The ‘invisible hand’ doesn’t exist

In his enterprising book, How Markets Fail: The Logic Of Economic Calamities, journalist John Cassidy recounts the story of Friedrich Hayek, an economist who had been critical of centralised planning and thus communism for a very long time. 

When the Berlin Wall fell, it was proved that Hayek had been right all along. As Cassidy writes about Hayek, “he greatly enjoyed watching the television pictures from Berlin, Prague, and Bucharest. He would beam benignly…” and comment, “‘I told you so.’”

Somewhat similar seems to be the case with Joseph Stiglitz’s new book Free Markets And The Sinking Of The Global Economy. Stiglitz, an American economist, won the Nobel Prize in 2001. Around ten years ago, he was sacked from his post as chief economist of the World Bank. Subsequently, he wrote a tell-all piece on how the International Monetary Fund (IMF) and the US government had botched up the South East Asian financial crisis. And he warned that “things will continue to go very, very wrong,” which they indeed have.

Ever since, Stiglitz has been a powerful critic of the notion that financial markets are self-correcting. As he writes in the book, “I was certainly not the only person who was expecting the US economy to crash with global consequences. New York University economist Nouriel Roubini, financer George Soros, Morgan Stanley’s Stephen Roach, Yale University housing expert Robert Shiller…all issued repeated warnings. They were all Keynesian economists, sharing the view that the markets were not self-correcting.”

In the light of this comment, Free Markets is largely an “I told you so” account of the financial crisis. And this attitude of the author somewhat distracts attention from what is essentially an insightful book on the current financial crisis as it plays out. It is a spirited attack on Wall Street, on the utopian ideal of free markets, and the cabal of investment banks.  

We have relied for far too long on the idea that markets are self-correcting, when they really are not. The model of 19th century capitalism doesn’t apply in the 21st, argues Stiglitz. His own vision of 21st century capitalism envisages, among other things, a redistribution of income through progressive taxation (taxing those at the top more heavily), and a new global reserve system which will ensure that developing countries that are flush with foreign exchange will spend more and save less.

Stiglitz devotes a major part of the book to explaining what went wrong, or “peeling the opinion” as he calls it. And he is not very optimistic about the future either. He is certain that growth in Asia cannot create a turnaround in the world economy. “Asia’s economies are too small (the entire consumption of Asia is just 40% of the United States), and their growth relies heavily on exports to the US. Even after a massive stimulus, China’s growth in 2009 was some 3 to 4% below what it had been before the crisis. The world is too interlinked; a downturn in the US could not but lead to a global slowdown,” he writes.

Indeed, this is a basic point which most economists and politicians refuse to acknowledge. The irony is that, though the global financial crisis was caused by a huge debt binge, policy makers are trying to save the world by trying to get it to borrow some more, not realising that two decades of mistakes cannot be corrected in two years.  

Stiglitz is highly critical of the Obama administration. Obama, Stiglitz feels, has just “muddled through” the crisis and stayed clear of “articulating a clear vision of the kind of financial sector that would emerge after the financial crisis.” What makes Stiglitz most unhappy is the fact that the big banks which caused the crisis in the first place have grown even bigger. He asks, “If some banks were so big that they could not be allowed to fail, why should we allow them to be so big?”

Fair point. There is now talk of reintroducing the Glass-Steagall Act, which was first introduced in the US in 1932 to separate normal banking from investment banking. The Clinton administration did away with the last remains of this law in the late 1990s, thereby allowing banks to be more cavalier in investing the deposits they collected. 

And all this clearly leaves Stiglitz very pessimistic. He concludes, “What worries me is that because of the choices that have already been made, not only will the downturn be longer and deeper than necessary, but also we will emerge from the crisis with a larger legacy of debt, with a financial system that is less competitive, less efficient.”

Freefall makes for an engaging read, the irritating ‘I told-you-so’s notwithstanding.