Business IdeasV V: Correcting the fault lines of capitalism
In the long run,” John Maynard Keynes had famously said, “we are all dead.” Keynes may not have been quite dead, but he had lived a ghostly half-life in the corridors of central banks and within the academia for decades. Now with the failures of unbridled capitalism on a global scale, he is back in fashion, along with Marx. John Cassidy, the finance correspondent for the New Yorker has come with How Markets Fail: The Logic of Economic Calamities (Allen Lane/Penguin £25), which draws heavily on Keynes to recount the story of America’s housing boom and the failures of regulators and self-deception of bankers that led to the present financial crisis. The book is a sequel to Cassidy’s earlier book DotCon that dealt with the stupidities of the stock market bubble in the late 1990s, but both deal with one central idea: the belief that society is best served when individuals are left free to pursue their self-interest was “Utopian economics” and led to disaster because of “the crooked timber of humanity”, and the uncertainty that is inherent in any human enterprise.
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There are three main ideas of Keynes that Cassidy draws upon in this book. The first is that the future is unknowable and, therefore, economic storms, especially those originating in the financial system, are not wild external shocks which impinge on smoothly adjusting markets, but parts of the normal working of the market system.
The second idea is that economies that are wounded by these “shocks” can remain in a depressed state if left to themselves for a long time. That is why governments need “stimulus packages” to revive sick economies which are all the rage now. Keynes was not an advocate of stimulus packages, but he tried to provide a “general theory” which explained how economies fell into slumps, and to indicate the policies and institutions needed to avoid them. Very simply, individual self-interest does not always benefit society; what benefits is “reality-based economies” that see things as they are, not what they would like them to be.
The third is a moral critique of societies which worshipped the pursuit of money and efficiency above everything else. “The love of money as a possession — as distinguished from the love of money as a means to the enjoyments and realities of life — will be recognised for what it is, a somewhat disgusting morbidity, one of semi-criminal, semi-pathological propensities which one hands over with a shudder to specialists in mental disease.”
No one has bettered Keynes’ description of the psychology of investors during a financial crisis. “The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct… the market will be subject to waves of optimistic and pessimistic sentiment.”
Cassidy weaves in all three factors within a broader framework of the history economic thought that takes Adam Smith (1776) as the starting point of the analysis of how markets fail. More important is how the “formal proof” of efficiency of markets evolved through American economist Kenneth Arrow and French mathematician Gerard Debreu’s “general equilibrium theory”. This gave the stamp of scientific approval to unregulated markets but was based on unrealistic assumptions that led to nasty failures like the present financial crisis.
To what extent do prices indicate the success or failure of markets? Do higher home prices depress demand? Not necessarily, Cassidy says. Higher prices can be a spur to buyers who hope to benefit from further rises. To home owners, it can be a signal to buy; to bankers, it is time to lend. Both look upon higher prices as an investment that would give higher returns in due course. Those who suspect a bubble and sit on the fence are neither here nor there. It is better to go with the crowd than being left out. What this amounts to is a “hit or miss” gamble, a suspension on your own individual judgment which inevitably leads to disaster.
In a real life situation, there are always asymmetries of information — when sellers know more than buyers, or vice versa for example, because some information has been kept hidden — that lead markets to flounder. This happened in the build-up to the present crisis. Bankers sold dud mortgages as supposedly safe bonds to investors; but bankers did not factor in bad debt and risky loans. Policy-makers and the central bank knew of the excesses and that a financial crisis was round the corner but did not intervene because that would have tampered with the free-market ideology. The moral is clear: markets are not self-correcting mechanisms; there have to be some regulations to curb irresponsibility and poor decision-making, or at least some kind of balance between individual autonomy and state oversight. “Free market idolatry” is what Cassidy is against in this big book.
It has been said that The Crash of ’08 happened because business-people and consumers acted in their self-interest. So, don’t blame capitalists, or the government. Blame capitalism. That might be going a bit too far, but checks and balances have to be put in place to check “the perfect storm of irresponsibility and poor decision-making that stretched from Wall Street to Washington to Main Street” as President Obama recently put it.