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Economics - Major Flaws In The American Banking And Financial System

Assume you are writing this essay to the President of the United States, the

Secretary of the Treasury, and the Chairman of the Federal Reserve System.

Assume they will do what you tell them to do, provided you make a solid case.

HOW MARKETS FAIL THE LOGIC OF

ECONOMIC CALAMITIES

JOHN CASSIDY

FARRAR, STRAUS AND GIROUX • NEW YORK

To Lucinda, Beatrice, and Cornelia

CONTENTS

Also by the Author Copyright Dedication

Introduction

PART ONE: UTOPIAN ECONOMICS 1. Warnings Ignored and the Conventional Wisdom 2. Adam Smith’s Invisible Hand 3. Friedrich Hayek’s Telecommunications System 4. The Perfect Markets of Lausanne 5. The Mathematics of Bliss 6. The Evangelist 7. The Coin-Tossing View of Finance 8. The Triumph of Utopian Economics

PART TWO: REALITY-BASED ECONOMICS 9. The Prof and the Polar Bears

10. A Taxonomy of Failure

11. The Prisoner’s Dilemma and Rational Irrationality

12. Hidden Information and the Market for Lemons

13. Keynes’s Beauty Contest

14. The Rational Herd

15. Psychology Returns to Economics

16. Hyman Minsky and Ponzi Finance

PART THREE: THE GREAT CRUNCH

17. Greenspan Shrugs

18. The Lure of Real Estate

19. The Subprime Chain

20. In the Alphabet Soup

21. A Matter of Incentives

22. London Bridge Is Falling Down

23. Socialism in Our Time

Conclusion

Notes Acknowledgments Index

INTRODUCTION

“I am shocked, shocked, to find that gambling is going on in here!” —Claude Rains as Captain Renault in Casablanca

The old man looked drawn and gray. During the almost two decades he had spent overseeing America’s financial system, as chairman of the Federal Reserve, congressmen, cabinet ministers, even presidents had treated him with a deference that bordered on the obsequious. But on this morning—October 23, 2008—Alan Greenspan, who retired from the Fed in January 2006, was back on Capitol Hill under very different circumstances. Since the market for subprime mortgage securities collapsed, in the summer of 2007, leaving many financial institutions saddled with tens of billions of dollars’ worth of assets that couldn’t be sold at any price, the Democratic congressman Henry Waxman, chairman of the House Committee on Oversight and Government Reform, had held a series of televised hearings, summoning before him Wall Street CEOs, mortgage industry executives, heads of rating agencies, and regulators. Now it was Greenspan’s turn at the witness table.

Waxman and many other Americans were looking for somebody to blame. For more than a month following the sudden unraveling of Lehman Brothers, a Wall Street investment bank with substantial holdings of mortgage securities, an unprecedented panic had been roiling the financial markets. Faced with the imminent collapse of American International Group, the largest insurance company in the United States, Ben Bernanke, Greenspan’s mild-mannered successor at the Fed, had approved an emergency loan of $85 billion to the company. Federal regulators had seized Washington Mutual, a major mortgage lender, selling off most of its assets to JPMorgan Chase. Wells Fargo, the nation’s sixth-biggest bank, had rescued Wachovia, the fourth-biggest. Rumors had circulated about the soundness of other financial institutions, including Citigroup, Morgan Stanley, and even the mighty Goldman Sachs.

Watching this unfold, Americans had clung to their wallets. Sales of autos, furniture, clothes, even books had collapsed, sending the economy into a tailspin. In an effort to restore stability to the financial system, Bernanke and the Treasury secretary, Hank Paulson, had obtained from Congress the authority to spend up to $700 billion in taxpayers’ money on a bank bailout. Their original plan had been to

buy distressed mortgage securities from banks, but in mid-October, with the financial panic intensifying, they had changed course and opted to invest up to $250 billion directly in bank equity. This decision had calmed the markets somewhat, but the pace of events had been so frantic that few had stopped to consider what it meant: the Bush administration, after eight years of preaching the virtues of free markets, tax cuts, and small government, had turned the U.S. Treasury into part owner and the effective guarantor of every big bank in the country. Struggling to contain the crisis, it had stumbled into the most sweeping extension of state intervention in the economy since the 1930s. (Other governments, including those of Britain, Ireland, and France, had taken similar measures.)

“Dr. Greenspan,” Waxman said. “You were the longest-serving chairman of the Federal Reserve in history, and during this period of time you were, perhaps, the leading proponent of deregulation of our financial markets . . . You have been a staunch advocate for letting markets regulate themselves. Let me give you a few of your past statements.” Waxman read from his notes: “ ‘There’s nothing involved in federal regulation which makes it superior to market regulation.’ ‘There appears to be no need for government regulation of off-exchange derivative transactions.’ ‘We do not believe a public policy case exists to justify this government intervention.’ ” Greenspan, dressed, as always, in a dark suit and tie, listened quietly. His face was deeply lined. His chin sagged. He looked all of his eighty-two years. When Waxman had finished reading out Greenspan’s words, he turned to him and said: “My question for you is simple: Were you wrong?”

“Partially,” Greenspan replied. He went on: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms . . . The problem here is something which looked to be a very solid edifice, and, indeed, a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and, obviously, to the extent that I figure out what happened and why, I will change my views.”

Waxman, whose populist leanings belie the fact that he represents some of the wealthiest precincts in the country—Beverly Hills, Bel Air, Malibu—asked Greenspan whether he felt any personal responsibility for what had happened. Greenspan didn’t reply directly. Waxman returned to his notes and started reading again. “ ‘I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We have tried regulations. None meaningfully worked.’ ” Waxman looked at Greenspan. “That was your quote,” he said. “You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Now our whole economy is paying the price. Do you feel that your ideology pushed you to

make decisions that you wish you had not made?” Greenspan stared through his thick spectacles. Behind his mournful gaze lurked a

savvy, self-made New Yorker. He grew up during the Great Depression in Washington Heights, a working-class neighborhood in upper Manhattan. After graduating from high school, he played saxophone in a Times Square swing band, and then turned to the study of economics, which was coming to be dominated by the ideas of John Maynard Keynes. After initially embracing Keynes’s suggestion that the government should actively manage the economy, Greenspan turned strongly against it. In the 1950s, he became a friend and acolyte of Ayn Rand, the libertarian philosopher and novelist, who referred to him as “the undertaker.” (In his youth, too, he was lugubrious.) He became a successful economic consultant, advising many big corporations, including Alcoa, J.P. Morgan, and U.S. Steel. In 1968, he advised Richard Nixon during his successful run for the presidency, and under Gerald Ford he acted as chairman of the White House Council of Economic Advisers. In 1987, he returned to Washington, this time permanently, to head the Fed and personify the triumph of free market economics.

Now Greenspan was on the defensive. An ideology is just a conceptual framework for dealing with reality, he said to Waxman. “To exist, you need an ideology. The question is whether it is accurate or not. What I am saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is, but I have been very distressed by that fact.” Waxman interrupted him. “You found a flaw?” he demanded. Greenspan nodded. “I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works, so to speak,” he said.

Waxman had elicited enough already to provide headlines for the following day’s newspapers—the Financial Times: “ ‘I made a mistake,’ admits Greenspan”—but he wasn’t finished. “In other words, you found that your view of the world, your ideology, was not right,” he said. “It was not working?”

“Precisely,” Greenspan replied. “That’s precisely the reason I was shocked. Because I had been going for forty years, or more, with very considerable evidence that it was working exceptionally well.”

This book traces the rise and fall of free market ideology, which, as Greenspan said, is more than a set of opinions: it is a well-developed and all-encompassing way of thinking about the world. I have tried to combine a history of ideas, a narrative of the financial crisis, and a call to arms. It is my contention that you cannot comprehend recent events without taking into account the intellectual and historical context in which they unfolded. For those who want one, the first chapter and last third of the book contain a reasonably comprehensive account of the credit crunch of 2007–2009. But unlike other books on the subject, this one doesn’t focus on the firms and characters involved: my aim is to explore the underlying economics of the

crisis and to explain how the rational pursuit of self-interest, which is the basis of free market economics, created and prolonged it.

