How Markets Fail by John Cassidy (review)

How Markets Fail by
John Cassidy
            For several decades, economists have
been fascinated with developing fancy, complex theories that explain how
markets work in what John Cassidy calls, “utopian economics.” Cassidy explores
the other side of markets—when they do not work. He stresses that some markets,
such as supply and demand for coffee, are straightforward, while others such as
financial and labor markets cannot simply be reduced to lines on a graph. Free
market theories assume that all consumers act rationally, but it unfortunately
does not take into account of reality based issues or “rational irrationality.”
In How Markets Fail, first Cassidy
discusses the rise of utopian economics, investigates the world of rational
irrationality. and lastly, how shortcomings of the market theories can be
applied to explain the financial crisis of 2008.
To start, free market ideology is
largely based on the rational pursuit of self-interest that each person is
looking to make themselves better off. A few notable utopian economists
believed this to be true and Cassidy walks the reader through history
elaborating on each economist’s contribution to the field. Adam Smith was the
forerunner of free market enterprises. Smith believed there was an “invisible
hand” that guided the economy and that prices hovered near a natural price. He
was also well known for his theories on the division of labor and the idea that
maximizing profits was self-evident for all companies. While Smith did not
believe in social impacts to the free markets, Friedrich Hayek did. He believed
that markets were intricately complex systems and market prices were meant to
gather information. It was an idea that looked attractive on paper, but it
couldn’t handle “the division of knowledge” or how to utilize knowledge of
resources. Hayek mainly focused on price signals, Walras studied supply and
demand but Pareto studied preferable outcomes later to be known as the “Pareto
effect.” The Pareto effect was that in trade each person would come out of the
trade better off even though they may not have gained the most profitable
outcome (such as gaining an apple yet giving away two oranges).
            While these contributions helped
shape economic thought and view of markets today, other influential students of
economics came into popularity that contradicted the traditional free market
beliefs. Cassidy mentions several influential economists whose theories can be
applied to the financial crisis of 2008, but two that stand out the most are
Ackerloff and Keynes. Ackerloff is primarily noted for his research on, “The
Market for Lemons,” which uses the used car market to discuss hidden
information and its effect on markets. Essentially, the sellers in the used car
market have more knowledge about what is wrong with their cars than the
potential people buying them do. The same can be applied to health insurance
and lenders of loans. A person wanting to buy health insurance in reality knows
more than a potential insurer does about their health because they know their
lifestyle and diet habits. From a financial standpoint, lenders do not have
perfect information about the people applying for loans. The individual knows
their income opportunities and spending habits better than the lender. One of
Keynes’ most notable theories was the concept of a beauty contest. When a crowd
is required to decide who is prettiest, each individual will more likely to
choose the outcome the majority will choose rather than basing their choice on
personal preferences. Individual opinions become lost and the desire to go with
the average opinion becomes stronger. Objections to the Keynes’ Beauty contest
were that while going with crowd had benefits in the short term, in the long
term true value would prevail, rewarding investors who stuck with the
fundamentals and personal choices. However, when applied to the financial
sector the opposite proved to be true. Brokers were more likely to expect what
their colleague’s moves would be and avoid investing in out of date or
unpopular stock options. This scenario can be applied almost perfectly to the
boom and crash of the real estate market which eventually led to the financial
crisis of 2008.
            Lastly, the 2008 Financial Crisis
arguably triggered the worst recession in American history. Cassidy devotes the
last part of the book to explain what led up to the crisis and how dangerous it
is to conform to ideological beliefs in today’s modern economy. The financial
crisis was largely brought on by an increased boom in real estate in the early
2000s. Home prices were at historic highs, but consumers were still purchasing
them. Speculations of a housing bubble began to surface but officials such as
the Fed chairman at the time, Alan Greenspan, ignored the signs stating that in
the free market bubbles are least likely to exist, let alone burst. The housing
market seemed stable so not only did consumers purchase more homes, but banks
decided to start buying and leveraging mortgages to increase profits. It
started to get out of control when the people who were buying homes did not
have the credit approval to purchase them. Corporate greed started to become an
issue when bank lenders ignored these warnings and approved the credit anyway,
simply to make a profit. When these home owners defaulted on the mortgage,
which was inevitable, banks quickly tried to sell off these bad assets to
someone else. No one wanted to buy them now. With bad assets and revenues
beginning to dwindle after a good investment gone badly, several banks were on
the verge of filing for bankruptcy. Lehman Brothers did end up going under but
investment firms such as Freddie Mac and Fannie Mae were bailed out along with
Citigroup and AIG by the government. The idea of “too big to fail” was no
longer true when everything came crashing down in the financial sector.
Investors and Greenspan were eventually very wrong about the presence of a
bubble but it was too late. The substantial trust in the free markets and that
everything would correct itself proved, in reality, not as reliable as they
thought. The financial crisis on Wall Street in turn set off shocks in other
economies around the world and started a global recession. It caused many
people to take a step back from the ideological beliefs of the past and form
new opinions of how markets truly work and fail.
            In conclusion, John Cassidy gives
the reader a well-rounded view of the history of economic thought and how it
has shaped economic beliefs today. He also provides a largely unbiased
perspective on the causes that led up to the financial crisis and how
untrustworthy ideological thinking really is. Behavioral economics is coming
into vogue and in regards to the modern economy it should be studied more than
classical economics. Free market ideologies are helpful in explaining general
economic concepts but when relied on heavily, adverse consequences and
financial ruin occur. Cassidy’s book discusses what most mainstream economists
will not. His underlying point is that markets in a realistic sense will all
fail, but it’s not a matter of if, but when.

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