ECONned | Yves Smith

Summary of: ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism
By: Yves Smith

Introduction

In the book ‘ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism,’ Yves Smith dissects the roots of the financial crisis of 2008 and offers a critical examination of the evolution of neoclassical economics. The book reveals how the misconceptions around market equilibrium, deregulation, and risk management contributed to the crisis. It explores how the development of the shadow banking system, fueled by financial deregulation, set the stage for the crash and sheds light on the role of complex financial instruments, such as collateralized debt obligations (CDOs) and credit default swaps (CDS), in exacerbating the problem. This summary provides an insightful analysis of the book’s key concepts and offers recommendations for regulatory and professional reforms to prevent future crises.

The Problems with Neoclassical Economics

In “The Wealth of Nations,” Adam Smith introduced the concept of the “invisible hand,” which refers to the individual self-interest that drives the supply and demand in a market. Neoclassical economics is the mathematical descendant of Smith’s teachings, which attempts to identify theoretically optimal economic states. However, this approach assumes unrealistic market conditions and encourages deregulation, leading to financial exploitation. By embracing unrealistic assumptions, neoclassical economics has become less applicable to real problems, and policymakers have misused it to reshape financial markets. This simplistic model of pure competition can serve as a guide for economic policy-making, but it is laden with debatable assumptions, which makes the math simpler. The result is an abstract and arguably less applicable field than before, which has contributed to the financial crisis.

An Illusion of Efficiency

The Fallibility of Financial Economics and Risk Management

Financial economics, a branch of neoclassical economics, emerged during the 1960s and 1970s, with its intellectual roots providing the political justification for the deregulation of financial markets in the 1980s and 1990s. It views uncontrolled commerce as an equilibrium-seeking force functioning continuously. This ideology led Paul Samuelson and Eugene Fama to introduce the “efficient markets hypothesis” and Harry Markowitz to develop the concept of the “efficient portfolio.” The hypothesis proposes that traded securities’ prices entirely reflect all available information, and the portfolio theory theorizes that each investor needs to strike the perfect balance between returns and risks.

However, financial economics’ assumptions do not hold in reality, with real markets often faltering for various reasons, and the assumption of perfect investor knowledge being unrealistic. Markowitz’s portfolio theory rests on dubious assumptions about risk management, as most modern tools for assessing investment risks tend to fail in predicting the most severe threats. Financial models, like the Value at Risk (VaR), have three common weaknesses: underestimating “tail risk,” assuming uninterrupted market operation, and assuming asset classes’ absence of simultaneous depreciation.

Moreover, economists position themselves as benign umpires, while their role is inherently political. Their attempts at modeling and proving the existence of optima ignore the question of what society wants to optimize. The fallibility of financial economics and risk management suggests that a rethinking of modern economic theory bending towards realism is necessary.

The Consequences of Financial Deregulation

The Great Depression led to the tightening of regulations on financial markets, but the trend reversed in the 1980s and 1990s. The deregulation movement was based on the belief that less government intervention would make the markets more efficient. The result was the development of a shadow banking system comparable in size to the legal banking system. Lax regulation added to the inflation of mortgage-based securities and the breakdown of the relationship between mortgage lenders and borrowers.

Want to read the full book summary?