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Hedging America


How Markets Fail: The Logic of Economic Calamities
By John Cassidy


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.







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.




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.


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.



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.


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.”



Cassidy quotes Alan Greenspan:


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.





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.



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