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Hedging America

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How Markets Fail: The Logic of Economic Calamities
By John Cassidy
(Farrar, Straus and Giroux, 390 pp., $28
 

One tried-and-true way to start off a course in elementary economics is to call the students’ attention to a common object, such as the spiral notebooks in which they are presumably busy taking notes. Somewhere paper is manufactured with the appropriate strength and slickness, somewhere else it is cut into blocks of the right size, the corners rounded, printed with lines about the right distance apart, provided with cardboard covers in the college colors, punched with the right number of holes, bound with those wire spirals that have been manufactured in yet another place, and delivered in reasonable numbers to the college bookstore at the beginning of each term. And all this happens smoothly, without any centralized direction, through the normal operation of a market economy. How does it really work? And how can it go wrong?

My late colleague Evsey Domar, who was, among other things, a student of the Soviet economy, told us how the planning bureau began by setting production quotas for paper factories in tons per year. The result was paper so thick that it could not fit in a Soviet typewriter or anywhere else. So the clever planning bureau changed to setting quotas in terms of square meters per year. The result was paper so thin that even a member of the planning bureau could see right through it. The lesson is that it is so much simpler and more effective to tell paper producers that they have to compete to sell their paper to notebook manufacturers (who are also competing with each other), and live off the proceeds.

If this is how more or less free, more or less competitive markets can deal with something as simple as a spiral notebook, how much more remarkable it is that they can do the same for something as complicated as a computer or a refrigerator. But there seems to be no other practical way to run a modern economy efficiently. That is what Adam Smith understood: a competitive market economy, motivated primarily by individual pecuniary self-interest, can produce coordination where one might expect only chaos.

He invented for that process the memorable image of the Invisible Hand. In the following two centuries and more, an army of economists has spent an enormous amount of time and intellectual effort refining and elaborating Smith’s initial insight, teasing out exactly how far that logic can be carried, how the hand operates, investigating when and how it breaks down, and elucidating odd or complex special cases such as professional team sports, or Internet services, or health care. (A recent issue of the highbrow American Economic Review contains highly technical articles aimed at understanding particular aspects of oil prices, gasoline taxes, urban transit, art auctions, and “two-sided matching markets” like that connecting graduate students and graduate schools.)

In one way it is an interesting intellectual game; in another, it is a deadly serious battle for very high stakes. For in the course of producing and distributing goods and services, market outcomes generate incomes, wealth, status, and power. Any modification of market outcomes modifies the allocation of incomes, wealth, status, and power. So it is no wonder that the discussion has become thickly encrusted with ideology. And one convenient way to turn subtle argument into ideology is to create dichotomies where there are originally fine gradations of more and less. For example: are you for or against “the free market”?

Today, of course, no one is against markets. The only legitimate questions are: What are their limitations? Can they go wrong? If so, how can we distinguish the ones that do from the ones that don’t? What can be done to fix the ones that do go wrong? When is some regulation needed, how much, and what kind? More broadly: how to protect the economy and society against specified tendencies to market failure without losing much of either the capacity of a market system to coordinate economic activity efficiently or its ability to stimulate and reward technological and other innovations that lead to economic progress?

The subtitle of John Cassidy’s book illustrates the problem. Most market failures--they occur every day--are not even nearly calamities. They start with the existence of partial monopoly power in this or that industry, with the result that the market price is “too high” and the rate of production “too low” in the precise sense that everyone could be made better off if that error were corrected. They extend to cases where the market does not impose the full costs of their actions on certain producers and consumers, with the result that economic activity is misdirected: the consequences may be minor (a small amount of pollution) or major (fish stocks collapse from overfishing) or potentially catastrophic (climate change from excessive unpenalized emission of greenhouse gases). And what are we to make of the stock-market collapse of October 1987, the largest one-day fall ever on the New York Stock Exchange? It was in one sense a calamity, but it left essentially no trace in the “real” economy of production, employment, consumption, and everyday life. Evidently being for or against “free markets” does not come close to being an adequate response to the problems that arise in a complex modern economy.

 

Cassidy, who writes on economics and finance for The New Yorker, yields a bit too easily to the journalist’s instinct to set this issue up as a battle of Light against Darkness. The first two parts of his book contrast what he calls “Utopian Economics” with “Reality-based Economics.” In fact he is aware of some of the qualifications and fine distinctions that fact and logic call for, and a careful reader will come away with at least a general feeling for the difficulties facing any serious attempt to understand the working of market economies. The last part of the book is a retelling of the financial meltdown of 2007–2009, from which the world is only beginning to emerge. Cassidy casts it as a story of Utopian Economics Carried Much Too Far.

