Friday, February 05, 2010

The writings of John Cassidy

For the last several weeks I have been enjoying John Cassidy's "How Markets Fail". I am almost done with the volume and have to say that it is one of the best and most balanced critiques of markets that I have read. Cassidy who was educated at Oxford and certainly knows his economics carefully documents the history of how academic mathematical theories like Arrow's impossibility theorem and Robert Lucas's theory of rational expectations came to be mistaken as practical rules for application to the free market when they were really supposed to be not much more than ideal mathematical constructs. Quants fell into the same trap (incidentally I saw a book today by Scott Patterson named "The Quants" which looked quite engaging).

Cassidy also documents very well how most free market theorists did not include the behavioral economic approaches later pioneered by psychologists like Daniel Kahneman and Amos Tversky. One of the important points that Cassidy makes is that a lot of these people who came up with models for finance and the free market thought that anomalies would not persist for long and that the market would iron them out, except that it doesn't, usually as a result of the (rather obvious) failure of models to forecast human behavior.

Even more enlightening is Cassidy's series of interviews with Chicago school economists like Richard Posner, Gary Becker and Eugene Fama in the New Yorker. It is heartening to see how most of these people who were once die hard free marketeers are now taking a more moderate stance towards the world and accepting the limitations of things like rational expectations and the efficient market hypothesis. One reason for the decline of the Chicago school has been the death of Milton Friedman, but another reason seems to be the genuine flaws that at least some of the practitioners seems to have acknowledged. All except Eugene Fama, who in his interview appears to be as much of a stubborn free market "fundamentalist" as anyone else; the last man manning the fort, keeping a brave face and clinging to the flag known as the efficient market hypothesis, with smoke and mirrors being his main weapon of combat. Behavioral economists who were once despised at Chicago are now part of the establishment there.

Very enlightening and more than a little gratifying. I would strongly suggest especially the interviews and also the book.

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