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How Markets Fail: The Logic of Economic Calamities [Tapa blanda]

John Cassidy

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44 de 47 personas piensan que la opinión es útil
5.0 de un máximo de 5 estrellas Very insightful but with imperfect solutions to problems 21 de diciembre de 2009
Por Rajesh Gajra - Publicado en
Formato:Tapa dura
The 2007 and 2008 crisis in world economics and financial markets have spawned many books. This is one book that talks about the same crisis but perhaps in a much more insightful way than any other. Dwelling on the interplay between economic policies and financial markets this book is difficult to put down once you realise the enormous promise it holds when you read the 12 pages of the 'Introduction' chapter. That promise is not belied although John Cassidy, the author, could have been clearer and more elaborate in the solutions he offers.
Cassidy refers to the idea that a free market economy is sturdy and well grounded as an "illusion of stability". He calls this "Utopian economics". This forms the first of three parts of his book and includes eight fascinating chapters on the people and ideas that shaped it.
This section of the book first lays out in great detail how economic theories and economists came about to have a large sphere of influence in central banks' monetary policy matters and governments' economic policies. It describes how the "Chicago School" of economics, propagating free market economy with almost zero regulations, ended up enormously broadening their sphere of influence in the top echelons of the US Federal Reserve and the Treasury department of the US government. What follows is an excellent exposition of 10-12 most-influential economists including Adam Smith, John Keynes, Milton Friedman, Robert Lucas and Friedrich Von Hayek, as well as a couple of mathematicians such as Eugene Fama.
Taking the reader back and forth in time, Cassidy beautifully connects the conservative economists with the "neo" liberalists, mathematics with economics, and evangelist-led economic theories with existing practices in financial markets and governmental regulations.
The second part of Cassidy's book has him propagating "reality-based" economics. Cassidy believes that free market economists dangerously ignore the very possibility of speculative bubbles, leave alone the fact that market prices during a speculative bubble provide incentives for individuals and companies to "act in ways that are individually rational but immensely damaging to themselves and others". He even gives examples of market failures beyond financial markets, such as markets encouraging "power companies to despoil the environment and cause global warming", health insurers excluding "sick people from coverage and CEOs stuffing "their own pockets at the expense of their stockholders."
The second part is as elaborate, articulate and insightful as the first. Cassidy puts forth the economics-linked issues of "the prisoner's dilemma", "the market for lemons", "the beauty contest", "the rational herd" and "ponzi finance". Like in the first part Cassidy beautifully uses the works of important contributors to economics to illustrate their--and his own--arguments. For instance, on the subject of market externalities, Cassidy talks about a paper, presented at Harvard University in the mid-1980s by W. Brian Arthur, a applied mathematician from Northern Ireland, wherein Arthur argued that chance events and network effects can enable inferior technologies to beat out superior products and take over entire markets.
Cassidy, however, fails to convince, why monopolies should be forced to co-operate with budding competitors. He talks about Microsoft refusing to make its products compatible with those of its rivals but does not rationalise why that is such a good thing in a competitive scenario and how much of sustainable benefits it will provide to consumers.
In the third and last part of the book Cassidy turns to the real-life happenings in financial markets and economies in the last 20-30 years and how they led to the complete financial meltdown in 2007 and 2008. This is again a very exciting read as Cassidy elaborately criticises Alan Greenspan's blind eye to the speculative bubbles in the real estate market, fanatic reduction of interest rates to artificially pump up the economy after the 'dot com' bust in 1999-2000, and dangerously preventing regulators such as Commodity Futures Trading Commission from laying out capital adequacy and risk-containment measures for complex financial products like credit default swaps and other complex financial derivatives.
Cassidy lays out in good detail the history of mortgages, including the sub-prime chain, and the bubble in real estate prices. There are rare insights into how the securitisation of mortgages by banks and Wall Street firms grew in size and led to extreme risks that ultimately exploded in the face of every financial market participant. He also points to the failure of capitalism in that tax payers money had to be used to bail out the failures in the market.
While Cassidy is great in describing what happened he is very weak in pointing out appropriate solutions in much detail. He does, however, says that free markets should not be devoid of active government intervention when prices are going up and building into a bubble. But Cassidy should have been more sharp and pointed out that if firms get too big to fail then they should be too big to succeed in the first place. Or, if free markets are to be allowed without restrictions, then any failures should also be allowed to happen freely without government bailouts. If profits are made by everyone during a bubble then losses can also be borne by everyone when the bubble bursts.
He also fails to highlight enough the dangers of uncontrolled leverage in not just financial derivatives but also in complex financial structured products whether traded directly between counterparties or traded on a financial exchange.
But, on the whole, the book is a great read.
145 de 169 personas piensan que la opinión es útil
5.0 de un máximo de 5 estrellas A must read critique of economic theory 11 de diciembre de 2009
Por Gaetan Lion - Publicado en
Formato:Tapa dura
Cassidy analyzes how orthodox economic theory (he calls Utopian economics) went astray. While Adam Smith advanced the merits of market competition and free trade in "Wealth of Nations" in 1776; He warned against unregulated credit creation and ensuing speculative excesses. But, economists focused solely on Smith's benefit of free markets. The field of economics became increasingly quantitative based on flawed assumptions including Cassidy's four basic Utopian illusions:
1) the illusion of harmony (free markets always generate good outcomes);
2) the illusion of stability (free market economy is sturdy);
3) the illusion of predictability (distribution of returns can be foreseen); and
4) the illusion of Homo Economicus (individuals are rational and act on perfect information).

