Shaking the Invisible Hand

Shaking the Invisible Hand

Mini Teaser: The chances of another cycle of optimism, overconfidence, hubris, panic and a long period of pessimism are high.

by Author(s): Liaquat Ahamed

John Cassidy, How Markets Fail: The Logic of Economic Calamities (New York: Farrar, Straus and Giroux, 2009), 400 pp., $28.00.

J. Bradford DeLong and Stephen S. Cohen, The End of Influence: What Happens When Other Countries Have the Money (New York: Basic Books, 2010), 176 pp., $22.00.

Richard A. Posner, The Crisis of Capitalist Democracy (Cambridge, MA: Harvard University Press, 2010), 408 pp., $25.95.

Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton: Princeton University Press, 2009), 496 pp., $35.00.

Joseph E. Stiglitz, Freefall: America, Free Markets, and the Sinking of the World Economy (New York: W. W. Norton & Company, 2010), 361 pp., $27.95.


THOUGH IN some sense all financial crashes are by definition unexpected, in retrospect, perhaps the oddest thing about the recent economic calamity was that it should have taken so many people by surprise. Different this time was not that disaster came out of the blue, but that in the lead-up to it so many people thought it simply could not happen. A financial crisis of this magnitude in an advanced economy was a thing of the past, a disease like smallpox-still found in poorer countries, but essentially eradicated from the developed markets of the West.

True, there were a few Cassandras predicting trouble ahead. But most of them looked in the wrong direction for the oncoming storm. They were all focused eastward, eyeing the growing current-account imbalances between the United States and Asia and predicting that disaster, when it came, would occur in the form of a currency crisis as China dumped its dollars. No one anticipated, let alone imagined, that instead the shake-up would originate at home and that, as a consequence, we would experience a gigantic run on the Western banking system that would bring it to the brink of collapse.

Oddly, this did not seem like complacency. There were seemingly good reasons to be confident. Changes in technology and the impact of globalization had led to an apparent dampening of the business cycle. And central bankers persuaded themselves that they had finally figured out the secret to conducting monetary policy in a stabilizing way, pointing to their success in having kept the economy on track after that series of jolts in the 1990s-the Asian crisis, the Russian default, the collapse of Long Term Capital Management and the pricking of the tech bubble.

Lurking in the background there was the disquieting example of Japan, an advanced economy that had experienced a bubble, a crash and a banking crisis followed by a lost decade of deflation and zero growth. But most economists brushed this off, arguing that Tokyo had always been sui generis, a hybrid economy hobbled by too much government intervention, not a real market economy like the United States or Great Britain.

Everyone really did think that this time was different, that a new era had begun. In the wake of the recent crisis, all that happy talk has been jettisoned.

Now comes the great rethink.


[amazon 0691142165 full] FINANCIAL CRISES are nothing new. Investors seem to have a way of making the same mistakes over and over and over again. Long before the alphabet soup of CDSs (credit-defaults swaps), CDOs (collateralized-debt obligations) and SPVs (special-purpose investment vehicles) had ever been invented, investors and bankers were taken in by such varied temptations as English county banks, South American mines, British canals and U.S. railroads, Florida real estate, radio stocks and multinational conglomerates. For those who want to relearn the forgotten lessons of the past, This Time is Different, by economics professors Carmen Reinhart and Kenneth Rogoff, is an excellent place to start. The authors attempt to give our long history of hope and disillusionment some order by identifying systematic regularities in the way the cycle of booms and busts has played itself out. These are lessons worth learning. While financial debacles may come in all sizes and shapes-Reinhart and Rogoff identify seven different generic types-they can all ultimately be reduced to too much borrowing.

This Time is Different broadly tells two different stories. The first is the history of governments borrowing too much and then finding themselves unable, or more accurately unwilling, to bear the political costs of paying their creditors. Until the end of the eighteenth century, such sovereign defaults were the most common source of financial turmoil. But since the Great Depression, no major government with an advanced economy has reneged on its debts. Sovereign defaults have largely become a problem of the developing world.

The second story sees the banks as the protagonists, the other main culprits behind financial chaos. It is a rich narrative because banking crises are a form of monetary neuralgia for which even advanced economies have yet to find a cure. In fact, the wealthier the country, the more frequent and bigger its banking problems. Since 1800, the greatest number of these crises have been seen in France (fifteen), the United States (thirteen) and the UK (twelve).

Drawing on their analysis of sixty-six countries over the last two hundred years, Reinhart and Rogoff identify some common patterns. Multiple bank failures are often heralded by credit booms, surges in inflows of foreign capital and rapidly rising asset prices, particularly in real estate and equities, which then collapse when banking troubles surface. These debacles are frequently also preceded by episodes of financial liberalization and deregulation. Hidden behind the statistics is an age-old cycle of optimism, overconfidence, hubris, panic and finally a long period of pessimism. To observers of our current woes, this should all sound depressingly familiar. More ominously for our present situation, Reinhart and Rogoff show that the hangover from a banking crisis lingers long after the catastrophe is over. It can take up to six years for an economy to recover from one of these episodes and the costs, both direct and indirect, associated with the cleanup are gigantic, typically causing government debts to almost double.

Adding to the disruption caused by these upheavals, as Reinhart and Rogoff so graphically document, crises do not arrive in isolation but come bunched together. There was a global wave beginning in 1800, another after 1820, then a lull for several decades. Another wave followed after 1870 and still one more took down the system in the 1930s. Why capitalist economies should be subject to these twenty- to forty-year cycles of instability is a fascinating topic for speculation-John Kenneth Galbraith thought it had something to do with the death of one generation of bankers and financiers who had experienced a bust, and the passing of the torch to the next generation, which was forced to learn its lessons once again.

But after the Second World War, these somewhat predictable ups and downs of the financial system went through an unusually long period in which they seemed to go dormant, perhaps because banking and international capital flows were so tightly regulated. Beginning in the early 1990s, however, something happened to reactivate the cycle. It is not a coincidence that this latest wave of financial crises was preceded by a swing of the ideological pendulum in favor of free markets; by a dramatic shift in policies away from government intervention in financial markets. Deregulation and liberalization may have brought a lot of benefits, but stability was not one of them.


ONE OF the more fervent evangelists for this revival of the free-market creed was Alan Greenpsan. In October 2008, in the middle of the turmoil, Greenspan caused a major stir when he testified to Congress that he was "shocked" to find that his whole worldview had been wrong. Pressed to justify his promotion of unregulated financial markets, Greenspan, suddenly looking almost defeated, admitted that he had miscalculated: "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 firms."

[amazon 0374173206 full] But this oh-so-heralded epiphany from Maestro Greenspan does not tell the whole story. For the financial crisis has revealed two problems. The first, as the former Federal Reserve chief confessed, is that bankers cannot always be counted on to act in the interests of their own shareholders-the so-called principal-agent problem. Yet it is the second conundrum that is perhaps more profound and poses a still-greater challenge: even if bankers had acted in the best interest of their shareholders, there is no guarantee that would have ended up being in the best interest of everybody else. What is good for banks is not necessarily good for society. It is this disconnect that is the central theme of How Markets Fail by John Cassidy, a writer for the New Yorker.

The heart of this wonderful book is the tale of how economists have gone about addressing one of the central questions of economics: do markets work, and if so, why? Not in practice of course-after all, these are economists we are talking about-but in theory. If, let us suppose, producers and consumers were allowed to choose what they could buy and sell freely in competitive markets, would the result in any sense lead to a beneficial outcome for society as a whole?

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