Greenspan isn’t the only one to whom the collapse of the subprime mortgage market and ensuing global slump came as a rude shock. In the summer of 2007, the vast majority of analysts, including the Fed chairman, Bernanke, thought worries of a recession were greatly overblown. In many parts of the country, home prices had started falling, and the number of families defaulting on their mortgages was rising sharply. But among economists there was still a deep and pervasive faith in the vitality of American capitalism, and the ideals it represented.

For decades now, economists have been insisting that the best way to ensure prosperity is to scale back government involvement in the economy and let the private sector take over. In the late 1970s, when Margaret Thatcher and Ronald Reagan launched the conservative counterrevolution, the intellectuals who initially pushed this line of reasoning—Friedrich Hayek, Milton Friedman, Arthur Laffer, Sir Keith Joseph—were widely seen as right-wing cranks. By the 1990s, Bill Clinton, Tony Blair, and many other progressive politicians had adopted the language of the right. They didn’t have much choice. With the collapse of communism and the ascendancy of conservative parties on both sides of the Atlantic, a positive attitude to markets became a badge of political respectability. Governments around the world dismantled welfare programs, privatized state-run firms, and deregulated industries that previously had been subjected to government supervision.

In the United States, deregulation started out modestly, with the Carter administration’s abolition of restrictions on airline routes. The policy was then expanded to many other parts of the economy, including telecommunications, media, and financial services. In 1999, Clinton signed into law the Gramm-Leach-Bliley Act (aka the Financial Services Modernization Act), which allowed commercial banks and investment banks to combine and form vast financial supermarkets. Lawrence Summers, a leading Harvard economist who was then serving as Treasury secretary, helped shepherd the bill through Congress. (Today, Summers is Barack Obama’s top economic adviser.)

Some proponents of financial deregulation—lobbyists for big financial firms, analysts at Washington research institutes funded by corporations, congressmen representing financial districts—were simply doing the bidding of their paymasters. Others, such as Greenspan and Summers, were sincere in their belief that Wall Street could, to a large extent, regulate itself. Financial markets, after all, are full of well- paid and highly educated people competing with one another to make money. Unlike in some other parts of the economy, no single firm can corner the market or determine the market price. In such circumstances, according to economic orthodoxy, the invisible hand of the market transmutes individual acts of selfishness into socially desirable collective outcomes.

If this argument didn’t contain an important element of truth, the conservative movement wouldn’t have enjoyed the success it did. Properly functioning markets reward hard work, innovation, and the provision of well-made, affordable products; they punish firms and workers who supply overpriced or shoddy goods. This carrot- and-stick mechanism ensures that resources are allocated to productive uses, making market economies more efficient and dynamic than other systems, such as communism and feudalism, which lack an effective incentive structure. Nothing in this book should be taken as an argument for returning to the land or reconstituting the Soviets’ Gosplan. But to claim that free markets always generate good outcomes is to fall victim to one of three illusions I identify: the illusion of harmony.

In Part I, I trace the story of what I call utopian economics, taking it from Adam Smith to Alan Greenspan. Rather than confining myself to expounding the arguments of Friedrich Hayek, Milton Friedman, and their fellow members of the “Chicago School,” I have also included an account of the formal theory of the free market, which economists refer to as general equilibrium theory. Friedman’s brand of utopian economics is much better known, but it is the mathematical exposition, associated with names like Léon Walras, Vilfredo Pareto, and Kenneth Arrow, that explains the respect, nay, awe with which many professional economists view the free market. Even today, many books about economics give the impression that general equilibrium theory provides “scientific” support for the idea of the economy as a stable and self-correcting mechanism. In fact, the theory does nothing of the kind. I refer to the idea that a free market economy is sturdy and well grounded as the illusion of stability.

The period of conservative dominance culminated in the Greenspan Bubble Era, which lasted from about 1997 to 2007. During that decade, there were three separate speculative bubbles—in technology stocks, real estate, and physical commodities, such as oil. In each case, investors rushed in to make quick profits, and prices rose vertiginously before crashing. A decade ago, bubbles were widely regarded as aberrations. Some free market economists expressed skepticism about the very possibility of them occurring. Today, such arguments are rarely heard; even Greenspan, after much prevarication, has accepted the existence of the housing bubble.

Once a bubble begins, free markets can no longer be relied on to allocate resources sensibly or efficiently. By holding out the prospect of quick and effortless profits, they provide incentives for individuals and firms to act in ways that are individually rational but immensely damaging—to themselves and others. The problem of distorted incentives is, perhaps, most acute in financial markets, but it crops up throughout the economy. Markets encourage power companies to despoil the environment and cause global warming; health insurers to exclude sick people from coverage; computer makers to force customers to buy software programs they

don’t need; and CEOs to stuff their own pockets at the expense of their stockholders. These are all examples of “market failure,” a concept that recurs throughout the book and gives it its title. Market failure isn’t an intellectual curiosity. In many areas of the economy, such as health care, high technology, and finance, it is endemic.

The previous sentence might come as news to the editorial writers of The Wall Street Journal, but it isn’t saying anything controversial. For the past thirty or forty years, many of the brightest minds in economics have been busy examining how markets function when the unrealistic assumptions of the free market model don’t apply. For some reason, the economics of market failure has received a lot less attention than the economics of market success. Perhaps the word “failure” has such negative connotations that it offends the American psyche. For whatever reason, “market failure economics” never took off as a catchphrase. Some textbooks refer to the “economics of information,” or the “economics of incomplete markets.” Recently, the term “behavioral economics” has come into vogue. For myself, I prefer the phrase “reality-based economics,” which is the title of Part II.

Reality-based economics is less unified than utopian economics: because the modern economy is labyrinthine and complicated, it encompasses many different theories, each applying to a particular market failure. These theories aren’t as general as the invisible hand, but they are more useful. Once you start to think about the world in terms of some of the concepts I outline, such as the beauty contest, disaster myopia, and the market for lemons, you may well wonder how you ever got along without them.

The emergence of reality-based economics can be traced to two sources. Within orthodox economics, beginning in the late 1960s, a new generation of researchers began working on a number of topics that didn’t fit easily within the free market model, such as information problems, monopoly power, and herd behavior. At about the same time, two experimental psychologists, Amos Tversky and Daniel Kahneman, were subjecting rational economic man—Homo economicus—to a withering critique. As only an economist would be surprised to discover, humans aren’t supercomputers: we have trouble doing sums, let alone solving the mathematical optimization problems that lie at the heart of many economic theories. When faced with complicated choices, we often rely on rules of thumb, or instinct. And we are greatly influenced by the actions of others. When the findings of Tversky, Kahneman, and other psychologists crossed over into economics, the two strands of thought came together under the rubric of “behavioral economics,” which seeks to combine the rigor of economics with the realism of psychology.

In Part II, I devote a chapter to Kahneman and Tversky, but this book shouldn’t be mistaken for another text on behavioral economics. Reality-based economics is a much broader field, a good part of which makes no departure from the axioms of

rationality, and it is also considerably older. I trace its development back to Arthur C. Pigou, an English colleague and antagonist of John Maynard Keynes who argued that many economic phenomena involve interdependencies—what you do affects my welfare, and what I do affects yours—a fact that the market often fails to take into account. After using global warming to illustrate how such “spillovers” arise, I move on to other pervasive types of market failure, involving monopoly power, strategic interactions (game theory), hidden information, uncertainty, and speculative bubbles.

A common theme of this section is that the market, through the price system, often sends the wrong signals to people. It isn’t that people are irrational: within their mental limitations, and the limitations imposed by their environment, they pursue their own interests as best they can. In Part III, The Great Crunch, I pursue this argument further and apply it to the financial crisis, using some of the conceptual tools laid out in Parts I and II. The mortgage brokers who steered hard-up working-class families toward risky subprime mortgages were reacting to monetary incentives. So were the loan officers who approved these loans, the investment bankers who cobbled them together into mortgage securities, the rating agency analysts who stamped these securities as safe investments, and the mutual fund managers who bought them.

The subprime boom represented a failure of capitalism in the presence of bounded cognition, uncertainty, hidden information, trend-following, and plentiful credit. Since all of these things are endemic to the modern economy, it was a failure of business as usual. In seeking to deny this, some conservatives have sought to put the blame entirely on the Fed, the Treasury Department, or on Fannie Mae and Freddie Mac, two giant mortgage companies that were actually quasi-governmental organizations. (The U.S. Treasury implicitly guaranteed their debt.) But at least one prominent conservative, Richard Posner, one of the founders of the “Law and Economics” school, has recognized the truth. “The crisis is primarily, perhaps almost entirely, the consequence of decisions taken by private firms in an environment of minimal regulation,” he said in a 2008 speech. “We have seen a largely deregulated financial sector breaking and seemingly carrying much of the economy with it.”

