How Markets Fail: A Rational Evaluation of Recent Crises and Financial Governance

What exactly happened in the economic crisis in the late 1990’s and the financial crisis of 2007? What is the role of the U.S. government and The Federal Reserve in containing these crises? How should we understand financial markets? Although all of these are quite broad and undoubtedly tough questions, John Cassidy manages to come to grips with them all in his recent book, How Markets Fail. Cassidy presents a thorough overview of “utopian” economic theories, primarily based on Adam Smith’s precepts, then translates and applies them in plain English to the recent economic crises. First providing a basis of the knowledge that influenced Alan Greenspan, Ben Bernanke, and other influential players, he untangles the web of problems that created the bubbles, evaluates behaviors, and proposes uncomplicated solutions. Overall, How Markets Fail is an excellent book for readers of all backgrounds and all levels of expertise; it is incredibly simple, given its comprehensiveness, and it imparts a wealth of useful knowledge at all stages.

Cassidy begins his book by outlining various components and aspects of “utopian economics.” Although his definition is somewhat vague, the term generally refers to the belief—notably held by Alan Greenspan—that markets are perfectly self-regulating, and that they naturally achieve an optimum state without government intervention. The book chronicles the development of pro-free market thought, and notes the major contributions of several individuals, such as Friedrich Hayek, John Stuart Mill, and Milton Friedman. Of course, there is also significant discussion of Adam Smith, whose concept of the “invisible hand” led many to believe that all markets are best left to their own devices (Cassidy 31, 36). Cassidy then moves to later work in this field, discussing price signaling, natural resource allocation, and a general support of a “hands-off” philosophy (Cassidy 42-43, 50). While Smith was actually skeptical of unregulated financial markets, over time, his views morphed into the false belief that markets are perfectly efficient and balanced when left untouched. Although Cassidy fails to explain how this happened, he makes a key point about which many, including Greenspan, were mistaken. It is clear that the “invisible hand” is undeniable, but a bit more discussion of the balance of free market and “planning” forces would have cleared up ambiguities in Cassidy’s position and would have segued nicely into his next points.

In the second and third sections of How Markets Fail, Cassidy unapologetically brings this idealistic conception to earth. His practical evaluation of the lead-up to recent financial crises is refreshing and adeptly-argued, explaining things in simple terms of incentives, group competition, and general psychology. Through this, Cassidy demonstrates the need of some government regulation and ownership, citing intellectual property protection and federal defense as some of the many beneficial and sensible examples (Cassidy 133, 136). He then moves onto a discussion of “rational irrationality,” or the confusing, self-interested behavior of financial players in response to incentives. This mode of thinking is incredibly useful, and it fits neatly within the overall depiction of the crisis. Essentially, there is always an incentive for firms and analysts to choose the most desired investments or stock (known as the “Keynes beauty pageant”), which leads to a lack of diversification and increased risk in the case of failure (Cassidy 178). Moreover, in a competitive market, there is an ever-present “prisoner’s dilemma.” Though lending groups may begin conservative, lending only to responsible businesses in order to ensure stability for all, there is always an incentive for one to game the system and offer loans to slightly riskier clients. Once this happens, bidding begins, and firms start pushing for more precarious loans. Such a phenomenon was forecast almost prophetically by Hyman Minsky, and was evidenced especially by the rapid expansion of adjustable rate subprime loans (Cassidy 208, 258).

After explaining the structural incentives driving this irresponsible behavior, Cassidy tackles the bubbles themselves. In the beginning of the five stages—displacement, boom, euphoria, peak, and bust—big lenders see high stock prices, rapidly expanding financial markets, and a safety net of government backing. Firms such as Citi Group, Goldman Sachs, and others, tried to “surf” the housing bubble, extracting maximum profits and hoping to jump ship just in time. Banks took on sizeable risks creating innumerable types of pooled capital, diversified risks, and hybrid loans, knowing full well that taxpayers would foot the bill if the projects failed (Cassidy 161, 184). While this was happening, the Fed continued to believe that recent innovations had made the financial system “resilient,” and that there was nothing to worry about (Cassidy 268). By contrasting this vicious incentive system—which created self-destructive rational irrationality—with the Fed’s hands-off approach, Cassidy makes it very clear why the market failed. It was only after the government stepped in, bailed out firms, socialized Fannie Mae and Freddie Mac, and realized the need for an active Fed that things began to get better. In Cassidy’s view, only government can counterbalance rational irrationality and create a framework of incentives that would reward responsibility, measured risks, and a degree of financial conservatism (Cassidy 329). 

In all, Cassidy’s take on market failure is quite thorough and logical, and there are few areas in which any would say that it is lacking. His choice to begin with the fundamentals of free market thought, and then progress to realistic evaluation of human behavior in complex financial markets, creates a straightforward explanation of a difficult topic. Moreover, Cassidy deftly cracks the disillusioned belief in Smith’s almighty invisible hand, presenting an argument for government intervention that would be received on both sides of the aisle. Still, however, one might wonder if any of this counterbalancing or checking could be done by the private sector—either by specifically-designated entities, or perhaps by agreement of the most influential players in the financial system. Similarly, though he is clearly a proponent of tempered government intervention, Cassidy is a bit unclear on when the Fed and policymakers ought to leave the market to its own devices. Of course, knee-jerk regulation may create stability and stop “bubble-surfing,” but it could easily smother innovation and de-incentivize growth. By delineating here between crisis and normal business cycle, Cassidy might have drawn a clearer line and supplemented his argument with intelligent discussion of a hotly-debated question.

While his ending proposal for re-structuring and re-thinking is quite reasonable, Cassidy unfortunately neglects one of the largest obstacles in monetary policymaking: time lag. Presumably, a good portion of his recommendations would be implemented as preemptive measures, and would already be in place when crisis threatened again. Still, he fails to mention that even a more active Fed would encounter difficulties, because it would take time for the economy to react to its adjustments. Furthermore, Cassidy notes that the housing bubble was unexpected, because Bernanke and others believed the economy to be immune to such a thing. Given the comprehensive, multi-perspective approach of this book, it would be quite interesting to see Cassidy’s projections about future crises. Though he proposes a model to combat some of these rational irrationality behaviors, there is likely still room for a new strain of financial busts. What his book intends, however, it achieves remarkably well. How Markets Fail is not only a lesson in foundational economic thought and mechanisms of crises, but also human behavior and group mentality—lessons that apply in any era or policy system.