How Markets Fail. John Cassidy.

Cassidy, John. How Markets Fail. Penguin New York, 2009. NF; 12/22.

As I mentioned in my review of Lanchester’s I.O.U.: Why Everyone Owes Everyone and No One Can Pay I not only can’t do simple arithmetic, I also despair of rationally managing my own money, let alone understand the world of international business and finance. I just don’t seem to be able to predict the future. I’m cynically comforted by a conclusion way smarter people than I reach: nobody properly understands these things. This is confirmed in this book by a 60-year-old journalist educated at Oxford, Harvard, and Columbia.

Mr Cassidy gently walks us through Economics History 101 and then expands on what Lanchester discussed in his simpler analysis of why the 2007-2009 Great Recession happened. Bottom line as of 2009: what Tom Malleson calls “U.S.-style unregulated winner-take-all capitalism” doesn’t protect against catastrophe, and government regulation of the financial industry is necessary but, just maybe, also impossible.

I won’t try to precis the dozens of Nobel economists described here whose ideas began with Scotsman Adam Smith in the late 18th century. He appears to have discovered that economic self-interest causes markets to self-correct. Sometimes. The history of academic economics since Smith pits that conviction against attempts by practical thinkers to deal with the sometimes when it doesn’t.

The problems with what I think of as Smith’s “market fundamentalism” are described at length. These have led over the years to unpredictable events which Lanchester says “as every grown-up in the world knows … happen all the time”. Classical economics relies for example on everyone involved being rational. But most people aren’t. We are badly informed, not so smart, followers-of-the-herd, and credulous. And there are way more of us than the people in a position to really know what’s going on. John Maynard Keanes whose philosophy governed government thinking about finance during most of the 20th century knew this and proposed government fiscal policies that were intended to keep us all out of trouble and serve the public good. That advice remained received wisdom through World War II and the 1960s.

But in the 1970s Keynes’s policies were not working as well, and as I remember an old Asian physician commenting in the hospital cafeteria one morning “the train (was) turning right”. Margaret Thatcher and Ronald Reagan were elected. The most influential economist became one Milton Friedman who won a Nobel prize and advised government that free-market economics and “monetarism” were the way out of trouble (I’ve figured out that fiscal policy – Keynesianism – involves adjustment of taxation and government spending whereas monetary policy – Friedman’s approach – involves manipulating the money supply and interest rates). Author Cassidy comments that Friedman “didn’t sweat the math”. As head of the US Federal Reserve from 1987 to 2006 Alan Greenspan agreed with Friedman’s approach.

Leading up to the 2008 Great Recession and the near-meltdown of the American (and world) economy several important things were happening. First, as interest rates were lowered to stimulate the economy following the collapse of the “.com bubble” around 2000, large commercial banks and brokerages were encouraged to increase their profits by expanding lending, and house prices increased first slowly then much faster. “Subprime mortgages” – lending to borrowers traditionally not qualified – and new derivative investments (Credit Default Swaps for example – CDSs) through which large lenders sold exposure to mortgage defaults to investors also appeared and grew rapidly.

It took me awhile to understand CDOs. They aren’t a swap exactly, more like a form of insurance that is provided to the original lender, insurance against the borrower defaulting. The original lender then pays to the insurer a small monthly fee which is better than other comparable investments for that insurer. They were a reasonably safe investment as long as house prices were rising because if the “subprime” borrower was building equity and was unlikely to default.

Certain other things were driving these events according to author Cassidy: Greenspan was determined to allow the market to govern interest rates rather than to make artificial changes, so rates stayed low. Banks’ and brokerages’ corporate leaders who knew that the housing bubble and derivatives combination was probably out of control and could drive the economy into trouble, also knew that company profits (and their hundred-million-dollar bonuses) would only continue to increase while profits from those loans were pouring in and derivative insurance protected against default. Reducing exposure to be safe in this profitable circumstance would have got a bank CEO fired as competitors focusing on their own interest continued to benefit by following the unreasonable trend. They all faced the same sort of “Prisoners’ Dilemma”: if I do the “right thing” and nobody else does, I’m screwed.

One official compared the situation to a game of musical chairs where you had to keep dancing until the music stops. But when it stops, look out! At the same time some economists had changed their guiding ideology from traditional market ideas such as “general equilibrium theory” (a sophisticated form of Adam Smith’s thinking) to game theory. Musical chairs and the prisoners’ dilemma seemed more in line with reality.

Subsequent events are of course history. When in 2008 housing prices stopped rising as too many unqualified borrowers were defaulting on their monthly payments, the value of mortgage-related derivatives like “credit default swaps” (these and other derivatives traded on exchanges like stocks) also quickly fell as owners of these – often the same banks with the subprime mortgages – who had promised to cover mortgage defaults needed to get out quickly. Next giant banks and brokerages like Bear Sterns, Lehman Brothers, and Goldman Sachs got overextended and couldn’t meet their commitments. The new Federal Reserve chair Ben Bernanke faced rescuing these huge hundreds-of-billion-dollar companies with public funds or watch them default which would have led to a second Great Depression. He chose to rescue one (Bear Stearns) but then let another (Lehman Brothers) default and collapse.

When over a matter of days it became clear that one giant finance company’s collapse would lead to others, Bernanke announced that the US federal government would guarantee within limits failing banks through the Troubled Assets Relief Program (TARP). This guarantee that the American government would not allow a full worldwide economic meltdown proved to be enough to slow and eventually reverse panic selling both of houses and loan-related derivatives.

Our author Cassidy is firmly in the government control of finance camp. He expressed (writing in 2009) the need for governments to prevent financial panics in the future. We legislate safety on the highway and we prohibit dangerous and poisonous toys and food so why would we not take steps to prohibit unwise financial activity? he asks. It’s been remarked however that with the Great Recession of 2008 capitalism met its most dangerous enemy, but that that enemy is capitalism!

Wondering what had happened since the publication of this book I read a few articles online on how the US economy is doing. As recently as last year apparently qualified and ideologically neutral authors were guarded in their future projections. Of course the Covid pandemic, another unexpected event, has resulted in inflation, expanded public debt, and important worldwide changes in “supply chains” of just about everything. People doing difficult and often low-paying jobs in service industries have switched to other ways of making a living and healthcare and retail sales for example are unable to find workers without increasing pay and contributing to inflation.

Is something like a solution even possible? To me this is far from clear. The age-old struggle between market fundamentalism and government control continues, and from what I’ve read I suspect extremely highly motivated finance wizards will continue to find ways to benefit themselves which avoid control that governments can exert and still be elected. And damn the public consequences. The Prisoners’ Dilemma is alive and well and as I said in another book review we would all be better off if we trusted one another. But the hell of it is we can’t.

As a book on the Great Recession this is just fine if you don’t mind the “Economics 101” first half which I thought was interesting. But beach or bedtime reading it’s not so much. And Mr. Cassidy is certainly left-leaning in his views however well he supported them. He is an interesting, humorous, and engaging writer. Whether you take this on or not depends on how interested you are in world finance. My scores are the best I can do for what I imagine is the average reader.


About John Sloan

John Sloan is a senior academic physician in the Department of Family Practice at the University of British Columbia, and has spent most of his 40 years' practice caring for the frail elderly in Vancouver. He is the author of "A Bitter Pill: How the Medical System is Failing the Elderly", published in 2009 by Greystone Books. His innovative primary care practice for the frail elderly has been adopted by Vancouver Coastal Health and is expanding. Dr. Sloan lectures throughout North America on care of the elderly.
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