This idealized framework allowed economists to develop overreaching math models increasingly disconnected from reality. This trend started with Friedrich Hayek, leading Austrian economics, who stated in late 1930s that prices communicate near perfect information that determined underlying demand and supply. This was a brilliant insight if not taken too far. In the 1970s, Eugene Fama builds upon Hayek's insight with the Efficient Market Hypothesis (EMH) that stated stock prices captured all available information. Thus, stock prices move randomly and both technical and fundamental analysis do not add value. The theory was popularized by Burton Malkiel in A Random Walk Down Wall Street: Completely Revised and Updated Edition. The EMH was a brilliant insight backed by data (the majority of mutual fund managers do not beat the index to this day). But, it lead to Robert Lucas Rational Expectation Hypothesis (REH) in the 1980s. The REH stated that all markets (goods, labor, etc...) are efficient not just securities. It also stated that individuals act upon their anticipating of future events. This entailed that fiscal or monetary policies have no effect since the public counters them. Cassidy states REH was the most hubristic Utopian economics theory as it was completely disconnected from reality. The next Utopian manifestation was the General Equilibrium Theory (GBT). The latter represents more than century long effort (Leon Walras, French economist, first pronounced it in 1870s) to demonstrate that all markets affect each other and each has a single interdependent equilibrium price. The underlying math is forbidding; yet GBT utility and accuracy is null.

Cassidy discredits Milton Friedman and Alan Greenspan the most. Friedman is "The Evangelist" libertarian who broadcasted his anti-government views in two manifestos Free to Choose: A Personal Statement and Capitalism and Freedom: Fortieth Anniversary Edition. His anti-Keynesian theory of monetarism is completely obsolete. It was shortly tried in the early 1970s in the U.S. and the U.K. and was a dismal failure (source: Paul Krugman).

Cassidy states Greenspan was the main culprit of the housing bubble and ensuing financial crisis on two grounds. First, he kept interest rates too low for too long in the first half of this decade. This contributed to skyrocketing home prices. Second, his Utopian view that financial markets better self-regulate their risks than regulators promoted egregious mortgage underwriting (the Subprime mess). It also facilitated unregulated collateral debt obligations (CDOs) and credit default swaps (CDS) that spread the financial crisis worldwide.

Cassidy provides rebuttals to Utopian economics from many fields he lumps into "reality-based economics." The latter includes Game Theorists John von Neumann and John Nash. Game Theory contradicts economic theory as individuals respond strategically to each others' actions (Prisoner's Dilemma) instead of economic incentives. Reality-based economists also include Daniel Kahneman and Amos Tversky, psychologists, who demonstrated individuals are irrational as we are more sensitive to losses than gains. We overweight our firsthand experience and events that occurred recently. Richard Thaler, an economist, will apply their ideas thereby creating behavioral economics.

The most successful reality-based economist is Hyman Minsky. His theories pervade Cassidy section on the current financial crisis. Minsky is an American economist (1919-1996) ignored during his lifetime; but, is now experiencing a resurgent posterity. This is because the first decade of the 21st century with the and housing bubbles confirmed the relevance of his model. The later entails that free market economies are inherently unstable prone to booms and busts caused by asset bubbles. This is because the credit cycle exacerbates the business cycle. Bankers lend too much when collateral values go up (causing bubbles) and not enough when collateral values flatten (credit freeze). Minsky's model is scalable from homeowners defaulting on their mortgages to countries defaulting on sovereign debt. Charles Kindleberger leveraged Minsky's model to explain 400 years of financial crisis in his formidable Manias, Panics, and Crashes: A History of Financial Crises (Wiley Investment Classics).

