How Markets Fail | John Cassidy

Summary of: How Markets Fail: The Logic of Economic Calamities
By: John Cassidy


In ‘How Markets Fail: The Logic of Economic Calamities’, John Cassidy explores the 2008 financial crisis and the factors that led to it, challenging the conventional wisdom of free-market economic theory. The book delves into the history of economic thought, the consequences of financial deregulation, and the disastrous innovations in the mortgage industry. Cassidy also scrutinizes the roles of key figures such as Alan Greenspan and the influence of faulty economic beliefs in shaping public policy. By examining the concept of ‘rational irrationality’, he argues for a reality-based economics that takes into account the market’s inherent imperfections and the need for regulation.

The True Causes of the 2008 Financial Crisis

The 2008 financial crisis took the world by surprise, even the top-level regulators. The collapse of Lehman Brothers caused a panic among banks, which deepened an already-existing economic recession by shrinking the willingness of banks to loan money. The crisis was caused by the bursting of a massive bubble of inflated US home prices, which affected consumer faith in the value of residential real estate. The bubble burst because of the purchase of too many securities bundled with subprime mortgages that were in default. This led to a plunge in overnight lending between banks, as financial executives were uncertain about each other’s exposure to the mortgage mess. The notion of financial markets as rational and self-correcting mechanisms is an invention of the last 40 years, which is what led to misguided public policies and deregulation that brought about the crisis. The financial sector of the economy defies the theory of market equilibrium, and classic economic theory fails to capture everyday realities of financial markets.

Adam Smith’s Economic Ideology

A famous Scottish economist, Adam Smith, was a promoter of the free market whose book, The Wealth of Nations, compares dynamic economic growth to a benevolent “invisible hand.” Although he advocated limited government involvement, Smith recognized the dangers and speculative excesses of uncontrolled financial markets. He believed that banning banks from issuing interest-bearing notes to “speculative lenders” was necessary to prevent recurring gaps in credit availability. Smith’s position on government intervention highlights the importance of controlling risk, rather than relying too heavily on statistical models.

The Dangers of Free Market Deregulation

The US government’s deregulation of banks and financial institutions put the banking system at risk. Their attempts at encouraging free market competition in the market for bank deposits pushed banks to put money into high-return assets, leading to high-risk loans. The repeal of regulatory caps on interest rates banks could pay depositors, as well as the lifting of the Glass-Steagall Act, allowed banks to engage in investment activities that resulted in banks like Lehman Brothers and Bear Stearns collapsing. Policymakers requiring banks to adjust their capital based on credit ratings caused credit rating agencies, such as Moody’s, Standard & Poor’s, and Fitch, to replace government regulators. These agencies become the leading examiners of banks and their balance sheets, although their assessments became unreliable due to the inherent conflict of interest arising from debt issuers paying for credit ratings. “Liar loans” and “option ARMs”, among other innovations, resulted in the 2008 financial crisis as lenders made new, riskier types of mortgage loans to subprime borrowers. The banks sold these loans to investment firms, which packaged them and resold them to American and global investors. Unfortunately, the upward trend in housing prices blinded some parties to the possibility of a national collapse in residential real estate.

Alan Greenspan’s Economic Legacy

As the Federal Reserve chairman from 1987 to 2006, Alan Greenspan spearheaded policies that led to a borrowing frenzy and a laissez-faire financial environment. He championed low interest rates below 2.5% in the final years of his tenure, encouraging reckless lending. Greenspan also criticized the Glass-Steagall Act, allowing commercial and investment banking to operate freely. By the end of his term, the US had accrued massive debt due to the expansion of credit availability brought about by low interest rates and financial deregulation. Greenspan’s economic legacy remains controversial.

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