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How Markets Fail - the logic of economic calamities

Geoff Riley

26th December 2009

A huge number of well-known economists and a remarkable number of ideas make an appearance in John Cassidy's new book How Markets Fail – the logic of economic calamities. From Akerlof and Arrow to Von Neumann and Walras, John Cassidy's ambitious and lucid work takes us on a swift journey through over two hundred years of economic thought and policy-making through to the moment when the global financial system stared over the abyss in the early autumn of 2008.

Cassidy's core theme is that the ideas of efficient markets, rational expectations and general equilibrium theory have so many fault-lines as to render them useless in explaining regular speculative bubbles. In just twenty years we have seen unsustainable bubbles in tech stocks, property and physical commodities such as oil and metals. Central to understanding the causation of these episodes is the idea of rational irrationality – defined as the application of rational self-interest in the market place that leads to an inferior and socially irrational outcome. In short we observe on numerous occasions decisions by people, businesses and governments that are purposeful and rational but ultimately self-defeating.

The book is a critique of the conventional wisdom of micro and macroeconomics taught in schools and universities. “Many economists educated in the past forty years have little time for history and still less for the history of ideas." Rational expectations (RE) remains a core part of PhD programmes in economics but RE has little or no role in explaining bubble activity in energy markets, real-estate and technology start-ups. Instead Cassidy argues for a renewed focus on what he called reality economics, a reflection that humans are social animals, with imperfect computational abilities and who tend to rely on heuristics and biases in their behaviour. Cassidy's reality economics describes a world where spillover effects (externalities) are endemic and where misaligned incentives can have powerful and damaging effects on the wider community. The gigantic losses sustained by financial businesses during and after the crisis and the eye-watering cost of the bail-outs of failed institutions by governments are borne by all of us in higher taxes in a new age of fiscal austerity – losses are socialised whereas the individuals who caused them rarely bare the costs themselves.

As a writer in economics and finance at the New Yorker magazine since 1995 John Cassidy is well placed to produce a compelling explanation for the unfolding financial and economic crisis. Students of market failure will appreciate his taxonomy of market imperfections, many of which are then skilfully woven together to understand more about what was happening in the financial markets in the last twenty years. John Cassidy draws on fundamental market imperfections such as hidden and asymmetric information and links them with central ideas from game theory (including inter-dependence and the Prisoner's Dilemma) all blended with perspectives drawn from behavioural economics. It is clear that Cassidy's intellectual heroes are Keynes, Minsky, Stiglitz, Kahnemann, Amos Tversky, Shiller and Galbraith and all of them are employed in a bid to unearth the causes of financial and economic instability. It is a compelling book that does not seek to sensationalise the crisis but chooses instead to argue that market failure (or reality economics) should be a starting point for economics teaching and analysis and not something that is taught after the conventional laws of market economics have been ingrained in student's minds.

Geoff Riley

Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.

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