How could such a thing happen? Bad economic policy decisions played an important role. In keeping interest rates too low for too long, Greenspan and Bernanke distorted the price signals that the market sends and created the conditions for an unprecedented housing bubble. Greed is another oft-mentioned factor; stupidity, a third. (How could those boneheads on Wall Street not have known that lending money to folks with no income, no jobs, and no assets—the infamous “NINJA” mortgage loans—was a bad idea?) In the wake of the revelations about Bernie Madoff and his multibillion-dollar Ponzi scheme, criminality is yet another

thing to consider. At the risk of outraging some readers, I downplay character issues. Greed is ever

present: it is what economists call a “primitive” of the capitalist model. Stupidity is equally ubiquitous, but I don’t think it played a big role here, and neither, with some obvious exceptions, did outright larceny. My perhaps controversial suggestion is that Chuck Prince, Stan O’Neal, John Thain, and the rest of the Wall Street executives whose financial blundering and multimillion-dollar pay packages have featured on the front pages during the past two years are neither sociopaths nor idiots nor felons. For the most part, they are bright, industrious, not particularly imaginative Americans who worked their way up, cultivated the right people, performed a bit better than their colleagues, and found themselves occupying a corner office during one of the great credit booms of all time. Some of these men, perhaps many of them, harbored doubts about what was happening, but the competitive environment they operated in provided them with no incentive to pull back. To the contrary, it urged them on. Between 2004 and 2007, at the height of the boom, banks and other financial companies were reaping record profits; their stock prices were hitting new highs; and their leaders were being lionized in the media.

Consider what would have happened if Prince, who served as chief executive of Citigroup from 2003 to 2007, had announced in 2005, say, that Citi was withdrawing from the subprime market because it was getting too risky. What would have been the reaction of Prince’s rivals? Would they have acknowledged the wisdom of his move and copied it? Not likely. Rather, they would have ordered their underlings to rush in and take the business Citi was leaving behind. Citi’s short-term earnings would have suffered relative to those of its peers; its stock price would have come under pressure; and Prince, who was already facing criticism because of problems in other areas of Citi’s business, would have been written off as a fuddy-duddy. In an interview with the Financial Times in July 2007, he acknowledged the constraints he was operating under. “When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Four months later, Citi revealed billions of dollars in losses on bad corporate debts and distressed home mortgages. Prince resigned, his reputation in tatters.

In game theory, the dilemma that Prince faced is called the prisoner’s dilemma, and it illustrates how perfectly rational behavior on the part of competing individuals can result in bad collective outcomes. When the results of our actions depend on the behavior of others, the theory of the invisible hand doesn’t provide much guidance about the likely outcome. Until the formulation of game theory in the 1940s and 1950s, economists simply didn’t have the tools needed to figure out what happens in these instances. But we now know a lot more about how purposeful but self-defeating behavior, or what I refer to as rational irrationality, can develop

and persist. In Part III, The Great Crunch, I show how rational irrationality was central to the

housing bubble, the growth of the subprime mortgage market, and the subsequent unraveling of the financial system. Much as we might like to imagine that the last few years were an aberration, they weren’t. Credit-driven boom-and-bust cycles have plagued capitalist economies for centuries. During the past forty years, there have been 124 systemic banking crises around the world. During the 1980s, many Latin American countries experienced one. In the late 1980s and 1990s, it was the turn of a number of developed countries, including Japan, Norway, Sweden, and the United States. The collapse of the savings-and-loan industry led Congress to establish the Resolution Trust Corporation, which took over hundreds of failed thrifts. Later in the 1990s, many fast-growing Asian countries, including Thailand, Indonesia, and South Korea, endured serious financial blowups. In 2007–2008, it was our turn again, and this time the crisis involved the big banks at the center of the financial system.

For years, Greenspan and other economists argued that the development of complicated, little-understood financial products, such as subprime mortgage– backed securities (MBSs), collateralized debt obligations (CDOs), and credit default swaps (CDSs), made the system safer and more efficient. The basic idea was that by putting a market price on risk and distributing it to investors willing and able to bear it, these complex securities greatly reduced the chances of a systemic crisis. But the risk-spreading proved to be illusory, and the prices that these products traded at turned out to be based on the premise that movements in financial markets followed regular patterns, that their overall distribution, if not their daily gyrations, could be foreseen—a fallacy I call the illusion of predictability, the third illusion at the heart of utopian economics. When the crisis began, the markets reacted in ways that practically none of the participants had anticipated.

In telling this story, and bringing it up to the summer of 2009, I have tried to relate recent events to long-standing intellectual debates over the performance of market systems. The last ten years can be viewed as a unique natural experiment designed to answer the questions: What happens to a twenty-first-century, financially driven economy when you deregulate it and supply it with large amounts of cheap money? Does the invisible hand ensure that everything works out for the best? This isn’t an economics textbook, but it does invite the reader to move beyond the daily headlines and think quite deeply about the way modern capitalism operates, and about the theories that have informed economic policies. We tend to think of policy as all about politics and special interests, which certainly play a role, but behind the debates in Congress, on cable television, and on the Op-Ed pages, there are also some complex and abstract ideas, which rarely get acknowledged. “Practical men, who believe themselves to be quite exempt from any intellectual influences,

are usually the slaves of some defunct economist,” John Maynard Keynes famously remarked on the final page of The General Theory of Employment, Interest and Money. “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

Keynes had a weakness for rhetorical flourishes, but economic ideas do have important practical consequences: that is what makes them worthy of study. If the following helps some readers comprehend some things that had previously seemed mystifying, the effort I have put into it will have been well rewarded. If it also helps consign utopian economics to the history books, that will be a bonus.

PART ONE

UTOPIAN

ECONOMICS

1. WARNINGS IGNORED AND THE CONVENTIONAL WISDOM

A common reaction to extreme events is to say they couldn’t have been predicted. Japan’s aerial assault on Pearl Harbor; the terrorist strikes against New York and Washington on September 11, 2001; Hurricane Katrina’s devastating path through New Orleans—in each of these cases, the authorities claimed to have had no inkling of what was coming. Strictly speaking, this must have been true: had the people in charge known more, they would have taken preemptive action. But lack of firm knowledge rarely equates with complete ignorance. In 1941, numerous American experts on imperial Japan considered an attack on the U.S. Pacific Fleet an urgent threat; prior to 9/11, al-Qaeda had made no secret of its intention to strike the United States again—the CIA and the FBI had some of the actual plotters under observation; as far back as 1986, experts working for the Army Corps of Engineers expressed concerns about the design of the levees protecting New Orleans.

What prevented the authorities from averting these disasters wasn’t so much a lack of timely warnings as a dearth of imagination. The individuals in charge weren’t particularly venal or shortsighted; even their negligence was within the usual bounds. They simply couldn’t conceive of Japan bombing Hawaii; of jihadists flying civilian jets into Manhattan skyscrapers; of a flood surge in the Gulf of Mexico breaching more than fifty levees simultaneously. These catastrophic eventualities weren’t regarded as low-probability outcomes, which is the mathematical definition of extreme events: they weren’t within the range of possibilities that were considered at all.

The subprime mortgage crisis was another singular and unexpected event, but not one that came without warning. As early as 2002, some commentators, myself

included, were saying that in many parts of the country real estate values were losing touch with incomes. In the fall of that year, I visited the prototypical middle-class town of Levittown, on Long Island, where, in the aftermath of World War II, the developer Levitt and Sons offered for sale eight-hundred-square-foot ranch houses, complete with refrigerator, range, washing machine, oil burners, and Venetian blinds, for $7,990. When I arrived, those very same homes, with limited updating, were selling for roughly $300,000, an increase of about 50 percent on what they had been fetching two years earlier. Richard Dallow, a Realtor whose family has been selling property there since 1951, showed me around town. He expressed surprise that home prices had defied the NASDAQ crash of 2000, the economic recession of 2001, and the aftermath of 9/11. “It has to impact at some point,” he said. “But, then again, in the summer of 2000, I thought it was impacting, and then things came back.”

