Book review: How Markets Fail, by John Cassidy

An entertaining read that fails to diagnose banking's deep-rooted problems, says John McLaren.

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Last Updated: 25 Oct 2010

John Cassidy's previous tome, dot.con (2002), was a post-mortem of the internet bubble, and this one aims to place the credit crunch in a historical context. I haven't been able to track down any seminal works by him of, say, 1998 or 2005, exhorting us to pull back from the brink, so I guess he's a serial economic ambulance-chaser.

The history part - examples and causes of past market failures, together with a compendium of wise observations on the subject - is thoroughly enjoyable and entertainingly written. Although I can't claim to have conducted my own Which? survey of such histories, I don't doubt that this would get a 'best buy' recommendation. But most of the rest - the analysis of how we got into this fine mess and what we should do now - is much like that of other commentators.

It goes roughly like this: the dastardly Greenspan should get a life sentence on the naughty step for having fallen for the utopian notion that markets do regulators' jobs for them; Paulson and Bernanke should be kept in detention for 'self-deceit' and inconsistency in saving Bear Stearns but throwing Lehman overboard; and bankers should write out 100 times, 'I understand that mortgage-backed securities can damage our health', and be forced to keep a higher percentage of the financial instruments they flog than Obama and Geithner demand. We should be a bit tougher on bankers' bonuses. Finally, there's the invocation of the need to take away the punchbowl just as the party gets going.

The most striking omission is a workthrough of what would have happened if the banking system had fallen over. The disclosure came in November that the Bank of England had secretly pumped many extra billions into RBS (as well as Lloyds). This was necessary because 70% of all bank settlements in this country pass through that group. However, if Merrill, Morgan Stanley, Goldman, Wachovia et al had collapsed all at once, a firestorm of panic would have been ignited which, in 24 hours, would have engulfed most other countries, and no government could have withstood a simultaneous run on all its banks.

The next day, a trucker coming down the M1 with a lorryload of Lincolnshire lettuces bound for a Tesco depot would have pulled into a service station, found that his credit card was not honoured, and parked up while the icebergs rotted. As word spread, consumables would have been stripped from supermarket shelves, not to be replaced. The Government - unable to pay police, soldiers and doctors - might eventually have got the genie back in the bottle, but only after an interlude of anarchy, deprivation and violence. The economy would have been in tatters.

The authorities and banks have, understandably, refrained from acknowledging this, but there has been much hand-wringing about the need to learn lessons and avoid a recurrence. But nearly all the proposals - including Cassidy's - are half-hearted and miss the point. Insisting that bonuses be deferred for a few years may annoy the odd trader lusting after a penthouse, but it will have little impact on risk- taking. As has been said many times, Lehman's executives were more than happy to take bonuses in equity; they - like almost everyone else - failed to see the crash coming and thought their own shares were as good a bet as any.

The fundamental problem is the deliberate dismantling over the past 25 years of any sense of mutual loyalty between banking employer and employee. Bankers generally have maybe five or six years to make it or fail. Making it means star status in their sub-sector and rich opportunities in their own bank or elsewhere. Failure means being put out on their ears or becoming also-rans. So during this critical phase, they have no conceivable motivation other than to go for broke.

As for bank bosses, they prosper doubly by the high pay and the efforts of their tyros. The pay regime creates a natural up-draught to boost their own packages, and the 'outperformance' that comes from their stars' efforts leads to a rising share price, enhancing the value of their stock options.

All this might be harmless if it weren't for one snag. In the City and in Wall Street, most people are smart and hard-working, and innovations are soon copied; so the only way to outperform is to edge up the risk curve. That's just what most banks do, inch by inch, with the illusion of safety in numbers, until one day they push it too far - and you know what happens then.

If we're going to let this process recur, we'd better start growing our own lettuces and buying shotguns. The only people to benefit might be writers like John Cassidy, who would have another, much bigger ambulance to chase.

'How Markets Fail: The logic of economic calamities' by John Cassidy, Allen Lane, £25.00

- John McLaren is chairman of the Barchester Group

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