How Markets Fail: The Logic of Economic Calamities
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For fifty years, economists have been developing elegant theories or how markets facilitate innovation, create wealth, and allocate society's resources efficiently. But what about when they fail, when they lead us to stock market bubbles, glaring inequality, polluted rivers, and credit crunches? In How Markets Fail, John Cassidy describes the rising influence of "utopian economies"―the thinking that is blind to how real people act and that denies the many ways an unregulated free market can bring on disaster. Combining on-the-ground reporting and clear explanations of economic theories Cassidy warns that in today's economic crisis, following old orthodoxies isn't just misguided―it's downright dangerous.
invisible hand satisfying wants, equating costs with benefits, and otherwise working its magic. Take Harvard’s Greg Mankiw, the author of two popular textbooks and the founder of the Pigou Club, which supports higher carbon taxes. In a May 2009 column in The New York Times, Mankiw conceded that teachers of freshman economics would now have to mention some issues previously relegated to more advanced courses, such as the role of financial institutions, the dangers of leverage, and the perils of
mortgage brokers who steered hard-up working-class families toward risky subprime mortgages were reacting to monetary incentives. So were the loan officers who approved these loans, the investment bankers who cobbled them together into mortgage securities, the rating agency analysts who stamped these securities as safe investments, and the mutual fund managers who bought them. The subprime boom represented a failure of capitalism in the presence of bounded cognition, uncertainty, hidden
that had plagued general equilibrium theory. A modern economy is immensely complicated, and aggregate outcomes, such as the rate of unemployment and inflation, emerge from decisions made by countless individuals and firms. The American economy, for example, is made up of roughly 300 million people, 110 million households, and about 30 million companies. Other important players include the federal government, which accounts for about a fifth of GDP, fifty state governments, and numerous
owners, or SUV buyers. Like most people in the economy, they pursue their self-interest, reacting to the signals that the market provides them. The key to global warming, and the source of the market failure that Stern was talking about, is the presence of something that economists call negative “spillovers” or “externalities.” When a power station burns coal to create electricity, the carbon dioxide it creates is a by-product that spills over into the atmosphere. The power station suffers
regular defaults on credit card bills, car loans, home mortgages, and other credit products. They know how to track these defaults, and they do a reasonable job of setting aside reserves to meet them. But Guttentag and Herring pointed out that the banks tend to underestimate the chances of a systemic shock that could render many of their lenders simultaneously unable to repay their loans, such as the American economy plunging into a deep recession, or a sovereign government defaulting on its