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The book gives a detailed account of how the formal “proof” of the efficiency of free markets evolved. The breakthrough was made in the early 1950s by Kenneth Arrow, an American economist, and Gérard Debreu, a French mathematician who died in 2004. Mr Cassidy admires the maths, but points out that their findings rely on some unrealistic assumptions, something the two theorists were quite open about. Arrow and Debreu’s “general equilibrium theory” seemed to give the stamp of scientific approval to unfettered markets. And it may have made it harder to challenge the purist free-market views of Alan Greenspan, the Federal Reserve chairman until 2006 whom Mr Cassidy partly blames for the dotcom and housing bubbles.
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Individual self interest does not always benefit society, he argues, and draws on a deep pool of research (what he calls “reality-based economics”) to support his case. Markets fail if prices send the wrong signals. For instance, an increase in house prices ought to discourage new homebuyers. In practice, however, higher prices are a spur to buyers who hope to benefit from further rises. For would-be homeowners, the signal is that it is time to buy; for banks, that it is time to lend. Those who suspect a bubble face the same dilemma as textbook prisoners: it makes sense to act sensibly only if others do so too. Since that cannot be relied upon, it is safer to go with the herd. The result of such individually rational behaviour is a housing and credit boom, followed inevitably by a nasty bust.
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Markets also founder when there is hidden information—if sellers know more than buyers, for example—and when the prices paid by individuals do not fully reflect social costs, such as pollution. Such failures were evident in the build-up to the current crisis: dud mortgages were packaged as supposedly safe bonds to investors; banks did not factor in the wider costs of bad debt when making risky loans. Policymakers should have intervened to curb the excesses but were hamstrung by free-market ideology.
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“How Markets Fail” is an ambitious book, and one that mostly succeeds. [...] Its call for a better balance between individual autonomy and state oversight might have seemed off-centre just a few years ago. Now its prescription is firmly in the mainstream.
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Individual self interest does not always benefit society, he argues, and draws on a deep pool of research (what he calls “reality-based economics”) to support his case. Markets fail if prices send the wrong signals. For instance, an increase in house prices ought to discourage new homebuyers. In practice, however, higher prices are a spur to buyers who hope to benefit from further rises. For would-be homeowners, the signal is that it is time to buy; for banks, that it is time to lend. Those who suspect a bubble face the same dilemma as textbook prisoners: it makes sense to act sensibly only if others do so too. Since that cannot be relied upon, it is safer to go with the herd. The result of such individually rational behaviour is a housing and credit boom, followed inevitably by a nasty bust.
[...]
Markets also founder when there is hidden information—if sellers know more than buyers, for example—and when the prices paid by individuals do not fully reflect social costs, such as pollution. Such failures were evident in the build-up to the current crisis: dud mortgages were packaged as supposedly safe bonds to investors; banks did not factor in the wider costs of bad debt when making risky loans. Policymakers should have intervened to curb the excesses but were hamstrung by free-market ideology.
[...]
“How Markets Fail” is an ambitious book, and one that mostly succeeds. [...] Its call for a better balance between individual autonomy and state oversight might have seemed off-centre just a few years ago. Now its prescription is firmly in the mainstream.
The best sentence is "Policymakers should have intervened to curb the excesses but were hamstrung by free-market ideology.", describing the 2008-2009 subprimes crisis. I am happy to hear that policy makers are free-marketers and I can't wait for Bernanke's next speech at CATO's.
I have never read that Arrow-Debreu's work was a proof that markets are working. Gérard Debreu’s contributions are in general equilibrium theory—highly abstract theory about whether and how each market reaches equilibrium. In a famous paper coauthored with Kenneth Arrow and published in 1954, Debreu proved that under fairly unrestrictive assumptions, prices exist that bring markets into equilibrium, that is, an equilibrium in which all markets are in equilibrium. Using new mathematical techniques, Arrow and Debreu showed that one of the conditions for general equilibrium is that there must be futures markets for all goods. Of course, we know that this condition does not hold—one cannot buy a contract for future delivery of many labor services, for example. In his 1959 book, The Theory of Value, Debreu introduced more general equilibrium theory, using complex analytic tools from mathematics—set theory and topology—to prove his theorems. In 1983 Debreu was awarded the Nobel Prize “for having incorporated new analytical methods into economic theory and for his rigorous reformulation of the theory of general equilibrium.”
The second paragraph is interesting...
The market failure criticism fails to appreciate how the historical argument in favor of markets from Adam Smith to F. A. Hayek did not focus on the equilibrium properties of the market, but on the adjustment properties of the market system. Today’s inefficiency represents tomorrow’s profit for the entrepreneur who recognizes and grasps the opportunity. The strength of the market economy in this rendering is its dynamic adjustment to constantly changing circumstances. Entrepreneurs react to the existing array of prices to realize gains from trade through arbitrage, and the lure of pure profits spur entrepreneurs to realize the gains from innovation through the introduction of new products or discovering better ways to produce and/or deliver existing products.
"Its call for a better balance between individual autonomy and state oversight might have seemed off-centre just a few years ago." Seriously?
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