Hi guys, I just finished reading a pretty good book, "How Markets Fail", by John Cassidy.
Here's a short review, to give you a sense of it.
"How Markets Fail" is a detailed depiction of how the current financial crisis exposes the weakness of utopian free market notions. According to efficient market theory, the "invisible hand" aligns self interest and collective prosperity. But in truth, that's not always the case, especially in finance (even Adam Smith didn't think his general theories applied to banking).
As a perfect example of how the micro and macro are often de-coupled, it's helpful to examine Keynes' "paradox of thrift". During nasty economic downturns (like today's crisis), individuals turn to saving in an effort to shore up household finances. However, that (perfectly rational) action saps the economy of its aggregate demand when it's needed most -- hence the need for government stimulus to reignite growth before devastation takes hold.
In other words, there are times when "rational irrationality" becomes the rule for individual behavior, when perfectly sane micro-level decisions result in harmful aggregate effects. Nowhere is the effect greater than in a speculative market -- indeed, it is often the cause of over-heated activity.
In the latest crisis, examples abound:
* investors trying to guess what the market will do (anticipating herd behavior) for short-term gains, vs. objectively assessing long-term fundamentals.
* investment banks moving risk off the books via credit default swaps and structured investment vehicles, thus freeing up capital and creating an even more over-levered position.
* loan originators lowering standards, because of a hungry secondary market for securitized mortgages.
* ratings agencies driving up fees from issuers through generous assessments (giving even equity tranches in subprime CDOs decent grades).
*low interest rates encouraging all sorts of carry trade activity.
* investors and banks, amid the downturn, carrying out the dominant game-theory strategy of withdrawing funds and refusing to lend.
In each of these cases, there's nothing irrational about the individual behavior, but the collective effect has been a disastrous lock-up of liquidity. Private players had theoretically mitigated their risk through fancy VAR math and derivatives trading (falling into disaster myopia), but the "invisible hand" had no power over the 50,000-foot view. Or put another way, the "efficient market" model predicted that if everybody simply acted out of self interest, there could by definition be no collective breakdown. But in the end, it was the exact opposite: nobody had enough skin in the game to see the big picture. Hidden information made it impossible for counterparties to regulate each other.
And what’s worse, once the implosion took root, self interest only amplified larger-scale credit problems. Very few who criticize the Fed or TARP ever answer the question of what things would look like now without those interventions -- if we had simply gotten out of the way and let individuals / companies pull all money out of the system.
Cassidy explains all of this in various contexts -- game theory (the prisoner's dilemma), the problem of hidden information, behavioral heuristics, etc.
None of this means that markets don't work generally. In my view, the bigger point is that they have to be structured and regulated in a way that more so aligns individual and collective impact -- at least in areas like finance, where the misalignments are a recipe for massive instability.
The result of all this will likely be vast expansions in the field of behaviorial / reality-based economics.