By and large, the kinds of people buying houses in Levittown were the same as they had always been: cops, firefighters, janitors, and construction workers who had been priced out of neighboring towns. The inflation in home prices was making it difficult for these buyers even to afford Levittown. This “has always been a low- down-payment area,” Dallow said. “If the price is three hundred and thirty thousand, and you put down five percent, that’s a mortgage of three hundred and thirteen thousand five hundred. You need a jumbo mortgage. For Levittown.” When I got back to my office in Times Square, I wrote a story for The New Yorker entitled “The Next Crash,” in which I quoted Dallow and some financial analysts who were concerned about the real estate market. “Valuation looks quite extreme, and not just at the top end,” Ian Morris, chief U.S. economist of HSBC Bank, said. “Even normal mom-and-pop homes are now very expensive relative to income.” Christopher Wood, an investment strategist at CLSA Emerging Markets, was even more bearish: “The American housing market is the last big bubble,” he said. “When it bursts, it will be very ugly.”

Between 2003 and 2006, as the rise in house prices accelerated, many expressions of concern appeared in the media. In June 2005, The Economist said, “The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops.” In the United States, the ratio of home prices to rents was at a historic high, the newsweekly noted, with prices rising at an annual rate of more than 20 percent in some parts of the country. The same month, Robert Shiller, a well-known Yale economist who wrote the 2000 bestseller Irrational Exuberance, told Barron’s, “The home-price bubble feels like the stock-market mania in the fall of 1999.”

One reason these warnings went unheeded was denial. When the price of an asset is going up by 20 or 30 percent a year, nobody who owns it, or trades it, likes to be told their newfound wealth is illusory. But it wasn’t just real estate agents and condo

flippers who were insisting that the rise in prices wouldn’t be reversed: many economists who specialized in real estate agreed with them. Karl Case, an economist at Wellesley, reminded me that the average price of American homes had risen in every single year since 1945. Frank Nothaft, the chief economist at Freddie Mac, ran through a list of “economic fundamentals” that he said justified high and rising home prices: low mortgage rates, large-scale immigration, and a modest inventory of new homes. “We are not going to see the price of single-family homes fall,” he said bluntly. “It ain’t going to happen.”

As the housing boom continued, Nothaft’s suggestion that nationwide house prices were unidirectional acquired the official imprimatur of the U.S. government. In April 2003, at the Ronald Reagan Presidential Library and Museum, in Simi Valley, California, Alan Greenspan insisted that the United States wasn’t suffering from a real estate bubble. In October 2004, he argued that real estate doesn’t lend itself to speculation, noting that “upon sale of a house, homeowners must move and live elsewhere.” In June 2005, testifying on Capitol Hill, he acknowledged the presence of “froth” in some areas, but ruled out the possibility of a nationwide bubble, saying housing markets were local. Although price declines couldn’t be ruled out in some areas, Greenspan concluded, “[T]hese declines, were they to occur, likely would not have substantial macroeconomic implications.”

At the time Greenspan made these comments, Ben Bernanke had recently left the Fed, where he had served as governor since 2002, to become chairman of the White House Council of Economic Advisers. In August 2005, Bernanke traveled to Crawford, Texas, to brief President Bush, and afterward a reporter asked him, “Did the housing bubble come up at your meeting?” Bernanke said housing had been discussed, and went on: “I think it’s important to point out that house prices are being supported in very large part by very strong fundamentals . . . We have lots of jobs, employment, high incomes, very low mortgage rates, growing population, and shortages of land and housing in many areas.” On October 15, 2005, in an address to the National Association for Business Economics, Bernanke used almost identical language, saying rising house prices “largely reflect strong economic fundamentals.” Nine days later, President Bush selected him to succeed Greenspan.

In August 2005, a couple of weeks after Bernanke’s trip to Texas, the Federal Reserve Bank of Kansas City, one of the twelve regional banks in the Fed system, devoted its annual economic policy symposium to the lessons of the Greenspan era. As usual, the conference took place at the Jackson Lake Lodge, an upscale resort in Jackson Hole, Wyoming. Greenspan, who had, by then, served eighteen years as Fed chairman, delivered the opening address. Most of the other speakers, who included Robert Rubin, the former Treasury secretary, and Jean-Claude Trichet, the head of the European Central Bank, were extremely complimentary about the Fed boss.

“There is no doubt that Greenspan has been an amazingly successful chairman of the Federal Reserve System,” Alan Blinder, a Princeton economist and former Fed governor, opined. Raghuram G. Rajan, an economist at the University of Chicago Booth School of Business, who was then the chief economist at the International Monetary Fund, took a more critical line, examining the consequences of two decades of financial deregulation.

Rajan, who was born in Bhopal, in central India, in 1963, obtained his Ph.D. at MIT, in 1991, and then moved to the University of Chicago Business School, where he established himself as something of a wunderkind. In 2003, his colleagues named him the scholar under forty who had contributed most to the field of finance. That same year, he took the top economics job at the IMF, where he stayed until 2006. He could hardly be described as a radical. One book he coauthored is entitled Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity. Bruce Bartlett, a conservative activist who served in the administrations of Ronald Reagan and George H. W. Bush, described it as “one of the most powerful defenses of the free market ever written.”

Rajan began by reviewing some history. In the past couple decades, he reminded the audience, deregulation and technical progress had subjected banks to increasing competition in their core business of taking in deposits from households and lending them to other individuals and firms. In response, the banks had expanded into new fields, including trading securities and creating new financial products, such as mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). Most of these securities the banks sold to investors, but some of them they held on to for investment purposes, which exposed them to potential losses should the markets concerned suffer a big fall. “While the system now exploits the risk-bearing capacity of the economy better by allocating risks more widely, it also takes on more risks than before,” Rajan said. “Moreover, the linkages between markets, and between markets and institutions, are now more pronounced. While this helps the system diversify across small shocks, it also exposes the system to large systemic shocks—large shifts in asset prices or changes in aggregate liquidity.”

Turning to other factors that had made the financial system more vulnerable, Rajan brought up incentive-based compensation. Almost all senior financiers now receive bonuses that are tied to the investment returns their businesses generate. Since these returns are correlated with risks, Rajan pointed out, there are “perverse incentives” for managers and firms to take on more risks, especially so-called tail risks—events that occur with a very low probability but that can have disastrous consequences. The tendency for investors and traders to ape each other’s strategies, a phenomenon known as herding, was another potentially destabilizing factor, Rajan said, because it led people to buy assets even if they considered them overvalued. Taken together, incentive-based compensation and herding were “a volatile

combination. If herd behavior moves asset prices away from fundamentals, the likelihood of large realignments—precisely the kind that trigger tail losses— increases.”

Finally, Rajan added, there is one more ingredient that can “make the cocktail particularly volatile, and that is low interest rates after a period of high rates, either because of financial liberalization or because of extremely accommodative monetary policy.” Cheap money encourages banks, investment banks, and hedge funds to borrow more and place bigger bets, Rajan reminded the audience. When credit is flowing freely, euphoria often develops, only to be followed by a “sudden stop” that can do great damage to the economy. So far, the U.S. economy had avoided such an outcome, Rajan conceded, but its rebound from the 1987 stock market crash and the 2000–2001 collapse in tech stocks “should not make us overly sanguine.” After all, “a shock to the equity markets, though large, may have less effect than a shock to the credit markets.”

As a rule, central bankers don’t rush stages or toss their chairs; if they did, Rajan might have been in physical danger. During a discussion period, Don Kohn, a governor of the Fed who would go on to become its vice chairman, pointed out that Rajan’s presentation amounted to a direct challenge to “the Greenspan doctrine,” which warmly welcomed the development of new financial products, such as securitized loans and credit default swaps. “By allowing institutions to diversify risk, to choose their risk profiles more precisely, and to improve the management of the risks they do take on, they have made institutions more robust,” Kohn went on. “And by facilitating the flow of savings across markets and national boundaries, these developments have contributed to a better allocation of resources and promoted growth.”

