I gave this book four stars because the book did indeed do a good job showing how markets fail. I kept off that last star because the implicit assumption throughout the book (and sometimes made explicit) is that more government regulation would improve markets. He certainly did not show this, and often provided evidence to the contrary. I was impressed by the understanding of a journalist for economics, a much better understanding than most journalists (such as Naomi Klein). But he did have the blind spot in not understanding that to show regulation is in order he must not only show that the free market can fail but that regulation will make this less likely. It is in the latter case that he failed miserably. I gave as many stars as I did only because government regulation wasn't what the book was about.
He had three convincing ideas showing how markets may not achieve maximum efficiency:
1) Rational irrationality. This is a strange label for the situation when what benefits individuals doesn't always benefit society. Thus in a pure market society with no FDIC insurance, it may make sense for individuals to make a run on the bank to protect the individual investment even though it hurts others that lose their investment when the bank runs out of cash. Also, it may be rational for individuals to contribute to an investment bubble, even though the ultimate crash is bad for everyone.
2) Externalities. This is the free market failing that is always brought up, and is agreed to by every serious economist, despite Cassidy's denial. An example of an externality is pollution -- a free market will despoil common property if there are no regulations to stop it.
3) Disaster myopia. This is the tendency of people to underestimate the possibility of disaster if it hasn't happened for awhile. Of course this is as true of government regulators as for business people, so it certainly is not an argument for regulation.
Rational irrationality is the main crux of Cassidy's argument showing how markets failed, causing the recent financial collapse. But this is one area in which Cassidy does not understand the free market. He made the point that the CEOs of financial institutions have incentives to continue a financial bubble, so they need regulation to keep them in line. But it isn't the CEOs that are the free market regulatory mechanism, it is the holders of the inflated assets. They are the ones that get hurt when the bubble bursts, so they are the ones that should be holding the CEOs in check. That is how the markets failed, and so that is where we need to look to fix it.
Which brings me to the causes of the financial collapse. The causes of the collapse, based mostly on Cassidy's diagnosis, but adjusted by my own knowledge and beliefs:
1) There was too much interlocking debt, so that when one financial institution went down, it brought down all the others. In my opinion, our society has too much debt, period, and this is what made the economy so vulnerable. If we had a whole lot less debt, pricking of the bubble might have destroyed some institutions, but the economy as a whole would've been alright.
2) All the financial experts (both in industry and in government) didn't understand the risk of so much sub-prime debt. They thought that any collapse of a real estate bubble would be regional, so it wouldn't bring down the whole economy, or even severely effect any sub-prime securities that covered the whole country.
3) The rating agencies simply didn't do their job of downgrading very risky debt
4) Disaster myopia.
5) Lack of information. The holders of sub-prime debt didn't know how likely the mortgage holders were to default.
So the question is, how would greater regulation have avoided this result, and can it help in the future?
1) Debt. Government has been mostly encouraging more debt, especially mortgage debt, so that more people can own homes. It might be useful for government to somehow encourage less debt in the future. But currently it is the federal government that is making the economy more vulnerable, as it greatly increases its own debt, and is strongly encouraging corporations to spend their cash hoards. It is the private companies who have these cash hoards that are doing the most to avoid another catastrophe. A good example of regulation worsening the situation.
2) Risk of sub-prime debt. One of the main causes of the Great Recession was that most financial experts thought that diversity of geographic holdings would protect security holders. Regulation would not have helped here, because the financial experts in the government had the same misconception as industry experts. Regulation doesn't help now, because both sides now realize the danger.
3) Rating agencies. The big problem here is that there are only such few rating agencies. However, this is something the government caused, since they don't allow additional agencies. This was definitely a failure of government, not the market.
4) Disaster myopia. As with #2, this was a failure on both sides. Hindsight is 20-20, but it doesn't argue for more regulation.
5) Information. The regulators didn't know any more than the security holders.
It would have been nice to see a similar discussion of the failures of government, with the perhaps the following list:
1) Rent seeking of lobbyists seeking and often getting a mis-allocation of resources in the direction of their clients
2) Incentives of government aren't to create the best results for society, but instead the best results for those who can help them get re-elected
3) Governments don't go out of business when they fail, they merely ask for more resources
4) Politics determines who gets the most resources, as well as the distribution of resources, not the desires of those receiving the resources, as is the case in a free market
5) The free market has an automatic regulation in that those with the most to lose will struggle the hardest to keep things on an even keel. Government needs to build in these regulations manually, and they simply don't work as well and are more prone to failure.
Towards the end of Chapter 11, Cassidy bemoans the "blind reliance on self-interest" by advocates of the market. Although Cassidy understands the free market pretty well, this is one place he shows his ignorance. It isn't that free market advocates promote untethered markets because self interest works so well, although it mostly does work well. It's that it is human nature to do whatever is in each person's self interest to do. The incentives of the free market usually harness that self interest towards the benefit of society. This is less likely to be the case for those in government.
I hope John Cassidy's next book is "How Governments Fail." He does a good job documenting the problems. With such a book we'd really have something to discuss.