There is a certain amount of truth in that characterization. By “utopian economics,” Cassidy means, in the first instance, the careful elaboration of the precise scope of Adam Smith’s Invisible Hand. It turns out to be a lot more complicated and attenuated than sloganeering can afford to acknowledge. To begin with, if a market economy is to be advertised as doing an acceptable job, we need a definition of a good economic outcome.

The standard version says that one allocation of goods and services to individuals (call it A) is better than another (B) if everyone is at least as well off (in his or her own estimation) in A as in B, and at least one person is better off. So there is to be no trading off of one person’s well-being against another’s. That sounds fair; but notice that judgments about inequality are ruled out: if everyone is equal but poor in A, and B differs only by making one person fabulously rich, B is better than A. That sounds a little less appetizing, but this extreme case underscores the individualistic nature of the whole exercise: nothing is supposed to matter to anyone but his or her own access to goods and services. Notice also that, by this definition, most As and Bs simply cannot be compared: some people are better off and some worse off in A than in B, so neither is “better” than the other.

The next step is to say that such an allocation is “efficient” if no feasible allocation can leave everybody at least as well off as they were and make somebody better off. In other words, there is no “better” allocation. You would like your economy to lead to an efficient outcome. There are many efficient allocations, some egalitarian and some just the opposite, and none of them is better or worse than any of the others. They cannot be said to be equal either; they are simply not comparable in this language.

It is important to understand what this definition does not mean: it does not say that any efficient allocation is better, more desirable, than any inefficient one. Why not? Suppose you happen to gain from the inefficiency and I happen to lose. Then eliminating the inefficiency does not meet the test for a “better” state: you lose and I gain. More concretely: suppose your favorite plumber would gladly work an extra hour for $50, and suppose that you would gladly pay $50 for the work that she would do in that hour. It would be a socially useful transaction, if no one else were affected. But if your plumber pays a 20 percent marginal tax rate, she would clear only $40, and then this socially useful transaction does not happen. An income tax is “distortionary.” It creates an inefficiency. But now imagine that the tax revenues are used to provide education or health care or other benefits to poor or disabled or otherwise deserving people who would otherwise have to do without. Then one cannot say that the no-tax efficient allocation is better than the inefficient one. Some other criterion has to be invoked.

I have insisted on these gory--or dreary--details for a reason. Careful analysis shows that, if there are no distortions (and under further assumptions, to be discussed in a moment), a competitive market economy in equilibrium will achieve an efficient allocation of resources. That much is, so to say, a theoretical fact, and Cassidy lays it out well. Now comes the layer of ideology: advocates, some of whom may know better, use the “efficiency of free markets” to argue against taxes and regulation in general--they are distortions--and in favor of laissez-faire. Any interference with the free market, they declaim, is ipso facto a bad thing.

There are at least two things wrong with this ploy. The first has already been discussed. If a tax or regulation creates an inefficiency, “better” outcomes are available, but the pre-tax or pre-regulation situation is very unlikely to be among them. Some group will have gained from the regulation or from the tax and the use of its revenues. Finding and achieving one of the better outcomes requires thought and judgment. “Just say no” is not good policy. Perhaps I should be explicit also on the other side: many taxes and regulations create large inefficiencies for very little gain. The point is that no blanket statement is possible.

The second reason is that the Invisible Hand Theorem is valid only under certain assumptions, some of which only need to be stated to be seen as very dodgy. Clarifying those assumptions is the role of Cassidy’s “reality-based economics.” One of them is the absence of distorting taxes and regulations. Another is the absence of elements of monopoly, or monopolistic imperfections that fall well short of monopoly, like catchy brand names or advertising gimmicks that give a seller some freedom in setting prices, or other barriers to competition. Of course such imperfections are ubiquitous in every modern economy. The existence of economies of large-scale production in some industries is already a deal breaker for the Invisible Hand, and they make some element of monopoly essentially inevitable.

And that is far from the end of the matter. The informational requirements for the validity of the Invisible Hand Theorem are considerable. All buyers and sellers must have access to the same information, preferably complete information, and they must be able to process the relevant information, and they must be willing and able to behave rationally in the light of it. (Unpacking the notion of “rationality” in this context would be tedious: it involves having consistent, non-contradictory preferences about one’s consumption of goods and services, and knowing how to find one’s way to the most preferred among all feasible configurations.)

