How Markets Fail: the Logic of Economic Calamities

Some people have been doing very nicely in the past year or two. Versatile accountants who once enjoyed the fruits of entrepreneurial exuberance have continued to prosper by turning their skills to counting the costs of all that deplorable excess. It reminds us that the term "entrepreneur", when first adopted by the Victorians, often used to be translated literally as "undertaker".

John Cassidy is no undertaker at the funeral of capitalism; nor is How Markets Fail an obituary. His thesis is not that the system must fail, in a terminal way, but that markets can fail, in a way that only government intervention can remedy. If this sounds like common sense, well and good. Why on earth would anyone ever suppose differently? Because they have studied economics in Chicago is one answer, as readers of this engaging book will discover.

How Markets Fail gives an overview of the collapse that almost brought down the world economy a year ago. It also stands back from the immediate crisis in order to explain why it all happened. And this takes us into a long preliminary digression on two rival traditions in the history of economics.

At this point many readers may blench. Too sensational for Oscar Wide's Miss Prism, issues of economic theory remain notoriously intractable. But anyone who enjoys a good read can safely embark on this tour with Cassidy as their guide. Not for nothing is he a staff writer on the New Yorker, which has played host to earlier drafts of some of his liveliest chapters. Like his colleague Malcolm Gladwell, Cassidy is able to lead us with beguiling lucidity through unfamiliar territory.

Cassidy makes a fundamental distinction between what he calls "utopian economics", which is the problem, and "reality-based economics", which is the solution. Though Adam Smith appears here as the founder of the utopian tradition, his status as a great economist is never derided. What went wrong with economics was that suggestive metaphors, notably Smith's "invisible hand", were successively reinterpreted as rigid doctrines about the infallibility of the free market and its limitless powers of self-correction.

That baleful outcome is apparent in the career of Alan Greenspan. As chairman of the Federal Reserve, he held office under Republicans and Democrats alike from 1987-2006. In the latter years of his tenure, he was credited with almost uncanny skills as the technocrat who kept the long boom boiling. Only after it had boiled over in 2008 was he summoned back by a suddenly attentive Congress to account for his stewardship. "I made a mistake," Greenspan confessed, "in presuming that the self-interest of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."

It is a key quotation, well worth unpacking. The point is not to scapegoat Greenspan personally, but to reveal the significance of his simply "presuming" that the market was its own best regulator. The reigning precepts of the past 30 years have, in short, been built on the assumption of market efficiency. Once such an axiom is accepted, it seems obvious that the market can do no wrong. Indeed, the idea that it can fail becomes unthinkable.

All of this is the legacy of utopian economics, as Cassidy tells us. While the ramifications of such doctrines were elaborated with ever-increasing mathematical rigour at such universities as Chicago, however, the rival tradition of reality-based economics was never snuffed out. Its realism can be expressed in different ways, but the common theme is that the market can fail to capture all the information necessary to sustain the assumption of infallibility.

Cassidy writes, in particular, of "rational irrationality" as the central flaw. He finds such a concept developed particularly in the writings of John Maynard Keynes and in the work of the American Keynesian Hyman Minsky. The point is not so much that individuals personally do not act as rational agents (though they often fail to do so): the trouble lies deeper. For there are many situations in which, by pursuing our individual interest in an apparently rational way, we help to produce an outcome that is collectively irrational. Hence, markets may spiral out of control, unless the collective interest is expressed through some form of intervention, or what Cassidy nicely calls "adult supervision".

Little wonder, as even Chicago economists now acknowledge, that we all become Keynesians in the foxhole. How Markets Fail does not claim to have all the answers, but it deftly illuminates some crucial problems in the light of our recent experiences.

 

How Markets Fail: the Logic of Economic Calamities
John Cassidy
Allen Lane, 400pp, £25

 

Peter Clarke is the author of "Keynes: the 20th Century's Most Influential Economist" (Bloomsbury, £16.99)

 

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