The Greenspan doctrine didn’t imply that financial markets invariably got things right, Kohn conceded, but “the actions of private parties to protect themselves— what Chairman Greenspan has called private regulation—are generally quite effective,” whereas government “risks undermining private regulation and financial stability by undermining incentives.” Turning to Rajan’s suggestion that some sort of government fix might be needed for Wall Street compensation schemes, Kohn insisted it wasn’t in the interests of senior executives at banks and other financial institutions “to reach for short-run gains at the expense of longer-term risk, to disguise the degree of risk they are taking for their customers, or otherwise to endanger their reputations. As a consequence, I did not find convincing the discussion of market failure that would require government intervention in compensation.”

Lawrence Summers, who was then the president of Harvard, stood up and said he found “the basic, slightly lead-eyed premise of this paper to be largely misguided.”

After pausing to remark on how much he had learned from Greenspan, Summers compared the development of the financial industry to the history of commercial aviation, saying the occasional plane crash shouldn’t disguise the fact that getting from A to B was now much easier and safer than it used to be, and adding, “It seems to me that the overwhelming preponderance of what has taken place is positive.” While it was legitimate to point out the possibility of self-reinforcing spirals in financial markets, Summers concluded, “the tendency towards restriction that runs through the tone of the presentation seems to me to be quite problematic. It seems to me to support a wide variety of misguided policy impulses in many countries.”

The reaction to Rajan’s paper demonstrated just how difficult it had become to query, even on a theoretical level, the dogma of deregulation and free markets. As a longtime colleague and adviser of Greenspan’s, Kohn might be forgiven for defending his amour propre. Summers, however, was in a different category. During the 1980s, as a young Harvard professor, he had advocated a tax on securities transactions, such as stock purchases, arguing that much of what took place on Wall Street was a shell game that added nothing to overall output. Subsequently, he had gone on to advise presidential candidates and serve as Treasury secretary in the Clinton administration. Along the way, he had jettisoned his earlier views and become a leading defender of the conventional wisdom, a phrase John Kenneth Galbraith coined for the unquestioned assumptions that help to frame policy debates and, for that matter, barroom debates. As Galbraith noted in his 1958 bestseller, The Affluent Society, the conventional wisdom isn’t the exclusive property of any political party or creed: Republicans and Democrats, conservatives and liberals, true believers and agnostics, all subscribe to its central tenets. “The conventional wisdom having been made more or less identical with sound scholarship, its position is virtually impregnable,” Galbraith wrote. “The skeptic is disqualified by his very tendency to go brashly from the old to the new. Were he a sound scholar . . . he would remain with the conventional wisdom.”

But how does the conventional wisdom get established? To answer that question, we must go on an intellectual odyssey that begins in Glasgow in the eighteenth century and passes through London, Lausanne, Vienna, Chicago, New York, and Washington, D.C. Utopian economics has a long and illustrious history. Before turning to the flaws of the free market doctrine, let us trace its development and seek to understand its enduring appeal.

2. ADAM SMITH’S INVISIBLE HAND

In everyday language, a market is simply somewhere things are bought and sold. The convenience store on the corner is a market, as is the nearest branch of Wal-Mart, Target, and Home Depot. Amazon.com is a market, so is the NASDAQ, and so is the local red-light district. Many towns and cities have organized street markets, including Leeds, in northern England, where I grew up. Every few days, my grandmother, who kept a boardinghouse, would go to Leeds market in search of cheap cuts of meat and other bargains. If Alan Greenspan is at one end of the spectrum when it comes to thinking about how markets work, she was at the other. An Irishwoman with little formal education but a wealth of personal experience, she regarded the shopkeepers and tradesmen she dealt with as “robbers,” “villains,” and “feckers,” each of whom was out to cheat her in any way he could.

That is an extreme view to hold. So, too, is the idea that free markets invariably work to the benefit of all. Of course, when economists use the term “free markets,” they are referring not to individual shopkeepers but to an entire system of organizing production, distribution, and consumption. Taking the economy as a whole, there are three markets of importance: the goods market, where shoppers purchase everything from Toyota Corollas to haircuts to vacations in Hawaii; the labor market, where firms and other types of employers hire workers; and the financial market, where individuals and institutions lend out or invest their surplus cash.

Each of these markets is distinct. Economists tend to obscure their differences, treating computer programmers and stock index futures in the same way as iPods and canned tomatoes—as desirable commodities. Generalizing like this obscures the fact that markets are social constructs, but it allows economists to focus on some underlying commonalities, such as the roles played by incentives, competition, and

prices. Market systems have proved durable for several reasons. In allowing individuals, firms, and countries to specialize in what they are best at, they expand the economy’s productive capacity. In providing incentives for investment and innovation, they facilitate a gradual rise in productivity and wages, which, over decades and centuries, compound into greatly improved living standards. And in relying on self-interest rather than administrative fiat to guide the decisions of consumers, investors, and business executives, markets obviate the need for a feudal overlord or omniscient central planner to organize everything.

One of the first economists to put these arguments together was Adam Smith, a bookish Scot who was born in Kirkcaldy, a town on the Firth of Forth, north of Edinburgh, in 1723. Smith’s father, a lawyer and government official, died before his son’s birth. After being brought up by his mother, Smith attended Glasgow University, where he studied philosophy under Francis Hutcheson, one of the great figures of the Scottish Enlightenment. He moved on to Oxford and Edinburgh universities, before returning to Glasgow, where from 1752 to 1764 he taught moral philosophy, a catchall subject that included ethics, jurisprudence, and political economy. Resigning his professorship to take a higher-paying job tutoring a wealthy young aristocrat, the Duke of Buccleuch, Smith began writing his great opus, The Wealth of Nations, which was eventually published in 1776, the same year as the American Declaration of Independence.

With a big nose, protruding teeth, and a slight stammer, Smith was far from an imposing figure. Famously absentminded, he often jabbered to himself as he walked the streets of Glasgow. But his metaphor of an unseen hand directing the economy is as powerful now as it was 230 years ago, and it remains central to any discussion of how markets operate. This is not just my opinion. “It is striking to me that our ideas about the efficacy of market competition have remained essentially unchanged since the eighteenth-century Enlightenment, when they first emerged, to a remarkable extent, from the mind of one man, Adam Smith,” Alan Greenspan wrote in his 2007 memoir, The Age of Turbulence. “[I]n a sense, the history of market competition and the capitalism it represents is the story of the ebb and flow of Smith’s ideas. Accordingly, the story of his work and its reception repays special attention.”

Smith based his arguments not on abstract principles but on acute observation. He began by describing the operations of a pin (nail) factory. In the late eighteenth century, the process of mechanization was only beginning, and most factories in the British Isles were small; even the biggest of them had only three or four hundred employees. Already, though, each worker carried out a specialized task: “One man draws out the wire,” Smith wrote, “another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it

is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will perform two or three of them.” Whereas one workman unacquainted with the methods and machines used in such establishments “could scarce, perhaps, with his utmost industry, make one pin a day,” Smith went on, ten factory workers experienced and skilled in their individual tasks “could make among them, upwards of forty-eight thousand pins a day.”

What applies to the making of pins applies to the production of many other items. Specialization, which Smith referred to as “the division of labor,” generates “a proportionable increase of the productive powers of labor,” first by increasing the dexterity of individual workers; second, in saving time moving from one task to another; third, in encouraging the invention of machines, which “enable one man to do the work of many.” The result is what modern economists would refer to as a steady increase in productivity, or output per head. In a subsistence agricultural economy of the sort that had existed in Britain and elsewhere for centuries, most people struggled to feed and clothe their families. In a modern market system— Smith preferred the phrase “commercial society”—workers and tradesmen produce a surplus over and above their daily necessities, which they use to buy other, inessential goods, such as fashionable clothes and comfortable furniture. “It is,” said Smith, “the great multiplication of the productions of all the different arts”— professions—“in consequence of the division of labor, which occasions, in a well- governed society, that universal opulence which extends itself to the lowest ranks of the people.”

Considering that Smith was writing about a society in which bands of hungry laborers sometimes roamed the countryside, and in which cities such as Manchester and Leeds would soon be filling up with impoverished factory workers, many of them still children, his description of a capitalist economy may seem to our eyes rather uncritical. Still, as the industrialization of Britain continued and intensified over the ensuing century, wages and living standards did eventually increase, confirming Smith’s point: free market capitalism raises living standards. The pattern has repeated itself in many other countries, with China and India providing recent examples. After decades of centralized control, both countries have opened up their economies and entered the global division of labor. As was the case in Great Britain and the United States, the development of the Chinese and Indian economies has involved sweatshop labor, rising inequality, and large-scale environmental degradation. But it has also created a great deal of wealth, at least some of which has already trickled down to “the lowest ranks of the people.” Nobody would claim that the typical inhabitant of China or India is rich; but over the past couple of decades, many, many people have been raised from poverty. In China between 1981 and 2005,

according to a recent study by researchers at the World Bank, the poverty rate fell from 84 percent to 16 percent, a drop of almost two-thirds. By the end of the period, more than 600 million Chinese had been lifted out of poverty.

