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How Markets Fail

 

If you want to be reminded of the myriad of ways in which markets fail, you will welcome the new and timely book by John Cassidy titled simply How Markets Fail.  Cassidy is not only an economist but a rare one who can write.

Indeed, he writes so well that he is a regular contributor to the writerly The New Yorker, with a delightful piece, at least for progressive economists, in the January 11 issue of this year (since his book was published) on the trials and tribulations of the Chicago School in the aftermath of the financial crisis that was not supposed to happen.  Interestingly, Robert Lucas of rational-expectations fame — who, says Cassidy, defines rationality “as having a mathematically correct model of the entire economy in your head and acting upon it” — simply refused to give an interview to Cassidy.  If Lucas is made mute by the crisis, the world is already a better place.

If there is a single phrase that seems to encapsulate the failure of the efficient market crowd, it may be “the herding instinct.”  Each free marketeer may imagine that he or she is behaving rationally but the behaviour of the herd, which is overriding, is a different matter.

It is said that you can’t herd cats, but how about bulls and bears?  The illusion in financial markets is one of rationality, but the reality is frenzy and mayhem and episodic crises.  To the well known Madness of Crowds, let us add the Hubris of Herds.

There have always been those economists who knew that.  They were just ignored by the profession, itself being powerfully subject to the herding instinct with its practice of odd person out.  The hero of Cassidy’s story is Hyman Minsky who never gave up insisting that what the great Keynes taught us, if we would but pay heed, was that instability lay at the core of capitalism because of irreducible uncertainty about the future, and that financial regulation was a necessary even if necessarily insufficient policy.

But Minsky taught for most of his academic life at Washington University in St. Louis, at the outer margins of the conventional wisdom, and never got a Nobel Prize in Economic Science — that word “science” should have been the giveaway; there is slight hope for our profession until the Swedes remove it and reward simply Economics — while more than half a dozen went to the Chicago Boys.

Who else got it right according to Cassidy?  Well, would you believe, the Marxist economists around Monthly Review, notably Paul Sweezy who insisted throughout the decades after World War II that the financial sector had taken over the world and a price would have to be paid.

“The worldwide slump demonstrated,” writes Cassidy of the present calamity, “that Minsky and Sweezy had been right when they said the fortunes of the economy at large couldn’t be divorced from what happened on Wall Street.”  Would that they had survived to witness their vindication.

Perhaps predictably for an American writer, the greatest of the culprits are Greenspan — “more than any other individual, the former Fed chairman was responsible for letting the hogs run wild” — and those at the Fed and beyond who paid fealty to him.  That includes Ben Bernanke — whose inability to see a housing bubble and the subprime bust as late as October 2007 Cassidy calls “a failure of imagination” — and, it seems to this writer, it is a sign of Obama’s want of economic populism, and his consequent political weakness of Main Street, that he insisted on fighting for his reappointment.

And, difficult though it still is for me to admit, what American economists (plus Sir John Hicks in the U.K.) did to Keynes is, as Cassidy argues, very much part of the problem.  I studied at MIT in the 1950s when it was arguably the greatest economics department in the world and the prime place where Keynesianism was bastardized (in Joan Robinson’s telling phrase), the better to marry microeconomics and macroeconomics in the Neo-Classical Synthesis popularized by my mentor Samuelson with its magical fine tuning of capitalist economies.  It was all too good to be true and its false promises created the opening for monetarism and all the other sins that were even worse in theory and in practice than a juiceless, stable, self-sustaining Keynesianism.

Cassidy is encyclopedic in listing all the other market failures: carbon emissions that cause global warming and extremities of climate; monopoly power; obscene CEO pay; Galbraith’s “private affluence, public squalor”; R&D; etc., etc.  But his main story is the financial crisis and the inability of money markets to self-regulate, for there’s no market failure that quite catches the eye like systemic bank failures and a burgeoning economic crisis.

So what is to be done?  Cassidy is right to see a ray of hope in the new behavioral economics that rejects the simplistic logic of rational behaviour that has ruled our lives too long.  If it will cause economics to abandon the utopianism that has gripped it in the last half century plus, and to admit that markets must be regulated, it will be a move forward.  To expect more from our mainstream colleagues at this moment is probably unrealistic.

Meantime, let us all (re-)read The General Theory (I didn’t as a graduate student at the world headquarters of Keynesianism), and read Minsky and Monthly Review, and thank Cassidy for his swabbing of the imperial decks.  And wake me up if anything novel and exciting is happening in the mainstream Canadian profession.

(While the views expressed here are my own, I am grateful to John Hutcheson for urging me to read How Markets Fail, and for giving me a xerox of an excerpt from Minsky’s 1975 book John Maynard Keynes that he use in a course he teaches at York University.)


Mel Watkins is professor emeritus of economics and political science at the University of Toronto.  This article was originally published by The Progressive Economics Forum on 27 January 2010; it is reproduced here for non-profit educational purposes.




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