While driving my son to school one morning, I heard a National Public Radio interview with John Cassidy, author of the new book How Markets Fail. Fortunately, we got to the front of the line before Cassidy let out the zingers. A few minutes earlier, and my son would have seen Daddy lose his temper.
Cassidy first caricatures the case for free markets, then tries to demonstrate the hypocrisy of a "free-market" financial bailout. Yet his arguments obviously don't bear on whether markets fail or need government supervision. Indeed, Cassidy himself acknowledges that what happened at the end of the Bush administration was anything but the free market.
Adam Smith's Famous Argument
Here's how the interview started:
RENEE MONTAGNE, host: Believers in the free market say that when individuals act on their own rational self-interests, society benefits. There have always been skeptics who say free markets can and do go awry.
Among them now is John Cassidy. He's an economics writer for the New Yorker magazine and has a new book called How Markets Fail. In one chapter, he describes what happened to a new footbridge over the River Thames in London.
JOHN CASSIDY: Ten minutes after it opened, it started shaking violently with hundreds of people on it, and nobody could explain what had happened. So they closed it down. It was a great embarrassment. Turns out that the problem was as the bridge started to sway, everybody started to step in sync with each other to avoid falling over, and that produced additional sideways forces on the bridge and added to the sway.
So everybody was acting in their own self-interest trying to prevent falling over, but it had a disastrous outcome. People in the financial markets tend to feed on each other, and people follow each other rather than just doing things because they think it's a good idea for themselves. You can get this development of a speculative bubble which then can lead to disaster.
OK, that is a neat story, and it's true that it does show an interesting example of self-interested behavior leading to collective disaster. Yet this is nothing new; for instance, the famous prisoner's dilemma from game theory has long epitomized this possibility.
It's also true that Adam Smith famously argued for the benefits of international trade by writing, "What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom."
Yet it is not true that the case for the free market rests on the (false) claim that when people do what's in their own immediate interest, it will always lead to the best outcome for all. The great insight of Adam Smith (as well as earlier and later thinkers) was that this happens to be the case very often in the market economy. But this doesn't commit the believer in free markets to a straitjacket rule where he has to hope writers like Cassidy never hear about the Thames footbridge.
"There are many examples of apparent failures of 'naked self-interest' that are in fact failures of the government overseeing the issue."For one thing, it wouldn't surprise me if the footbridge were designed and constructed by the government. There are many examples of apparent failures of "naked self-interest" that are in fact failures of the government overseeing the issue. Conservationists point to overfishing as a refutation of Adam Smith, for example, when in reality overfishing underscores the importance of property rights.
For a different example, the economist A.C. Pigou used a hypothetical illustration of traffic congestion to show that the government could raise total welfare by imposing a tax on drivers who wanted to take a route that could accommodate only a limited number of vehicles. Frank Knight, however, showed that if the road were privately owned, then the alleged "market failure" would disappear — the private road owner would maximize his profit by charging a toll exactly equal to the hypothetical "optimum Pigovian tax."1
Laissez-Faire Doesn't Mean "No Rules"
There is a growing literature on "herding behavior," "informational cascades," and so forth, that uses neoclassical models of agents with rational expectations who end up making dumb investment decisions when they occasionally get locked into a "bad equilibrium." Many of the economists working on these models believe that they demonstrate the necessity for government regulation of financial markets.
Yet this is a complete non sequitur. Someone can be a proponent of free markets and still agree that professional basketball games need referees. The point is that the referees should be privately employed by organizations that receive voluntary payments from their customers.
More generally, the believer in laissez-faire isn't forced to renounce all forms of airline inspection or product safety. But these procedures can be supplied privately, either by the companies themselves, by outside watchdog groups, or by insurance companies.
The choice isn't, "Rules or no rules?" The choice is, "Rules made and enforced by voluntary contractual arrangements, or rules made and enforced by coercive agencies that can't go out of business?"
Cassidy Gives Away the Game
When it comes to discussions of the bank bailouts, Cassidy follows in a long line of critics who (a) blame the bailouts on "deregulated free markets," and then (b) point out that the bailouts are not examples of a free market. Point (b) is not intended to contradict point (a), of course, but rather to show the hypocrisy of "free-market" politicians and regulators. Here's the relevant exchange from the transcript, after they played a clip of Greenspan admitting he had been shocked by the financial crash:
CASSIDY: [Greenspan's admission is] going to go down in the history books as a very famous exchange. I actually opened my book with it. The idea underpinning the free market model is that self-interest plus people acting rationally leads to a good outcome. Greenspan thought the banks would look after their own self-interest and wouldn't do anything which would be damaging to them and then damaging to the economy as a whole. That turned out to be completely wrong, of course.
It turned out that the banks had taken on enormous risks and when the housing market collapsed, the banks, most of their capital was wiped out and they couldn't afford to lend to anybody. And that sent the economy into a big recession.
MONTAGNE: Well then, what's a better approach to the markets?
CASSIDY: OK. Well, as far as the Fed's concerned, there are two central issues. One, it should go back to its original mission of trying to prevent financial crashes. So if it sees a lot of speculation emerging in various markets, it should act to stop it either by raising interest rates or telling banks not to lend people 100 percent mortgages who can't afford it.…
Under the current system, the banks are too big to fail. So that means that we, the taxpayers, are basically subsidizing the risk-taking activities of the big banks. That appears to me to be intolerable. It's also not a free market idea. You know, the free market idea is that if you take a risk and it goes well, you do well. If you take a risk and it goes badly, you lose your money.
Cassidy doesn't realize it, but he has just significantly undercut his whole thesis. Many proponents of truly free markets have criticized (a) the Fed's low interest rates for fueling the boom and (b) the expectation of future bailouts for causing "moral hazard" and leading large financial firms into taking very risky positions. As Cassidy himself admits, what we just lived through was not a free market, even though he later describes it as a "laboratory experiment" of regulation versus deregulation.
The critics do have a limited point: The worst of all worlds occurs when large financial institutions can make aggressive bets and then keep the money if they win but get bailed out by the taxpayers if they lose. If the taxpayers really are going to be forced to backstop certain firms, then this blank check needs to be supplemented with other restraints lest the Treasury go broke once the next crisis hits.
However, acknowledging that reality in no way justifies the sweeping new regulations being foisted on the financial sector. The proper way to avoid bankrupting the taxpayers is to stop bailing out big banks. And while we're at it, we should get rid of the printing press too. Is it really surprising that financial markets are so volatile, when one person (the Fed chair) can inject trillions of dollars at virtually his personal discretion?
Conclusion
John Cassidy did not convince me that markets fail. Although he didn't realize it, his analysis underscored the role that government policies played in the recent financial disaster.
- 1Frank Knight (1924), "Some Fallacies in the Interpretation of 'Social Cost,'" Quarterly Journal of Economics, Vol. 38, No. 4, pp. 582–606.
