Book review: "How Markets Fail" by John Cassidy

There has been almost as much comment and media analysis of the credit crisis as there were panicked trades in the markets at its peak. Most comment has taken an aggressive or defensive position around the role of bankers. John Cassidy’s outstanding book is a dispassionate but engaging look at the historical, economic, sociological and academic context of the sub-prime crash and its terrible aftermath.

Cassidy does have a message, eloquently argued: the vast majority of economists, bankers and policy makers of the last three decades have been blindly irresponsible in their wholehearted espousal of the unfettered free market. Indeed, he refers to the ideologies of the Chicago school as “Utopian Economics”. His arguments are deep, broad and lucid. He shows, quite irrefutably, how the perfect market, enlightened self interest, full information and other such axioms of the Friedman revolution are disastrously simplistic. The evidence of huge areas of hidden information, beauty contest group psychology and the paradoxical force of game theory outcomes is undeniable. The underlying force of markets, “rational self interest” often or even usually works against the mathematics of supply, demand and perfect information. His analysis of the reality of how bubbles happen and how disturbing they are for traditional economic theories of the market is explosively enlightening.

How Markets Fail also looks at the agents behind the disaster of the last two years. Cassidy is especially unforgiving of the once God-like Alan Greenspan. The old Fed Chairman’s explanation for his arrogant irresponsibility in allowing – indeed encouraging – two major speculative bubbles (dot-com and sub-prime) to explode unchecked was a pathetic “The problem is.. a critical pillar to market competition and free markets did break down...that shocked me. I still do not fully understand why it happened.”

Cassidy also looks at the bankers, in particular, the brilliant mathematical minds behind all their risk calculations and the lethal Value at Risk (VAR) model so widely touted as the unsinkable ship for navigating the icebergs of the market. I was shocked to find that these models and, indeed, the bedrock Black-Scholes option pricing formula, are based on long outdated analyses of how markets work, namely the random walk of share prices and a normal distribution curve for market pricing in general. In other words, all that sophisticated, grotesquely overpaid risk analysis edifice was built on an infantile assumption that all trades are independent of each other and traders never follow the herd.

Although there is a good deal of solid economic and  financial analysis in this book it is imminently readable, sometimes un-put-down-able. His description of how the sub-prime market came into existence, grew and exploded reads like a thriller.

If, like me, you were once enthralled by the mathematical, organic beauty of the free market, the self correcting forces that would always take us back to a satisfying and essentially good equilibrium, this book is essential reading. John Cassidy’s alternative prescription, a plea for “reality based economics” that takes into account how bankers, traders, business managers, house-owners and consumers” act in the real, non-utopian world is powerfully defended and should make us take stock and rethink. After all, what has happened is, fundamentally, a massive intellectual failure, a collapse of an ideology of hubristic wishful thinking. We’ve had enough of all that Master of the Universe stuff: what we need is rational, modest, realistic wisdom. How Markets Fail gives us exactly that.

BTW I was childishly pleased to find that what Cassidy writes does, decidedly more soberly and infinitely more academically, back up most of my rant on bankers in December 2009.