How Free-Market Delusions Destroyed the Economy
By Raj Patel
December 01, 2009 "Information Clearing House" -- If war is God’s way of teaching Americans geography, recession is His way of teaching everyone a little economics. The great unwinding of the financial sector showed that the smartest mathematical minds on the planet, backed by some of the deepest pockets, had not built a sleek engine of permanent prosperity but a clown car of trades, swaps and double dares that, inevitably, fell to bits. The recession has not come from a deficit of economic knowledge, but from too much of a particular kind, a surfeit of the spirit of capitalism. The dazzle of free markets has blinded us to other ways of seeing the world. As Oscar Wilde wrote over a century ago: "Nowadays people know the price of everything and the value of nothing." Prices have revealed themselves as fickle guides: The 2008 financial collapse came in the same year as crises in food and oil, and yet we seem unable to see or value our world except through the faulty prism of markets.
One thing is clear: The thinking that got us into this mess is unlikely to rescue us. It might come as some consolation to know that even some of the most respected minds have been forced to puzzle over their faulty assumptions. Perhaps the most pained admission of ignorance happened in a crowded room in front of the House Committee on Oversight and Government Reform when, on October 23, 2008, Alan Greenspan described the failure of his worldview.
Greenspan was one of the acknowledged legislators of the world’s economy over the past nineteen years in his role as chairman of the Federal Reserve. A card-carrying member of the free market brigade, he used to sit at the feet of Ayn Rand who, although largely unknown outside the United States, remains influential long after her death in 1982. Her 1957 book Atlas Shrugged, in which heroic business moguls fight the scourge of government officials and union organizers, has once again scaled the bestseller lists. Regarding altruism as “moral cannibalism," Rand was the cheerleader for an extreme free market libertarian school of thought, which she called “Objectivism."
Drawn into her circle by this heady philosophy, Greenspan earned himself the nickname “the Undertaker" for his jolly demeanor and dress sense. When Greenspan chose a career in government, it was rather like a hippie joining the marines, a lapse that his former friends could never forgive. Despite this, Greenspan remained largely faithful to Rand's philosophy, continuing to believe that egoism would lead to the best of all possible worlds, and that any form of restraint would result in disaster.
At the end of 2008, Greenspan was summoned to the U.S. Congress to testify about the financial crisis. His tenure at the Fed had been long and lauded, and Congress wanted to know what had gone wrong. As he began to read his testimony, Greenspan looked exhausted, his skin jowly and sagging, as if the vigor that once kept him taut had all been spent. But he came out swinging. In the first round, he took aim at the information he’d been working with. If only the input had been right, the economic models would have worked, and the predictions would have been better. In his words, a Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria.
Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.
This is a garbage-in-garbage-out argument: The model worked just fine, but the assumptions about risk and data, based only on the good times past, were faulty and so the output was correspondingly wrong. Greenspan’s nemesis on the panel, Henry Waxman, pushed him to a deeper conclusion, in this remarkable exchange:
The flaw, to be clear, wasn’t a minor one of shoddy data. Nor was it the bigger Black Swan problem that writers like Nassim Taleb discuss, a problem of failing to account for highly unlikely events that, should they happen, involve catastrophic consequences. Greenspan’s flaw was more fundamental still. It warped his view about how the world was organized, about the sociology of the market. And Greenspan is not alone. Larry Summers, the president’s senior economic advisor, has had to come to terms with a similar error -- his view that the market was inherently self-stabilizing has been "dealt a fatal blow." Hank Paulson, Bush’s Treasury Secretary, has shrugged his shoulders with similar resignation. Even Jim Cramer from CNBC’s "Mad Money" admitted defeat: "The only guy who really called this right was Karl Marx." One after the other, the celebrants of the free market are finding themselves, to use the language of the market, corrected.
So we would expect alpha to be rare, and it is, but driven by the desire to cash in, there were many who created fake alpha through bets that appeared to produce consistently good returns despite having a small built-in chance of catastrophic loss. If the expected value of this loss were factored in, the alpha would disappear. But the risks were ignored and bonuses flowed. The frat boys who ran the economy, and profited from its poor regulation, made billions. They were paid today for outcomes that they predicted would happen in the future, using a "mark to model" accounting practice that essentially allowed them to book today what they projected they'd earn tomorrow. This practice was justified on the grounds that "markets know best."
Excerpted with publisher's permission from "The Value of Nothing" (Picador, 2010) by Raj Patel. - Visit Raj Patel's site to read more of his work.