Yet another requirement is the absence of significant external effects or “externalities.” An externality occurs whenever one person’s or one firm’s behavior directly affects the well-being of other persons or firms positively or negatively without the first party bearing the costs or being remunerated for the costs or benefits that it inflicts or bestows on the others. Thus, if my chemical plant is allowed freely to stink up the neighborhood, there will be more such chemicals produced than the Invisible Hand would like. And if others can read the scientific literature and use the results of your basic research without paying you for it, there will be less basic research done than would be efficient. Again, externalities are ubiquitous in a densely populated modern economy. Some taxes and subsidies, instead of being distortions, are designed to correct the distortions that arise from such externalities (carbon taxes, cap-and-trade systems), and many regulations are intended to prevent or minimize negative externalities (no pig farms in city limits, no billboards in scenic areas).

Faced with this list of obstacles, one might be tempted to give up on the market economy altogether. That would be as much of a mistake as the one made by doctrinaire free marketeers. The real point is that the choice is not either/or, but when and how much. Many distortions, imperfections, and externalities are small. To try to correct them all would be intolerably bureaucratic. The large ones cannot be wished away or ignored for reasons of piety; they cause large inefficiencies, and they can redistribute income in ways that most people would reject. And so there is no good alternative to case-by-case decision-making. I think Cassidy gives this a reasoned treatment.

 

Earlier I skated over the issue of rationality, but Cassidy is not so abstemious. He is fond of a notion that he calls “rational irrationality.” He refers in this way to situations in which rational choices by each individual lead to a kind of collective irrationality. There are relatively benign examples of this: if those in the front row at a football game stand up at an exciting moment, those in the second row will be forced to stand up in order to see at all, and then the third row, until in the end everyone is standing and everyone would see just as well if everyone were comfortably sitting down.

There are also dangerous examples: we all know that if we each dash for the exit at a hint of fire in a crowded theater, the likely result is a stampede, congestion, and fatalities, but we are individually tempted anyway, and such disasters sometimes happen. A managed--regulated--exit will be better. Financial markets are especially vulnerable to this kind of herd behavior, especially in the presence of asymmetries in information. The panic seller (or frantic buyer) next door may know something that I don’t know. Technically, this sort of herd behavior leads to the instability of a market system. The market reacts destructively to small disturbances even if, at rest, it does a fairly good job. Market instability can be very damaging, as a long succession of financial crises has demonstrated.

Serious evaluation of the capacities and the failures of idealized market economies, and of the circumstances that tend to lead them in one direction or the other, is useful work, given that market economies of one kind or another are all that we are likely to experience. Nor is that kind of work necessarily auto-intoxicating: it does not automatically infect those who do it with some blind infatuation with “free markets.” In fact, the most profound inquirers into the properties of market systems have not been free marketeers, not in this sloganeering sense. One of them remarked to me that his goal in pursuing this trail has been to show just how special and stringent the assumptions are that are required to make the Invisible Hand work well.

The market evangelists, who tend to claim more for unregulated markets than solid theory can justify, are ideologically motivated. They dislike and distrust governments so much that they overlook the exceptions and the implausible assumptions, and simply propose the blanket principle that the market knows best. What is improper in this manner of argument is the frequent casual hint that it is authorized by economic theory. Nothing so general is ever authorized by economic theory.

 

Cassidy provides an interesting selective survey of the other side--the analysis of whole classes of situations in which the unregulated market is bound to fail, in the sense that it will lead to inefficient outcomes. This is what he calls “reality-based” economics. That is a tendentious label, of course. Since markets do not always fail, some of what is said about well-functioning markets is “reality-based,” too.

Economics has a long history of studies of generic causes of market failure, and sometimes also of possible remedies. Pollution of the environment, both local and global, can be met by corrective taxation. (Positive externalities--basic research is an important example--should attract, and have attracted, public subsidy.) The analysis of monopoly was begun by A.A. Cournot about sixty years after Adam Smith, and a theory of imperfect competition dates from the 1930s. There the remedy, when it has been applied, has been breakup or regulation. More difficult cases of strategic behavior had to wait for the tools of game theory, developed after World War II. Cassidy mentions all these, plus asymmetric information, systematic deviations from rationality, and more.

