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46 of 54 people found the following review helpful:
5.0 out of 5 stars
A must read critique of economic theory, December 10, 2009
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 dot.com 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.
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12 of 15 people found the following review helpful:
5.0 out of 5 stars
Very insightful but with imperfect solutions to problems, December 21, 2009
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.
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18 of 24 people found the following review helpful:
3.0 out of 5 stars
How Authors Fail, December 18, 2009
This is actually a very well done book with a ton of great information but it can be a real slog at times. I also have it on audio and actually found it easier to listen to this than to read it myself. In any event, this is heavy on economic theory - much of it "on background" but although dense, this is really interesting becuaes you come to realize that "free market economics" as the term is thrown around by politicians and others who do not know what they are talking about. In addition, we learn that there are many respected economists who understood the problem and the solution and they were, of course, ignored.
The real point is that there are assumptions about how the free-market works that turn out to be plain false. This leads to a clear role for government (and this is not socialism). Next, greed overpowers the effecient operation of markets.....big time. Our latest "crash" is a story of greed and negligence that left me wondering really what IS the difference between Andrew Fastow and Ken Lay (Enron) and the CEO's of Bear Stearns, Goldman Sachs, Merril Lynch etc, etc......they were all hiding dept off the balance sheet so they could be overly leveraged taking on huge amounts of risk with no downside. Profits are truly privatized and losses are socialized. Why are the teabaggers not railing about this is just plain beyond me.
Bottom line - there are a lot of books covering this ground and unless you have a passion for economics this may not be the one you should read to understand what happened.
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