As the division of labor proceeds, a fine and complex web of mutual trade and dependency comes into existence. Smith used the example of a day laborer’s humble woolen coat, drawing attention to all the different professions that contribute to its manufacture: “The shepherd, the sorter of the wool, the wool comber or carder, the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser, with many others, must all join their different arts in order to complete even this homely production. How many merchants and carriers, besides, must have been employed in transporting the material from some of those workmen to others who often live in a very distant part of the country!” That is just the first round of interconnections. What about all the steps that go into supplying, say, the dyer with his dye or the shearer with his shears? Smith listed another baker’s dozen of them, invoking the merchant, the shipbuilder, the sailmaker, the rope maker, the sailor, the timber seller, the miner, the smelter, the brickmaker, the bricklayer, the millwright, the forger, and the smith. All this for a single cheap overcoat! If we also consider the laborer’s other possessions, such as the contents of his home, Smith pointed out, and consider the labor that goes into them, we shall find that “without the assistance and cooperation of many thousands, the very meanest person in a civilized country could not be provided, even according to what we very falsely imagine the easy and simple manner in which he is commonly accommodated.”

Today, of course, the division of labor is much more global and intricate than it was in Smith’s day. Apple’s iPod, of which more than 175 million have been sold, was conceived in Silicon Valley; most of the software it operates on was written in Hyderabad, India; and it is manufactured in China, where Apple has outsourced production to a number of Taiwanese companies. The music player contains 451 parts, including a hard drive made by Japan’s Toshiba; two microchips produced by American companies, Broadcom and PortalPlayer; and a memory chip made by Samsung, a Korean firm. Each of these components, in turn, has a complicated global supply chain. The iPod is rightly seen as a triumph of American innovation and marketing. It is also a pocket-size emblem of the division of labor. (In June 2006, The Mail on Sunday, a British newspaper, revealed that many of the Chinese workers assembling iPods were young women who worked fifteen hours a day and lived in corporate dormitories, earning less than fifty dollars a month. Apple subsequently promised to improve the working conditions and hired a workplace standards auditing company.)

If a medieval monk were to descend on today’s immensely complex global economy, which in 2007 produced about $55 trillion worth of goods and services, he would surely have some basic questions that we, blinded by familiarity, seldom stop to ponder: Who tells all the specialized producers what goods to supply, and in what quantities? Who prevents them from overcharging for their wares? Smith’s answer was that no individual or authority has to carry out these tasks: the competitive market accomplishes them on its own. If, at any moment, demand for a particular commodity exceeds the amount presented for sale, its price will rise and existing suppliers will make excess profits, which will encourage others to enter the market. If the amount of a commodity offered for sale exceeds the demand, its price will fall and so will suppliers’ profits, encouraging some of them to exit the market. In a market economy, these adjustments happen all the time.

In Smith’s idealized version of the free market, competition forces businesses to supply what consumers want to purchase and to cut back on the production of less popular goods, while preventing them from profiteering. Prices gravitate toward a “natural price,” at which suppliers just cover their outlays for labor, raw materials, and rent, as well as making an unexceptional rate of profit. The market system is efficient in that human and physical resources are directed to where they are most needed and prices are tied to costs. It is also self-correcting. If a shortage develops, prices rise and supply expands. If a glut occurs, prices fall and production contracts until supply and demand come into balance.

The technical phrase for this type of process is negative feedback, and it is found in most stable dynamic systems, such as thermostat-controlled heating systems and the body’s hormonal system. When an initial disturbance occurs, price changes set in force offsetting movements, which restore equilibrium. (The opposite of negative feedback is positive feedback, which amplifies initial disturbances. Positive feedback helps to cause nuclear explosions, rapid population growth, and stock market bubbles.) It should be noted that none of these adjustments is imposed from above: in the language of systems analysis, they are all “emergent” properties, which result from a multiplicity of individual interactions. Each businessman “intends only his own gain,” Smith wrote, “and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention . . . By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”

In the presence of this fantabulous market mechanism, what is left for a government to do? With a few exceptions, such as providing for national defense and making sure laws are properly enforced, Smith said it should confine itself to clearing away outmoded conventions that prevent competitive markets from operating, such as

price controls and legal limits on entry to particular industries. “Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men.”

This philosophy is often referred to as laissez-faire—a French phrase that means leave alone. In the eighteenth-century context, laissez-faire involved strengthening property rights, lowering tariffs on imported goods, and abolishing what remained of the medieval economy, with its feudal privileges, its restrictive labor guilds, its government-imposed local monopolies on the production and distribution of certain goods, its hostile attitude toward moneylenders, and its suspicion of novel production methods. If the economy were freed of artificial restraints, competition would ensure that employment and the utilization of resources evolved in the direction “most agreeable to the interests of the whole society,” Smith wrote. Unlike some later economists, he didn’t spend much time discussing the nature of societal interests, or whether they existed. He took it as self-evident that the ultimate goal of economic policy was maximizing a country’s wealth, by which he meant the total value of the goods and services it produced on an annual basis, or what we now call the gross domestic product. Little “else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things,” Smith wrote in a 1755 paper.

With his espousal of free trade, limited government, and low taxes, it is easy to caricature Smith as the intellectual spokesman of the rising capitalist class, or bourgeoisie. Actually, he was deeply skeptical of businessmen’s motives. Like my late grandmother, he suspected them of trying to diddle their customers at every opportunity. (“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some diversion to raise prices.”) Here again, though, the free market comes to the rescue. Faced with actual and potential competition from rival suppliers, manufacturers and merchants have no choice but to trim their profit margins and invest in new production methods. In the Smithian world, competition cannot be avoided or circumvented. (Later economists would characterize it as a system of “perfect competition.”) And the ultimate beneficiary of all this competing among firms is the shopper, who gets to buy better products at lower prices. In the words of Ludwig von Mises, a twentieth-century Austrian economist who greatly admired Smith, consumers are sovereign.

Before turning to the strengths and weaknesses of Smith’s analysis, it is worth stepping back and admiring its scope. Starting out from the pin factory, he has characterized the entire economic organism, describing the workings of individual markets but also the outcome of countless households and businesses interacting in

many, many markets. And what does this body look like? It is a self-regulating mechanism that stimulates technological innovation, satisfies human wants, minimizes wasteful activity, polices rapacious businessmen, and enriches the populace. Perhaps most remarkably of all, the fuel that keeps the mechanism humming is human selfishness: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest,” Smith wrote in a famous passage. “We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities but of their advantages. Nobody but a beggar chooses to depend chiefly upon the benevolence of his fellow citizens.”

The free market isn’t merely an economic wonder: it is a godlike contraption that takes individual acts of egocentricity and somehow transforms them into socially beneficial outcomes. In the words of Milton and Rose Friedman: “Adam Smith’s flash of genius was his recognition that the prices that emerged from voluntary transactions between buyers and sellers—for short, in a free market— could coordinate the activity of millions of people, each seeking his own interest, in such a way as to make everyone better off. It was a startling idea then, and it remains one today, that economic order can emerge as the unintended consequence of the actions of many people, each seeking his own interest.” Small wonder that so many of Smith’s followers have expounded their arguments with a quasi-religious fervor, castigating government intervention in the economy as not just unwise but morally wrong. Utopian economics goes beyond a scientific doctrine: it is a political philosophy, a secular faith.

Following Smith’s death, in 1790, at the age of sixty-seven, the dual nature of his legacy became increasingly apparent. During the early and mid-nineteenth century, English “classical economists,” such as David Ricardo, Nassau Senior, and John Stuart Mill, developed the scientific side of his analysis, spelling out the logic of free trade, and explaining how, through the interplay of market forces, the revenues that businesses generated were split among rents, profits, and wages. Like Smith, these men believed free markets had internal laws that governments sought to interfere with at their peril. John Stuart Mill, a childhood prodigy who by the age of seven was reading Plato, spelled this out in his book Principles of Political Economy, which appeared in 1848 and was for forty years the bible of British economics: “Laissez-faire, in short, should be the general practice,” Mill wrote; “every departure from it, unless required by some greater good, is a certain evil.”

