How Markets Fail: The Logic of Economic Calamities
“I am shocked, shocked, to find that gambling is going on in here!”
—Claude Rains as Captain Renault in Casablanca
The old man looked drawn and gray. During the almost two decades he had spent overseeing America’s financial system, as chairman of the Federal Reserve, congressmen, cabinet ministers, even presidents had treated him with a deference that bordered on the obsequious. But on this morning—October 23, 2008—Alan Greenspan, who retired from the Fed in January 2006, was back on Capitol Hill under very different circumstances. Since the market for subprime mortgage securities collapsed, in the summer of 2007, leaving many financial institutions saddled with tens of billions of dollars’ worth of assets that couldn’t be sold at any price, the Democratic congressman Henry Waxman, chairman of the House Committee on Oversight and Government Reform, had held a series of televised hearings, summoning before him Wall Street CEOs, mortgage industry executives, heads of rating agencies, and regulators. Now it was Greenspan’s turn at the witness table.
Waxman and many other Americans were looking for somebody to blame. For more than a month following the sudden unraveling of Lehman Brothers, a Wall Street investment bank with substantial holdings of mortgage securities, an unprecedented panic had been roiling the financial markets. Faced with the imminent collapse of American International Group, the largest insurance company in the United States, Ben Bernanke, Greenspan’s mild-mannered successor at the Fed, had approved an emergency loan of $85 billion to the company. Federal regulators had seized Washington Mutual, a major mortgage lender, selling off most of its assets to JPMorgan Chase. Wells Fargo, the nation’s sixth-biggest bank, had rescued Wachovia, the fourth-biggest. Rumors had circulated about the soundness of other financial institutions, including Citigroup, Morgan Stanley, and even the mighty Goldman Sachs.
Watching this unfold, Americans had clung to their wallets. Sales of autos, furniture, clothes, even books had collapsed, sending the economy into a tailspin. In an effort to restore stability to the financial system, Bernanke and the Treasury secretary, Hank Paulson, had obtained from Congress the authority to spend up to $700 billion in taxpayers’ money on a bank bailout. Their original plan had been to buy distressed mortgage securities from banks, but in mid-October, with the financial panic intensifying, they had changed course and opted to invest up to $250 billion directly in bank equity. This decision had calmed the markets somewhat, but the pace of events had been so frantic that few had stopped to consider what it meant: the Bush administration, after eight years of preaching the virtues of free markets, tax cuts, and small government, had turned the U.S. Treasury into part owner and the effective guarantor of every big bank in the country. Struggling to contain the crisis, it had stumbled into the most sweeping extension of state intervention in the economy since the 1930s. (Other governments, including those of Britain, Ireland, and France, had taken similar measures.)
“Dr. Greenspan,” Waxman said. “You were the longest-serving chairman of the Federal Reserve in history, and during this period of time you were, perhaps, the leading proponent of deregulation of our financial markets . . . You have been a staunch advocate for letting markets regulate themselves. Let me give you a few of your past statements.” Waxman read from his notes: “‘there’s nothing involved in federal regulation which makes it superior to market regulation.’ ‘There appears to be no need for government regulation of off-exchange derivative transactions.’ ‘We do not believe a public policy case exists to justify this government intervention.’” Greenspan, dressed, as always, in a dark suit and tie, listened quietly. His face was deeply lined. His chin sagged. He looked all of his eighty-two years. When Waxman had finished reading out Greenspan’s words, he turned to him and said: “My question for you is simple: Were you wrong?”
“Partially,” Greenspan replied. He went on: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the i firms . . . The problem here is something which looked to be a very solid edifice, and, indeed, a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and, obviously, to the extent that I figure out what happened and why, I will change my views.”
Waxman, whose populist leanings belie the fact that he represents some of the wealthiest precincts in the country—Beverly Hills, Bel Air, Malibu—asked Greenspan whether he felt any personal responsibility for what had happened. Greenspan didn’t reply directly. Waxman returned to his notes and started reading again. “‘I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We have tried regulations. None meaningfully worked.’ ” Waxman looked at Greenspan. “That was your quote,” he said. “You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Now our whole economy is paying the price. Do you feel that your ideology pushed you to make decisions that you wish you had not made?”
Greenspan stared through his thick spectacles. Behind his mournful gaze lurked a savvy, self-made New Yorker. He grew up during the Great Depression in Washington Heights, a working class neighborhood in upper Manhattan. After graduating from high school, he played saxophone in a Times Square swing band, and then turned to the study of economics, which was coming to be dominated by the ideas of John Maynard Keynes. After initially embracing Keynes’s suggestion that the government should actively manage the economy, Greenspan turned strongly against it. In the 1950s, he became a friend and acolyte of Ayn Rand, the libertarian philosopher and novelist, who referred to him as “the undertaker.” (In his youth, too, he was lugubrious.) He became a successful economic consultant, advising many big corporations, including Alcoa, J.P. Morgan, and U.S. Steel. In 1968, he advised Richard Nixon during his successful run for the presidency, and under Gerald Ford he acted as chairman of the White House Council of Economic Advisers. In 1987, he returned to Washington, this time permanently, to head the Fed and personify the triumph of free market economics.
Now Greenspan was on the defensive. An ideology is just a conceptual framework for dealing with reality, he said to Waxman. “To exist, you need an ideology. The question is whether it is accurate or not. What I am saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is, but I have been very distressed by that fact.” Waxman interrupted him. “You found a flaw?” he demanded. Greenspan nodded. “I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works, so to speak,” he said.