Minsky success also reinforces the greatness of both Adam Smith and John Maynard Keynes. Smith fully anticipated the relevance of Minsky's model and the resulting need for tightly regulating credit. Keynes fully understood free market economies are inherently unstable and occasionally need a fiscal push (Keynesianism). Additionally, both Smith and Keynes were behavioral economists before it was cool as they fully grasped the irrationality of speculators.

Cassidy is by no means a socialist. He just thinks the dogmatic choice between free markets and socialism is wrong. He adheres to what Smith/Keynes/Minsky suggest. And, that is the credit market is a social utility that needs tight regulation to prevent the type of economic calamities we just experienced. And, his preventive recommendations are more stringent but in line with the proposals from the Obama Administration.
48 de 56 personas piensan que la opinión es útil
3.0 de un máximo de 5 estrellas Good in places, painful in others. 19 de julio de 2010
Por 1000Books - Publicado en
Formato:Tapa dura|Compra verificada
This book was great in places and painful in others.
On the one hand, I think he does do some wonderful things in the way of reviewing history and certain distortions that have lead to crisis. Part 2 of the book of is fairly accurate.

On the other hand, in his search to put everything on Alan Greenspans doorstep, he left out some very important details. Further he also just got parts of finance, particularly the parts that are important to this crisis, just plain wrong. I can't get too mad at him, because if I had a nickel for every journalist, let alone finance professional that has gotten it wrong, half right, somewhat confused, or otherwise, I'd have a lot more than 1$.

So let's go through it a bit.

1 - While it's nice to blame Greenspan, you really can't just do so, particularly when you're writing a book about market regulation. I mean, while the FRB did create the laws which cover Home Ownership and Equity protection as well as the Equity Credit Opportunity Act, it's actually the FTC that regulates the Mortgage brokers NOT the Fed. Further the FED does not solely regulate the Banking Trusts (Investment banks), the SEC, does that job. Nor does the Fed regulate the ratings agencies or the the insurance companies (AIG). Hence, to put it all on the fed, kind of misses the other parties that were a bit asleep at the wheel and also obsconds one of the major problems in the dependancies of the argument he sets forth in Chapter 1, i.e. "increasing regulation" or seeing the Greenspan as a period of "laissez faire". This is not to say that Cassidy makes the argument that Greenspan's world was without regulation. However, if you're going to come out strong against the man, you really ought to have your facts straight about ALL the regulators that are to be blamed and allocate the blame pie around accordingly.

2 - While he starts to discuss his argument for why Glas Steagel should not have been repealed, it's just not particularly well articulated. You can't just say, you need to not repeal glas-steagel because then the banks turn into investment banks. Why exactly do you think it's pernicious? Do you also want to address the aspects that are quite positive about re-pealing Glas Steagel? Do you understand why the banks might need a prop trading desk given what they are being asked to do as a function of the 20 years of finance that occurred from 1980's onward post the 2 debt crisis PLUS the Sarbanes Ox?

3- There were a few paragraphs that appeared to confuse CDS with CDO. Let's just clarify... a CDS stands for Credit Default Swaps. They do not require collaterol, because they are a swap. They require margin. They are not really that different from IRS (interest rate swaps) or Repos in that way. The ONLY cavaet that (and this is true of all swaps) is that there are 3 counterparties, BECAUSE these trade OTC and not on exchange. The 2 counterparties in the transaction should be margining and the 3rd counterparty is the bank that holds the two pieces in custody. Now... definately the bank needs to hold collatoral as per guidelines dealing with banking regulation. This is why it's so problematic when a major investment bank goes under, i.e. this evokes a credit event and calls into question the swap despite that both of the other two parties who engaged in the transaction might still be fully capable of carrying out their sides of the trade.

CDO - stands for Collateralized Debt Obligation. Notice that Collatoral is part of the name. Most people did in fact collaterollize these debt obligations, but admittedly under-collatorized. Hence, if you match that section of the book with this instrument and then do NOT try to carry similarities over to CDS (which incidentally is as different as if you were trying to say that a bond future is convertible bond or french is similar to spanish), you should actually be able to keep reading this section with less confusion.

4- Most VaR calculation do not fail because of correlation. They fail because of historical data. You can kind of in a VERY round about way say they fail because of correlation increasing to one, if you use the positive feedback loop argument (and to do so would be VERY generous), but more likely, given the way you wrote the paragraph you are confusing calculating VaR with calculating default risk. It's actually a completely different calculation derived from a fairly different body of math and financial mathematicians.