During the reign of Queen Victoria, who acceded to the throne in 1837, Mill’s prescription became the official doctrine of the British Empire. From Canada to the United Kingdom to India, free trade, limited government, and low taxes were the order of the day. Under the Poor Law Amendment Act of 1834, which Nassau Senior

helped to devise, outdoor relief for paupers—a form of welfare that dated back to feudal times—was abolished. Henceforth, impecunious workers faced the choice of getting a job or entering the dreaded “workhouse,” a jail-like institution where they would be provided with bread and gruel, but little else. Under the principle of “less eligibility,” the explicit aim of the 1834 law was to stigmatize idleness and force the out-of-work to accept any position available, regardless of the wages it paid. After subjecting the landless laborers and urban poor to the harsh disciplines of the market, the Victorian free market reformers administered similar shock treatment to farmers. In 1846, following an epic political battle, the Corn Laws, which, through a system of tariffs, protected British grain growers from foreign competition, were abolished, opening up the British market to cheaper foodstuffs produced in the American Midwest.

The classical economists justified their recommendations on economic grounds, but there was also a strong moral element to their teachings. Laissez-faire was the practical application of a philosophy that placed great emphasis on self-reliance and freedom of choice. “[T]he sole end for which mankind are warranted, individually or collectively, in interfering with the liberty of action of any of their number, is self- protection,” Mill wrote in his most famous book, On Liberty. “That the only purpose for which power can be rightfully exercised over any member of a civilized community, against his will, is to prevent harm to others. His own good, either physical or moral, is not sufficient warrant.”

For all their embrace of free market economics, and on occasion their righteous indignation, however, the classical economists were less dogmatic than many of their twentieth-century followers. Within confines, they saw a legitimate role for government programs. In The Wealth of Nations, Smith listed the three duties of government as defending the nation, administering justice, and “erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain; because the profit could never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.”

The third duty of government was defined broadly enough to admit a wide range of activities, such as building bridges and public parks, and operating public utilities, such as sewers and irrigation schemes. Smith’s followers added to this list. David Ricardo, the great defender of free trade, called for the nationalization of the Bank of England, which in his time was privately operated; Nassau Senior, for all his heartless approach to able-bodied adult workers, advocated a national system of public education for children. Classical economists supported child labor laws, mandatory safety standards for workplaces and new products, and the expansion of the civil service. “The principle of laissez-faire may be safely trusted to in some

things but in many more it is wholly inapplicable,” wrote J. R. McCulloch, a prolific Scot who helped to popularize the doctrines of Smith and Ricardo. “[A]nd to appeal to it on all occasions savours more of the policy of a parrot than of a statesman or a philosopher.” Even Mill, with his deep philosophical attachment to liberty, was an avid social reformer. “[T]he admitted functions of government embrace a much wider field than can easily be included within the ring-fence of any restrictive definition,” he wrote in Principles of Political Economy, “and it is hardly possible to find any ground of justification common to them all, except the comprehensive one of general expediency.”

Smith and his successors also believed that the government had a duty to protect the public from financial swindles and speculative panics, which were both common in eighteenth-and nineteenth-century Britain. The financial system was a two-tier one, consisting of a number of big banks based in London and dozens of smaller “country banks” located in other towns and cities. Many of these provincial banks issued their own promissory notes, which circulated as money. There was perennial concern that the banks would issue too much of this paper to unworthy borrowers, leaving them vulnerable to panics should concerned depositors try to withdraw their money. In book two of The Wealth of Nations, Smith cited the case of a Scottish bank that was established to provide loans to local entrepreneurs—“projectors,” he called them—on more favorable terms than existing lenders, and which quickly ended up with many heavily indebted customers. “The bank, no doubt, gave some temporary relief to those projectors, and enabled them to carry on their projects for about two years longer than they otherwise would have done,” Smith wrote. “But it thereby only enabled them to get so much deeper into debt, so that, when ruin came, it fell so much the heavier both upon them and upon their creditors.”

To prevent a recurrence of credit busts, Smith advocated preventing banks from issuing notes to speculative lenders. “Such regulations may, no doubt, be considered as in some respects a violation of natural liberty,” he wrote. “But these exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments, of the most free, as well as the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.”

Alan Greenspan and other self-proclaimed descendants of Smith rarely mention his skeptical views on the banking system, which were shared by many nineteenth- century economists who otherwise maintained a favorable view of the free market. J. S. Mill traced most economic downturns to disturbances that emerged from the financial system, as did Alfred Marshall, the late-Victorian economist whose Principles of Economics replaced Mill’s textbook as the standard work. Marshall said “reckless inflations of credit” were “the chief cause of all economic malaise,”

and he called for vigorous action on the part of the monetary authorities to prevent them.

The notion of financial markets as rational and self-correcting mechanisms is an invention of the last forty years. Before that, most economists sympathized with Charles Mackay, the journalist and sometime colleague of Charles Dickens whose 1841 book, Extraordinary Popular Delusions and the Madness of Crowds, compared speculative manias, such as the “tulipomania” that gripped Holland in the 1630s and the South Sea bubble of 1720s London, to witch trials, millennialism, and other examples of collective insanity. The transition from Mackay’s jaundiced opinion of finance to Greenspan’s sunny view took a long time, and it was based, at least partially, on a misreading of the theory of the invisible hand, which Smith had never intended to be applied to finance. The transition began, ironically enough, in the 1930s and 1940s, when capitalism appeared to be floundering and many economists were looking favorably on replacing the price system with central planning.

3. FRIEDRICH HAYEK’S TELECOMMUNICATIONS SYSTEM

Alan Greenspan first read Adam Smith shortly after World War II, a time, he recalls in his memoir, when “regard for [Smith’s] theories was at a low ebb.” To most survivors of the Great Depression and the war, the idea of the market economy as a benign, self-regulating mechanism was absurd. The laissez-faire regimen of free trade, small government, and low taxes was widely seen as responsible for the disasters of the early 1930s, when, in the United States, industrial production had fallen by half and the unemployment rate had reached one in four. Even among economists, especially the younger ones who had less of a professional stake in the old ideas, capitalism was widely viewed as inherently unstable. Most economists agreed with Keynes, the British economist and Treasury official, who had argued that the only way to prevent mass unemployment was for the government, through investing heavily in public works and other projects, to manage the level of demand in the economy.

On both sides of the Atlantic, governments had moved to protect people against the vagaries of the market, introducing unemployment benefits, Social Security, and much tighter regulation of the financial system. In the Soviet Union and its satellite territories, meanwhile, the effort to completely replace capitalism appeared to be having some success: Stalin’s government boasted that it had eliminated unemployment and mass poverty. (The human costs of these achievements weren’t yet clear to outsiders.) When, on October 4, 1957, the Soviet Union successfully launched Sputnik I, the first satellite to orbit the earth, some observers prematurely concluded that the Communist empire had moved ahead of the United States in the race for military and economic domination. “Chastened at home, Americans also felt

humiliated abroad as they read of reports of foreign journalists claiming the USSR had overtaken the United States and was now the number one superpower,” the historian John Patrick Diggins writes in The Proud Decades, his lively account of postwar America.

In such an environment, free market economists were relegated to the role of preachers in an obscure sect. They sustained themselves by offering eulogies up to Smith and the invisible hand. The two most important of these evangelists were Friedrich Hayek, a well-bred Austrian who was born in Vienna in 1899, and Milton Friedman, a voluble New Yorker who was born in Brooklyn in 1912. In the late 1940s, both Hayek and Friedman moved to the University of Chicago, where they helped to create the “Chicago School” of economics. Friedman, who died in 2006, remains a household name, but even among economists, Hayek, who died in 1992, is a much less well-known figure.

When I began studying economics at Oxford during the early eighties, Hayek was widely seen as a right-wing nut. True, he had received the Nobel Memorial Prize in 1974, but that was viewed within the economics profession as a political sop, with Hayek’s name added to balance that of his co-winner, Gunnar Myrdal, a left-wing Swedish economist. (Myrdal later said that he wouldn’t have accepted the award if he had known he would have to share it with Hayek.) Hayek’s proposals to emasculate the trade unions and privatize the money supply seemed outlandish: he was regarded more as a libertarian political philosopher than a practical economist. I made it all the way through undergraduate and graduate school without reading any of his articles or books, and I wasn’t unusual. Until recently, few economics textbooks mentioned Hayek’s name, and there was no scholarly biography of him available.

