic of Economic Calamities is from Farrar, Straus and Giroux (390 pages, $28). To buy this book in North America, click here.
(James Pressley writes for Bloomberg News. The opinions expressed are his own.)
To contact the writer on the story: James Pressley in Brussels at jpressley@bloomberg.net.
Last Updated: December 9, 2009 19:00 EST
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