It makes interesting reading, but I wish he had asked himself an additional question. Why, in the marketplace (sic!) of ideas, have the evangelists for the unrestricted market attracted so much attention and the “realists” so little? He argues, fairly convincingly, that the truth does not lie predominantly on that side of the issue. So is it that believers always make more effective advocates than skeptics do? Are we for some reason more receptive to simple answers than to complex ones? Is it that, in the nature of the case, there is more money backing one side than the other? Perhaps the long postwar prosperity provided good growing conditions for conservative political and economic ideology. If so, it will be interesting to see if the current recession and financial meltdown leave traces in the course of serious economics.

The last third of Cassidy’s book is in fact about “The Great Crunch.” The story of the current financial crisis is told not primarily as narrative, although there is some of that, but as an illustration of the failure of the dogma of the self-correcting market. The argument against regulating hedge funds, private equity firms, and the like was that the participants in those markets were expert, knowledgeable managers of wealth. Since they had a lot at stake, they would be motivated and able to estimate risks fairly, foresee pitfalls, price accordingly, and keep each other honest. In fact, as Cassidy shows, incentives were often perverse, short-run greed overcame long-run caution, information was hidden or badly processed, and the complexity of financial engineering outran the capacity for rational calculation. “Rational irrationality” and herd behavior led to disaster. In the case of financial markets, the “realists” have by now perhaps won out over the “utopians.”

 

It is nice that Cassidy is able to use the story of the financial crisis to exemplify some of the systematic sources of egregious market failure. But there is a deeper, or at least prior, question that he does not take up. Is all this financial activity socially useful, even in the absence of breakdown? It is worth a moment’s thought.

Cassidy quotes Alan Greenspan:

Recent regulatory reform coupled with innovative technologies has spawned rapidly growing markets for, among other products, asset-backed securities, collateral loan obligations, and credit derivative default swaps. These increasingly complex financial instruments have contributed, especially over the recent stressful period, to the development of a far more flexible, efficient, and hence resilient financial system than existed just a quarter-century ago.

Flexible maybe, resilient apparently not, but how about efficient? How much do all those exotic securities, and the institutions that create them, buy them, and sell them, actually contribute to the “real” economy that provides us with goods and services, now and for the future? The main social purpose of the financial system--banks, securities markets, lending institutions, and the rest--is to allocate society’s pool of accumulated savings, its capital, to the most productive available uses. It does a lot of this, beyond doubt.

We would be much poorer without a functioning financial system, and the flow of credit and equity purchases that it permits. If anyone who wanted to start a business--a software company, a biotechnology laboratory, a retail store--had to do so with his or her already saved-up wealth and the help of relatives, many good ideas would go unrealized, and some wealth would lie idle or be wasted. If every time you chose to invest in an existing company it was forever, because there was no way to sell your share and invest somewhere else, it would be much harder for promising enterprises to attract capital and grow.

But those needs were being taken care of a quarter-century ago, and well before that. The real question, to which Greenspan gave such a confident and grandiose answer, is whether anything much was added to the system’s ability to allocate capital efficiently by the advent of naked CDSs and CDOs and the rest of the alphabet. No blanket answer is possible. The securitization of mortgages and college loans is not intrinsically a foolish or useless idea--it enlarges the pool of capital available to finance home purchases and college educations; but the opportunity for you and me to bet a large sum of money on the outcome of somebody else’s bond issue is not nearly the same sort of thing.

Take an extreme example. I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move. Deep pockets in a large market can make a lot of money out of tiny advantages. (Of course, if you have any such advantage the temptation is irresistible to borrow a lot of money to enlarge your bets and your profits. Leverage is good for you, until it isn’t. It is not so good for the system.) A lot of high-class intellectual effort naturally goes into trying to invent ways to find those tiny advantages a few seconds before anyone else.

Now ask yourself: can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.

If that suspicion is valid--I emphasize that the necessary calculations have not been made and will be hard to make--the conclusion would be that our poorly regulated financial system is not only dangerously unstable, but also too big and too complex, absorbing talent and resources that could be better used doing something else. What is inadmissible is the assumption that, if the market creates a large and convoluted financial system, the market must be right. John Cassidy’s book should confer on a thoughtful reader a lasting immunity to erroneous free-market sloganeering, whether simpleminded or devious, while still conveying some feeling for what a well-functioning market system can actually do. Both ideas are important.

Robert M. Solow is Institute Professor of Economics emeritus at MIT. He won the Nobel Prize in Economics in 1987.

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