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

This makes for a brilliant history of economic thought, a tour d'horizon of the theory behind free markets from its original formulation in 1776 by Adam Smith, who coined the phrase "invisible hand," through its various refinements (including Frederick Hayek's idea that market systems act as a giant decentralized machine for conveying signals and processing information), to the more recent attempts to apply abstruse mathematical techniques like theoretical topology (the study of shapes and spatial properties) to prove that the resulting outcome is both efficient (in a very technical economic sense, that no one can be made better-off without making someone else worse-off) and stable. It is part of Cassidy's great skill as an economics writer that he is able to convey to the reader the potency of that set of ideas, and why they have had such a profound and seductive intellectual appeal.

He then proceeds step-by-step to chip away at the edifice he has erected, outlining all the various ways in which markets fail: for example, when the actions of one party impinge adversely on others (a coal-fired power plant letting off carbon emissions that effect climate change across the globe); or when there is uncertainty and it is hard to define what constitutes a rational course of action (a person buying stock in a company just because everyone else he or she knows is doing so); or when buyers and sellers do not have access to the same information (a borrower signing a complicated mortgage from a broker without reading the fine print). It turns out that because so much of finance involves making judgments about the future, these markets are especially prone to problems associated with uncertainty and a lack of information. It is this that causes them to be such a source of trouble for the economy.

My one reservation about the way in which Cassidy tells the story in How Markets Fail is that he leaves the impression that economists have for too long viewed the world through heavily rose-tinted glasses. He does not do adequate justice to a strand of economic thought that has been around since the early nineteenth century, which has always stressed the inherent instability of capitalism and the fragility of the financial system that supports it. It was no accident that the modern central bank was invented in the first half of the nineteenth century in Britain by men who were otherwise firm believers in the virtue of free markets but understood that occasionally the invisible hand loses its grip and requires some very visible brains to set it right.

That simple insight-that unfettered financial markets can occasionally and catastrophically break down-seems to have been forgotten as the move toward deregulation gathered momentum in the 1990s. And it was that excessive confidence in the workings of markets, Cassidy argues, that set the world on its course to the current financial disaster.

 

IT TOOK more than just malfunctioning markets, however, to get us into our present straits. As Cassidy himself describes in his story of the current crisis (which I should say is, in my view, the most concise and elegantly written account, among the many that have come out, of how we got into this mess), we got a big push from the Fed. In the early part of this decade, the Fed made a major policy mistake by keeping interest rates too low for too long. The result was the real-estate bubble.

There is an alternative narrative out there of just what went wrong. Its main proponent is Ben Bernanke. And the thesis goes like this: it was the gigantic sums of money accumulating in the hands of Asian central banks which, invested in the U.S. bond market, drove long-term interest rates down, made credit in the United States artificially cheap and thus provided the fuel for the real-estate boom. Cassidy does not mention this thesis, probably because he does not buy it.

While cheap financing may have provided the initial impetus for the real-estate bubble, a second factor was at work: the dramatic reduction in credit standards by banks. The combination of securitization gone crazy and excessive compensation on Wall Street created a set of perverse incentives for bankers and mortgage brokers to do as much lending as possible with little regard for how much would or could be paid off. It did not help that regulators turned a blind eye to all this predatory lending.

A real-estate bubble fueled by easy money and exotic mortgages would have been a problem. What converted it into a global catastrophe was the exceptionally precarious position of the financial system. Seduced by the apparent decline in market volatility and lulled by the belief that the Fed would ensure that the downside was protected by cutting interest rates and adding liquidity, as it had done in 1998 and 2000 (the so-called "Greenspan put"), financial institutions loaded up on risk. But they did not have enough capital for the risks they were taking and relied too much on borrowed money. Moreover, too great a proportion of this borrowed money was short-term in nature, and it evaporated at the first hint of trouble.

Thus, when the real-estate bubble eventually burst and financial institutions started sustaining big losses, investors everywhere rushed to pull out their cash. In late 2007 and 2008 the world faced a massive run on its financial system.

While economists like to debate and rarely agree about very much, an unusual consensus has emerged about the factors that led to the collapse. The vast majority of economists (aside from those few holdouts at places like the University of Chicago) would agree with 90 percent of this assessment of how the global economic system nearly fell apart.

 

THERE IS much less agreement however on how to handle its aftermath. Since the nineteenth century, central bankers have relied on a formula for dealing with a full-blown bank run: be prepared to inject sufficiently large amounts of money into the banking system so that no one can have any doubt about their bank's ability to pay. The central problems are deciding exactly when to act, how much money to inject, to which institutions, in what form-short-term loans from the central bank, explicit and implicit government guarantees on bank deposits and debts, or injections of capital-and on what terms.

Saving a banking system inevitably involves rescuing whole groups of depositors, investors or counterparts from the consequences of their own decisions. Some are deserving and some are not. It is a process that is inherently messy and unfair, one that cannot be easily fine-tuned or targeted. Furthermore, because of moral hazard, bailouts make future crises more likely. Some have argued that one of the ways to minimize the moral-hazard consequences is to leave who will be bailed out deliberately vague until the very last moment. The only rule that has evolved about the way a "lender of last resort" should behave is that there are no rules.

Unfortunately, because governments have so much discretion, financial rescues are inevitably followed by a lot of recrimination and controversy. Ever since the first recorded financial panic in AD 33, when the Roman Emperor Tiberius was forced to inject a million gold pieces of public money to keep the Imperial financial system from collapsing, people have complained about who was bailed out and why. Conspiracy theorists have had a field day. This crisis has been no different.

[amazon 0393075966 full] Two new books-Freefall, by the Nobel Prize-winning Joseph Stiglitz and The Crisis of Capitalist Democracy by the Federal judge, University of Chicago lecturer, polymath and part-time economist Richard Posner-provide accounts of the crisis and analyses of the actions the government has taken to date to save the financial system and promote recovery. Neither adds much to Cassidy's story of how the meltdown happened. The controversies begin with how the authorities responded-no more so than with the bailouts.

[amazon 0674055748 full] Both authors are highly critical of the U.S. government for the various false starts and blind alleys it went down in 2008 and 2009. It is hard to dispute this conclusion. For much of 2008, the Fed, but more especially the Treasury, kept misdiagnosing the problem, viewing it as a liquidity crisis (in which banks faced a temporary shortage of funds that could be cured by short-term loans from central banks) rather than a solvency crisis (which could not be fixed by temporary loans and required the provision of new long-term capital). It was only very late in the game, in October 2008, that the authorities finally recognized the true nature of the calamity and accepted the need to inject public money into the banks to bolster their equity. All that can be said in defense of the key participants in the drama-Treasury Secretaries Hank Paulson and Tim Geithner, and Fed Chairman Ben Bernanke-is that they were operating in the "fog of war" and dealing with a dysfunctional political system. I suspect that even they would agree, however, that with the benefit of hindsight they would have done things differently.

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