There are a few other issues in the book, but I'll save that for other Amazon reviewers.

So why even give it 3? Why not give it 2 or 1 star? Well...
1) I have to compare him to his peers and as wrong as he is, he is still relative more right than others that have tried to explain this.
2) He's got some good points, if - and this is not an insignficant "if" if you work in an area of finance that knows this stuff cold - you can just get past parts of the book being wrong
3) I like the graph on page 257. Is the addition of 1 or 2 stars generous because of a good graph, perhaps, but hey... I like a good graph, this is my review and when you write your own review you can use whatever criteria you want to allocate stars :)....

I would however recomomend over this book, The Myth of the Rational Market by Justin Fox. Also a journalist, I wasn't able to find anything that was wrong in his book. It was well written, accurate and fair. That said, he also doesn't try to make as strong a claim as Cassidy does; which is my biased preference for books of this nature.
9 de 9 personas piensan que la opinión es útil
4.0 de un máximo de 5 estrellas Powerfully Convincing 3 de febrero de 2010
Por Jiang Xueqin - Publicado en
Formato:Tapa dura
In "How Markets Fail: The Logic of Economic Calamities," New Yorker financial reporter John Cassidy brilliantly dissects the failed thinking and logic that led to the spectacular speculative bubbles that almost destroyed global capitalism. Divided into three parts Mr. Cassidy first traces the rise of "utopian" free market economics (in Mr. Cassidy's mathematical equation, this is rendered as "self-interest plus free competition equal nirvana"), and its current stranglehold over academic debate and economic policy. In part two Mr. Cassidy introduces "reality-based" economics as a necessary corrective to utopian economics; contrary to the market knows best mentality of many an economist, Mr. Cassidy argues that "rational irrationality" is a fact of the free market because of "externalities," hidden information, herd mentality, the prisoner's dilemma, and disaster myopia. Here Mr. Cassidy makes a powerful point about human nature: people are not bad, but if you permit and encourage them to be then they will behave badly.

And that is exactly what happened, as Mr. Cassidy argues in part three. Utopian economists applied the free market "invisible hand" principle to the financial sector (which economists have argued is inherently unstable), federal regulators simply did not do their job and Wall Street did their job too well. Using the prisoner's dilemma and logic Mr. Cassidy can understand why Wall Street behaved the way it did (they are paid to be amoral opportunists, after all), but he is not so forgiving of Alan Greenspan. As chairman of the Federal Reserve, Mr. Greenspan abetted the rise of spectacular speculative bubbles by first lowering interest rates and then refusing to intervene as the bubbles threatened America's financial system. Mr. Cassidy points out the logical contradiction in Mr. Greenspan's inaction:

"For almost two decades, Greenspan had headed an institution that was designed to save financial capitalism from itself. For him to claim that the market economy is innately stable wasn't merely contentious; it was an absurdity. If he had seriously believed what he wrote, he would surely have followed the lead of his fellow Randians and argued for the abolition of the Fed and the reestablishment of the principle that struggling financial institutions should be allowed to fail. This he never did. Instead, he helped make it easier for financiers to take on extra leverage and risk while pursuing a monetary policy that often seemed to protect them for their mistakes."

With righteous indignation Mr. Cassidy continues his onslaught:

"The combination of a Fed that can print money, deposit insurance, and a Congress that can authorize bailouts provides an extensive safety net for big financial firms. In such an environment, pursuing a policy of easy money plus deregulation doesn't amount to free market economics; it is a form of crony capitalism. The gains of financial innovation and speculation are privatized, with the bulk of them going to a small group of wealthy people who sit at the apex of the system. Much of the losses are socialized. Such a policy framework isn't merely inequitable; it is also destabilizing."

Mr. Cassidy is perceptive and accurate with all his assessments, and while the federal government has indeed saved global capitalism he also fears that we have not absorbed the lessons of the financial meltdown. Wall Street firms such as JP Morgan Chase are still "too big to fail," and utopian economics continues to dominate academia. The theoretical and regulatory frameworks which permitted this current recession are still in place, and that cannot bode well for the future.
9 de 11 personas piensan que la opinión es útil
4.0 de un máximo de 5 estrellas Markets fail, but so do governments 18 de marzo de 2011
Por Mark V Anderson - Publicado en
Formato:Tapa blanda|Compra verificada
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.
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