Waxman had elicited enough already to provide headlines for the following day’s newspapers—the Financial Times: “‘I made a mistake,’ admits Greenspan”—but he wasn’t i finished. “In other words, you found that your view of the world, your ideology, was not right,” he said. “It was not working?”
“Precisely,” Greenspan replied. “That’s precisely the reason I was shocked. Because I had been going for forty years, or more, with very considerable evidence that it was working exceptionally well.”
The book ‘How Markets Fall’ by John Cassidy traces the rise and fall of free market ideology, which, as Greenspan said, is more than a set of opinions: it is a well-developed and all-encompassing way of thinking about the world. John Cassidy has tried to combine a history of ideas, a narrative of the financial crisis, and a call to arms. It is his contention that you cannot comprehend recent events without taking into account the intellectual and historical context in which they unfolded. But unlike other books on the subject, this one [The book ‘How Markets Fall’ by John Cassidy] doesn’t focus on the firms and characters involved: the aim is to explore the underlying economics of the crisis and to explain how the rational pursuit of self-interest, which is the basis of free market economics, created and prolonged it.
Greenspan isn’t the only one to whom the collapse of the subprime mortgage market and ensuing global slump came as a rude shock. In the summer of 2007, the vast majority of analysts, including the Fed chairman, Bernanke, thought worries of a recession were greatly overblown. In many parts of the country, home prices had started falling, and the number of families defaulting on their mortgages was rising sharply. But among economists there was still a deep and pervasive faith in the vitality of American capitalism, and the ideals it represented.
For decades now, economists have been insisting that the best way to ensure prosperity is to scale back government involvement in the economy and let the private sector take over. In the late 1970s, when Margaret Thatcher and Ronald Reagan launched the conservative counterrevolution, the intellectuals who initially pushed this line of reasoning—Friedrich Hayek, Milton Friedman, Arthur Laffer, Sir Keith Joseph—were widely seen as right-wing cranks. By the 1990s, Bill Clinton, Tony Blair, and many other progressive politicians had adopted the language of the right. They didn’t have much choice. With the collapse of communism and the ascendancy of conservative parties on both sides of the Atlantic, a positive attitude to markets became a badge of political respectability. Governments around the world dismantled welfare programs, privatized state-run firms, and deregulated industries that previously had been subjected to government supervision.
In the United States, deregulation started out modestly, with the Carter administration’s abolition of restrictions on airline routes. The policy was then expanded to many other parts of the economy, including telecommunications, media, and financial services. In 1999, Clinton signed into law the Gramm-Leach-Bliley Act (aka the Financial Services Modernization Act), which allowed commercial banks and investment banks to combine and form vast financial supermarkets. Lawrence Summers, a leading Harvard economist who was then serving as Treasury secretary, helped shepherd the bill through Congress. (Today Summers is Barack Obama’s top economic adviser.)
Some proponents of financial deregulation—lobbyists for big financial firms, analysts at Washington research institutes funded by corporations, congressmen representing financial districts—were simply doing the bidding of their paymasters. Others, such as Greenspan and Summers, were sincere in their belief that Wall Street could, to a large extent, regulate itself. Financial markets, after all, are full of well-paid and highly educated people competing with one another to make money. Unlike in some other parts of the economy, no single firm can corner the market or determine the market price. In such circumstances, according to economic orthodoxy, the invisible hand of the market transmutes individual acts of selfishness into socially desirable collective outcomes.
If this argument didn’t contain an important element of truth, the conservative movement wouldn’t have enjoyed the success it did. Properly functioning markets reward hard work, innovation, and the provision of well-made, affordable products; they punish firms and workers who supply overpriced or shoddy goods. This carrot-and-stick mechanism ensures that resources are allocated to productive uses, making market economies more efficient and dynamic than other systems, such as communism and feudalism, which lack an effective incentive structure. Nothing in the book [The book ‘How Markets Fall’ by John Cassidy] should be taken as an argument for returning to the land or reconstituting the Soviets’ Gosplan. But to claim that free markets always generate good outcomes is to fall victim to one of three illusions identify: the illusion of harmony.
In telling this story, and bringing it up to the summer of 2009, John Cassidy has tried to relate recent events to long-standing intellectual debates over the performance of market systems. The last ten years can be viewed as a unique natural experiment designed to answer the questions: What happens to a twenty-first-century, financially driven economy when you deregulate it and supply it with large amounts of cheap money? Does the invisible hand ensure that everything works out for the best? This [The book ‘How Markets Fall’ by John Cassidy] isn’t an economics textbook, but it does invite the reader to move beyond the daily headlines and think quite deeply about the way modern capitalism operates, and about the theories that have informed economic policies. We tend to think of policy as all about politics and special interests, which certainly play a role, but behind the debates in Congress, on cable television, and on the Op-Ed pages, there are also some complex and abstract ideas, which rarely get acknowledged. “Practical men, who believe they to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist,” John Maynard Keynes famously remarked on the final page of The General Theory of Employment, Interest and Money. “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
Keynes had a weakness for rhetorical flourishes, but economic ideas do have important practical consequences: that is what makes them worthy of study. If the book by John Cassidy helps some readers comprehend some things that had previously seemed mystifying, the effort he has put into it will have been well rewarded. If it also helps consign utopian economics to the history books, that will be a bonus.