Book Review: The Malign Hand of the Markets

When I first saw the book, and read the introduction, my heart sank and I said to myself, “I doubt I will like this one.”

I was wrong, very wrong, and liked the book more and more as I read it.  The author is a professor of Psychology, Biology and Neurobiology, and is writing about economics.  Those who have read me for some time know that I favor ecological analogies to explain economics, rather than the pseudo-physics that most neoclassical economists employ.  I am beginning to think that non-economists have a better chance of understanding economics than most economists do, because they are free from the indoctrination that comes in the early economics classes where they teach you to assume away all reality, and assume that all men are maximizers of utility or profits, and that the world is radically simple, when it is really very messy.

To the Book

Sorry to be verbose, but I found the author’s approach to be refreshing.  Men are economically rational, but what do we mean by rational?  To some, being rational means imitating what seems good.  “My neighbor is making lots of money speculating in real estate, I will do this also.”  Or rationality can mean something higher, “Real Estate prices are getting far beyond the prices that rentals could justify, I think I will sell my house and rent.”  The difference is the degree of analysis, and the willingness to think about the system as a whole.

The book also highlights why free markets and democracy do not necessarily go together.  There is pressure from the moneyed to affect the democratic process, and there is pressure from the less-well-off to vote money to themselves from the public purse.

The book takes on the concept of economic efficiency, and shows that it leads to instability, as I have argued.  Stable economic systems have slack.  Stable systems do not optimize to the hilt.

He describes the process where more and more loans were provided to the housing market, leading to a bubble.  The bubble involved some sideshows, like CDOs, where Collateralized Debt Obligation buyers provided cheap capital that purchased risky pieces of residential mortgage loans.

Economists like to talk about equilibrium, because that allows them to publish their complex math papers, but economies are big on variation, things are far more volatile than theory can admit.

He takes a dim view of central banking but does not see how we can get rid of it.  The politics are too strong, and the aversion to gold too great.  He lays most of the blame for the bubble and bust at the feet of the Fed, which is right.

He finds Keynes to be a bright guy but with many unrealistic assumptions, and too much aggregation.  The simplification of the economy is too great, and the models don’t work.

Unlike many other books, he offers solutions, and I think they are reasonable.  He inveighs against insurance where the risk is voluntarily takes on.  We should not backstop voluntary risks, nor should we allow people to speculate on the losses of others, as I have argued elsewhere.

He also argues that the Dodd-Frank bill will largely be ineffective because it does not set rules. You can have rules or scrutiny.  We have used scrutiny in the past for financial regulation and it has not worked, because the regulators were wimps.  Over the last 30 years, they have mostly been wimps.

Rules have value, and insurance regulation has been more rules-based, which helps to account for its success.  Principles-based approaches allow a minority to bend the principles, leading to financial failure.

Particularly the Fed has been lax in financial oversight, as they are the overall regulator, and they have not been tough on the regulators that they oversee.

Naive faith in economic efficiency leads many to neglect the need to regulate banks tightly.  It is far better to set rules that provide negative feedback to banks that are taking too much risk, and negative feedback to those who borrow from or lend to other banks, which increases systemic risk.

At the end, he offers four rules that I will summarize:

  1. Limit the monetary policy discretion of the Fed. (Yes!)
  2. No bailouts.
  3. Insurance products that have the possibility of positive feedback should be banned.
  4. Investment Banks should be partnerships, and commercial banks should be limited from investment banking business.

I am in hearty agreement with all of this.  He adds one further proposal that suggests taxing investment banks on the riskiness of their books; if that can be properly achieved that is a worthy idea.

Quibbles

None.  Great book.

Who would benefit from this book:   Anyone who wants to understand economics and the crisis better would benefit from this book.  If you want to, you can buy it here: The Malign Hand of the Markets: The Insidious Forces on Wall Street that are Destroying Financial Markets – and What We Can Do About it.

Full disclosure: The publisher asked if I wanted the book.  I said “yes” and he sent it to me.

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