Books To Share: How Markets Fail

Posted on April 10, 2011


If, like me, you have wondered why you didn’t get a raise at the end of 2008 or a bonus in 2009 and what caused the great stock crash of 2008-09, then I would highly recommend How Markets Fail: The Logic of Economic Calamities by John Cassidy. The book is reasonably context-dense but the author does a fantastic job of explaining his line of thinking and the conclusions he arrives at.

The author begins by observing that the stock market is only a component, albeit a special, visible and glamorous component, of the general economy and the principles that govern and cause failures of markets at large also explain the failures of the stock market. As with any book on economic thought and philosophy, the author begins with discussing Adam Smith‘s theory of the Invisible Hand and how subsequent economists built on this idea. I found Freidrich Hayek’s insight, comparing markets to a  telecommunication network where prices are signals that participants use to coordinate their actions, particularly illuminating. The author then details the contribution made by a number of economists to the progress of what he calls the utopian economic thought that led us to the General Equilibrium Theory. The author then presents the competing views on what policy makers must do when the economy drifts from its general (and desired equilibrium). In the red corner we have John Maynard Keynes who argues that it is only massive government directed investment that can set right a drifting economy and in the blue corner we have Milton Friedman, who had no faith in any government’s ability to take a wise decision, insisted that only the market can correct its own excesses. In Friedman’s world the government’s job was merely to control the money supply that allowed the market to take actions to set right the balance. The author, however, argues that regardless of whose views (Keynes or Friedman) you find palatable, either of these lines of thought are utopian. They do not take into account that any market is a human construct and humans have limited knowledge & intellectual capacity, short time horizons for decision making, are unable to control or influence their physical environment and given to emotions and certainly not rational. The author therefore argues that markets are not can not autonomously find the equilibrium predicted by the General Theory and any intervention must account for the fraility of the humans that make up these markets.

In the second part of the book, the author reviews the contributions made to what he calls the reality-based economic thought. He reviews the work of Arthur Cecil Pigou in explaining the failures and imperfections of the market. Pigou’s key insight was the difference between the private value and public or societal value of a good or a service and a market that exclusively aims to maximize individual private value may not lead to maximizing societal value and in some cases may lead to market failure. It was Francis Bator who offered a taxonomy of market failure, identifying three principal contributing factors – monopolistic or oligopolistic market structure, little or no incentive to produce public goods (parks, accessible healthcare, etc.) and spillover or externality (pollution, etc.). The author then gives a fairly detailed overview of the impact Game Theory, non-Gaussian statistics and even Pschycology have had on the development of the reality-based economic thought. In essence the reality-based economic thought rejects the notion of a all-knowing, self correcting market and demands close monitoring and prompt policy intervention to prevent market failure.

In the last part of the book, the author chronicles how the ascendency of the utopian economic thought, more specifically the Friedmanian monetary thought, in the American (and British) policy making sowed the seeds of the 2008-09 whirlwind. The author lucidly, as possibly as it can be, explains the creation of the sub prime mortgage industry and associated stock market innovations.  He argues that the inability, nay the unwillingness, of policy makers and market watchdogs to monitor these developments and their misplaced belief in the efficacy of the market to correct itself, ultimately took the world to the edge of a precipice staring down at a global market failure of epic proportion. The author is particularly severe on Alan Greenspan who he blames of severe orthodoxy of economic thought and thereby precipitating the two market failures (the dot com bust and the sub prime bust) in his 20 year tenure as the head of Federal Reserve. Finally, the author chronicles the whirlwind months after the collapse of Bear Sterns to highlight how the American economic czars jettisoned their own belief in utopian economic thought in a race to save the world markets from a complete meltdown. It is the author’s strong case that if policy makers and market watchdogs were more respectful of the reality-based economic thought and used the associated mathematical framework to frame policy and intervention, the world could have easily avoided the crisis of 2008 and most importantly I would have got a raise and an annual bonus. 🙂

I thoroughly enjoyed the book. It does demand attention and took me significantly more time to finish it compared to other 350 page books I have read. I would highly recommend it and more so to those who have a touching belief in the market’s ability to solve all social and economic problems.


Posted in: Books To Share