According to Adam Smith’s renowned ‘invisible hand” theory, the market system functions well when untouched. But, does it? Can the market system function at its optimal level when left alone? The debate could go on for days, but everyone will agree that this theory does not apply to the current global economy. The 2008 financial crisis explicitly showed the flaws in Adam Smith’s theory.
Today, I will introduce a book that provides thorough explanation and interesting analogies of the catastrophies that destroyed financial markets and drove economies into recession. Unlike most people who pinpoint the blame of the 2008 global financial crisis on Wall Street, John Cassidy digs deeper and concedes that the situation is a byproduct of an accumulation of diverse factors. This book will help you get an insight into the broader scope of the economic crisis that we went through.
The book starts by introducing the term Utopian Economics. What is Utopian Economics you ask? People have fantasies; whether it’s about their life-long goal, love life or career, everyone enjoys daydreaming once in a while. The important point here is that you recognize that it’s nothing but a mere fantasy, and be cautious not to trip into the rabbit hole. Once you fall, it will be too late to turn the clock.
This is what happened in 2008. People put too much faith in the market system, and believed that the most ideal society is formed when individuals freely pursue their self-interest in free markets: which Cassidy refers to as “Utopian Economics”. During the 20th century, this theory might have fueled the economy, but in the 21st century the loopholes of this theory surfaced and caused the market to crash.
However, Utopian Economics is exactly what it is as the name indicates: utopian. Pursuing individual self-interests does not always benefit the society. Utopian Economics is based on the premise that everyone: buyers and sellers, is provided with full knowledge of the economy, but this does not apply to reality. Some hold more information than others, and it is difficult to distinguish the genuineness of the information.
Then what is the real world like? This is where Cassidy introduces a new term “Reality-based Economics. Unlike the assumption Utopian Economics laid out, the market is incapable of self-correction. Being human, we can’t always make rational decisions and have a tendency of being selfish. While people pursue their individual self-interests, there’s always a crash that causes the market to plummet, and the market can’t fix itself.
Additionally, market prices are often misleading. There is no guarantee that the prices set by the market are reasonable, and the market system does not function like Adam Smith’s “individual hand” theory suggests. As a result, when market prices send the wrong signal, it could cause the market to go down spiral.
Cassidy goes on to discuss about the Great Crunch, which Alan Greenspan’s career itself displays the ominous outcome. Greenspan made the mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms. We can’t put the entire blame on Greenspan, but his assumption that the market can regulate itself acted as a potent propeller of the crisis. When the system crashed, the free market had no answers, no self-correcting mechanisms, and no solutions.
Although individuals may pursue their personal interests in a rational way, the outcome could be collectively irrational. Thus, the market needs intervention that lay out preventive measures for calamities in which individuals can’t anticipate.
So did we learn something from this catastrophe? It’s difficult to draw a clear line, because although people recognize the mistakes we made, a lot of the factors that contributed to the financial crisis remain in place, ready to surface when given the chance. Nevertheless, knowing the mechanisms behind the crisis that we went through can act as guidelines to prepare ourselves for the next financial crisis we may face.
By Min Ho Jung