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from saturday's books section

The Great Depression: It led to Keynes, which led to Friedman, which brings us to today.



Last year, in the wake of the most severe recession since the Great Depression, the Queen famously asked a gathering of British economists how they could have got it so badly wrong. The British press did not report the economists' answer, but it is not at all inconceivable that they would have told the Queen that they got it exactly right, it was just that the world got it wrong. If only people were rational and behaved as economists tell them they should...

John Cassidy helps us to understand why the Queen might well have been given this apocryphal answer. He tells a story not only of how markets fail, but of how the profession of economists has failed.





The story of what Cassidy calls "utopian economics" begins, predictably, with the triumph of John Maynard Keynes, the great economist in Britain who wrote in the shadow of the Great Depression. Keynes and his followers argued that recessions were created by the lack of demand in the economy; consequently, government spending could stimulate demand and smooth out the business cycle until general economic demand improved. If that sounds familiar, it is because that is precisely what governments from Ottawa to Beijing have done in this past year.

Keynes and his successors held sway for 40 years, until the industrialized economies entered a prolonged period of "stagflation," low economic growth, high debt and high inflation, and economic thinkers turned back to markets as the solution. Cassidy takes us on an extended trip through the thinking of economists in the 20th century, and a fascinating and literate trip it is.









Economists were moving beyond arguments to demonstrating proofs through elegant mathematical equations. They "demonstrated," through the development of general equilibrium theory, that competitive free markets generate efficient outcomes. That sounds encouraging - just leave well enough alone - but the trial by fire was not long in coming. Economists quickly showed that, in many cases, the future of the economy was unpredictable; the outcome is indeterminate. Stable economies that rebalance without wild gyrations are a wish rather than a promise.

That story did not make it into the economics textbooks, nor did it reach former U.S. Federal Reserve chairman Alan Greenspan. And Milton Friedman, the brilliant evangelist of free markets at the University of Chicago, as Cassidy elegantly puts it, did not sweat the math.

The story gets worse. Mathematicians turned their attention to finance. Again at the University of Chicago, Eugene Fama, one of Milton Friedman's students, argued that speculative bubbles don't exist. The growing acceptance of "efficient market theory" transformed financial markets. It led to investment strategies that simply mirrored the markets and to the beginning of quantitative finance.





This, Cassidy argues, cemented the triumph of what he calls "utopian economics," the economics that enabled the speculative bubbles in technology, real estate and, ultimately, in the financial sector.

We are sadder and wiser today than were the Keynesians after the Great Depression. We know far more about the heavy hand of government regulation than they did. We are sadder and wiser than Milton Friedman, because we have learned a great deal more about the proclivities of unregulated markets to generate speculative bubbles that burst and leave destruction in their wake.

And we are sadder and wiser than Adam Smith. We know far more about human limitations and can no longer breezily assume that consumers or bankers are "rational," that they always act in their own self-interest. They do, at times, especially in the short-term, but often they do not, especially in the long term. And even when they do, individually rational decisions produce collectively irrational outcomes. The whole is more than the sum of its parts.

Utopian economics, Cassidy argues, generates three illusions that are dangerous to our economic health.

The first is the illusion of harmony, that free markets always generate good outcomes. Anyone who has lived through this past decade knows that to be untrue.

The second is the illusion of stability, the argument that free markets create stable and self-correcting mechanisms. We know that once a bubble begins, that is precisely when individual buyers and sellers do behave rationally, and when their individually rational choices produce a terrible collective outcome.

The third illusion is that of predictability, the expectation that financial markets will follow regular patterns that can be estimated. Despite all the technical expertise in the financial sector, it is economists who have demonstrated that analysis of fundamentals is a poor guide to market movements.

To Cassidy's three illusions, I would add a fourth: the core assumption of individual rationality, which is now contradicted by neuroscientific evidence and new work in behavioural economics, which studies the way people actually make decisions rather than models what they should do.

What John Cassidy teaches us in his fluent and lucid narrative of how markets fail is that there is no silver bullet, no single coherent set of ideas that can "fix" the global economy. Ideology is the enemy. The implosion of 2008 was a direct consequence of the deregulation of markets, but Keynesian economic strategies are no panacea. They create their own set of problems. Markets have always needed regulation and societies have always needed dynamic, innovative markets. The trick is to find the balance, between autonomy and supervision, between regulation and innovation, between oversight and decentralization. And the balance is never right for long; economies, just like financial portfolios, need rebalancing.

Sustaining healthy economies is more art than science. This last decade, however, has seen more than its fair share of bubbles, recessions and market failures. We need to think harder about failure, to design instruments that mitigate its worst consequences, to build in resilience and redundancy so that when failure comes, it is less catastrophic. Just as the insurance industry does, we need to plan for and protect against calamities. It is modesty, rather than hubris, prudence rather than certainty, that will be of most use as, stripped of our comforting illusions about markets, we navigate the turbulence ahead.

Janice Gross Stein is director of the Munk Centre for International Studies at the University of Toronto.

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