HOW MARKETS FAIL: GROUNDING ECONOMICS IN REALITY. John Cassidy.
IN BRIEF. Blind faith in effectiveness and efficiency of free markets led to the ...
HOW MARKETS FAIL: GROUNDING ECONOMICS IN REALITY John Cassidy IN BRIEF Blind faith in effectiveness and efficiency of free markets led to the Financial Crisis of 2008. To avoid future economic calamities, policy makers should adopt more “reality‐based economics” in their decision‐making. THE FREE MARKET SYSTEM: MERITS AND LIMITATIONS Merits of free market system Division of labour – In free markets, workers specialise in their comparative advantage, which increases productivity. Invisible hand of the market – Interactions of self‐interested consumers and producers result in an allocation of resources that is beneficial to the whole community. Limitations of free market system Public goods such as street lights and national defence may be under produced by markets. Negative externalities produced by some institutions – Adam Smith advocated that banking institutions be regulated as their bankruptcy can drag down the larger economy. Downward spirals – Thomas Keynes argued that capitalist economies are unstable due to the downward spirals during slumps. In recessions, firms lay off workers due to decreased demand. However, the increased number of unemployed would further decrease consumption, which would result in even more lay‐offs. Rational irrationality – According to Keynes, macroeconomics cannot be reduced to a microeconomic foundation due to possible fallacy of composition. Rational individual decisions can aggregate to a socially sub‐optimal outcome, especially in the finance industry (for example, hedge fund managers, who base their decisions on actions of competitors rather than fundamental evaluations). Asymmetric information – Free market theory assumes perfect information between participants. In reality, asymmetric information is prevalent and causes serious market failures, including adverse selection (e.g., Lemon market of second‐hand cars), moral hazard (irresponsible and unnecessary risk‐taking) and principle‐agent problem (sub‐optimal outcomes due to conflict of interests).
Bounded rationality – Behavioural economics challenges the assumption of rational behaviour of free market theory. People are generally disaster myopic due to representative heuristic (generalisation on a basis of a small sample) and availability heuristic traits of the human mind (prediction about the frequency of an event based on how easily an example can be brought to mind).
THE 2008 FINANCIAL CRISIS: A FAILURE OF ECONOMIC IDEAS Free markets were wrongly believed to be efficient, predictable and stable US policy makers and associated institutions (IMF, World Bank, etc.) were caught up in the dogma of laissez‐faire economics. Policies that advocate free markets became mainstream, while regulations were perceived to be leftist and outmoded. The popularisation of classical dogmas was supported by a powerful finance lobby and prominent policy figures who were genuine believers in the free market idea. The Crisis helped the revival of reality‐based economics. Following the Crisis, there was a tilt in advocacy towards more government intervention and less reliance on self‐correction of the free market. Interventionist policies were introduced to save the economy post‐Crisis: Stimulus packages (by both George W. Bush and Barack Obama) Fed: Lenders of last resorts for financial institutions, accepted junk securities as collateral Federal Deposit Insurance Corporation (FDIC): Extended guarantee to many debts issued bonds as even blue chip companies could not raise capital through debt Capital bailouts, injections. Post‐Crisis interventions were mainly successful, but at what cost? US stock markets are back to pre‐Crisis levels, financial institutions are making money again and GDP/capita has rebounded. However, the appropriateness of the size of the stimulus packages is still debatable as the US economy is still struggling with lagging housing market and high unemployment rate. Interventions “...saved the economy but lost the public....” (Tim Geithner). The public was antagonised by the fact that the government used tax‐payers’ money to bail out those who were directly responsible for the Crisis.
LONG‐TERM CONSIDERATIONS FOR POLICY MAKERS No fundamental change in economic thinking Even though interventionist policies have been introduced, a paradigm shift did not happen as it did after the Great Depression. Possible reasons include the fact that the Crisis was rather short‐lived and did not turn into a Depression. Market structure remains fundamentally intact, flaws and all Financial industry unreformed: The fundamentals of financial institutions that contributed greatly to the crisis have not changed. The compensation system is still heavily focused on myopic rewards and disregards long‐term effects. “Too big to fail” institutions were not split up to avoid future moral hazard problems. Low interest rates persist: Due to the 2008 Crisis and the still lagging economy, the Fed has kept the interest rate close to zero for quite a while. This sustained period of very low interest rates may lead to another economic bubble and subsequent recession unless investments are regulated to prevent excessive speculative transactions. Global imbalances remain: They were not addressed post‐Crisis and there seems to be insufficient political will to tackle this impending issue in the near future. Change is slow but it will happen As Robert Samuelson, an economist, phrases it: “Progress occurs funeral by funeral”. John Cassidy has been a staff writer at The New Yorker since 1995. He also writes a blog on The New Yorker’s website, entitled “Rational Irrationality”. In addition, he is a contributor to The New York Review of Books and a financial commentator for the BBC. Mr Cassidy is also a published author of the following books: “Dot.con: How America Lost its Mind and Money in the Internet Era” and “How Markets Fail: The Logic of Economic Calamities”.
This summary, based on the MTI‐CSC lecture on “How Markets Fail: Grounding Economics in Reality” at the Civil Service College on 31 March 2011, was summarised by the Centre for Public Economics, Civil Service College.