Friedrich August von Hayek—his full Austrian name—was a distant cousin of the philosopher Ludwig Wittgenstein. His father was a doctor; his mother came from a family of wealthy government officials. After serving as an artillery officer in World War I, he enrolled at the University of Vienna, where he studied under a number of leading Austrian economists, including Ludwig von Mises, a fervent free-marketer who, as early as 1922, wrote a book, Socialism: An Economic and Sociological Analysis, that dismissed collectivist planning as impractical. When he wasn’t teaching, von Mises worked at the Abrechnungsamt, a government office that dealt with Austria’s postwar debts, and he hired Hayek as a research assistant. The young economist quickly abandoned the moderately left-wing views he had formed during the Great War, adopting a laissez-faire outlook similar to that of von Mises. Many of

his fellow students would gather at the Kaffee Landmann to discuss Marxism and psychoanalysis, but Hayek found these fashionable disciplines “more unsatisfactory the more I studied them.”

During the 1920s, Hayek worked on the causes of business cycles, formulating the view that slumps were the inevitable result of prior booms, during which growth had become “unbalanced,” with investment in industrial capacity outstripping the supply of savings in the economy. Recessions, in this view, were a way of restoring the balance between savings and investment. Hayek’s theory, which was eventually expostulated in a 1931 book, Prices and Production, attracted attention in England, where Keynes and his young Cambridge acolytes were developing the theory that it was a lack of overall demand in the economy that caused recessions, and that an increase in government spending could be used to restore prosperity. After World War II, governments all over the world adopted Keynesianism as their guiding policy framework, but in the early 1930s it was new and controversial. Lionel Robbins, a well-known professor at the London School of Economics, was one of the economists defending the traditional view that recessions were “nature’s cure,” and that the only way to forestall them was through wage cuts and government retrenchment. Robbins, who read German, spotted Hayek’s work and saw a potential ally against Keynes. He invited Hayek to LSE in 1931 as a guest lecturer, and a year later as a full-time professor.

With Hayek’s arrival in London, the stage was set for an epic intellectual debate. He got things going with a critical review of Keynes’s 1930 book, A Treatise on Money, which identified too much saving as a cause of recessions, saying the book lacked a proper theory of capital investment and interest rates—an area Austrian economists considered the key to economic slumps. In 1931, Keynes returned fire, describing Hayek’s Prices and Production as “one of the most frightful muddles I have ever read.” It soon became clear that, despite the hopes Robbins had placed in him, Hayek, with his accented English and sometimes obscurantist prose, was no match for Keynes, an accomplished writer and debater. Hayek was an unknown; Keynes had been a public figure ever since the publication of his 1919 book, The Economic Consequences of the Peace, which correctly predicted that the punitive Treaty of Versailles would create great difficulties.

Rather than continuing to squabble publicly with Hayek, Keynes invited him to Cambridge, where they dined at King’s College and talked with Piero Sraffa, a brilliant young Italian economist who had also written critically of Hayek’s theories. One-on-one, the aloof Cambridge aesthete and the reserved Austrian enjoyed each other’s company; among other things, they shared a passion for antiquarian books. “Hayek has been here for the weekend,” Keynes wrote to his wife, Lydia, in March 1933. “I sat by him in hall last night and lunched with him at Piero’s today. We get on very well in private life. But what rubbish his theory is.”

Keynes won the great debate. Even before he wrote The General Theory of Employment, Interest and Money, which was published in 1936, most British economists had dismissed Hayek’s theory of the business cycle, which failed to provide much guidance about how to end the Depression. Despite being bested by Keynes, Hayek greatly enjoyed his time in England. Endowed with the fastidious habits and elaborate manners of prewar Vienna, he fell in love with an educated British society that shared many of the same traits. He worked at home in the morning and went to LSE in the afternoon, often stopping for lunch at the Reform Club, on Pall Mall. The seminar that he ran with Robbins attracted many economists who later became famous, including John Kenneth Galbraith, John Hicks, and Nicholas Kaldor. Galbraith, who was visiting Cambridge from Harvard, and took the train to London every week to attend, later described Hayek as “one of the gentlest in manner, most scholarly and generally most agreeable men I have known,” but added that his seminar was “possibly the most aggressively vocal gathering in all the history of economic instruction.”

Finding his views on macroeconomics increasingly ignored, Hayek turned to other issues, such as the intensifying dispute between collectivists and supporters of the free market. As the Great Depression dragged on, some left-leaning economists argued that the adoption of central planning would enable resources to be directed to socially useful areas while avoiding the ups and downs of capitalism. Attempting to construct a middle way between laissez-faire and communism, these economists advocated a form of “market socialism,” which would combine state ownership of major industries with a modified price system: the central planner would determine some prices; and the free market, others. Hayek, who had edited a book of essays on collective planning, was highly dubious of this idea. In the absence of genuine competition, how would the government know what prices to set, he asked, and how would factory managers know which goods to produce and in what quantities? “To assume that all this knowledge would be automatically in the possession of the planning authority seems to me to miss the main point,” he wrote in a 1940 essay.

Hayek believed, with some justification, that many critics of the free market ignored the role it played in coordinating the actions of millions of individual consumers and firms, each with differing wants and capabilities. As early as 1933 he referred to the market as “an immensely complicated mechanism” that “worked and solved problems, frequently by means which proved to be the only possible means by which the result could be accomplished.” In 1937, Hayek published a paper entitled “Economics and Knowledge.” Although it attracted little attention at the time, it marked the first appearance of his most lasting contribution to economics: the suggestion that market prices are primarily a means of collating and conveying information. Centralized systems may look attractive on paper, Hayek argued, but they couldn’t deal with the “division of knowledge” problem, which he described as

“the really central problem of economics as a social science.” To understand what Hayek was getting at, imagine the task facing a central

planner in a collectivized economy. Before he can decide where to direct the raw materials and workers that are available, he needs to know what goods people want to buy and how they can be produced most cheaply. But this knowledge is held in the minds of individual consumers and businessmen, not in the filing cabinets (or, later, computers) of a planning agency. Unless the central planner can find some way of eliciting this information, he won’t be in any position to direct the workers and raw materials to their most productive uses, and great waste will result. In any economy, Hayek wrote in a 1945 paper, “The Use of Knowledge in Society,” the central problem is “how to secure the best uses of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.”

The great advantage of organizing production in a market system, Hayek pointed out, is that firms don’t need to go out and ask consumers what things to manufacture and how many to make: prices transmit that information. If consumers want more of a good—soap, say—than the market is supplying, its price will rise, signaling to business that they should step up production. If firms are already making more soap than consumers want to buy, its price will drop, signaling to businesses that they should cut back production. The same process applies to raw materials such as tin. If demand for tin increases, perhaps a new production process that uses it has been invented, and its price will rise, perhaps sharply. This will prompt existing users of tin to economize on its usage, and it will also encourage tin miners to supply more.

“We must look at the price system as . . . a mechanism for communicating information if we want to understand its real function,” Hayek wrote. And he went on: “The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction . . . I have deliberately used the world ‘marvel’ to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design . . . this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.”

Hayek’s description of the free market as a coordination device echoed The Wealth of Nations but went beyond it. The invisible hand sounds like something unworldly and magical. Hayek’s metaphor of the market as a “system of telecommunications” is more direct and specific. It helps explain how markets work —via the transmission of price signals—and why they are so difficult to replicate.

“The most significant fact about this [market] system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action,” Hayek wrote. “In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned.”

The history of the Soviet bloc demonstrated what happens when governments replace market price signals with central planning and prices that are administratively determined. As a method of ramping up the production of basic goods, such as steel and wheat, collectivism proved pretty effective. But once the Communist economies moved beyond the stage of industrialization, they couldn’t deal with the variegated demands of a consumer-driven society. Innovation was lacking, and information about consumer preferences got lost, or was ignored. Even after the Soviet government, under Mikhail Gorbachev, freed up some prices, shortages and surpluses were endemic, which confirmed Hayek’s argument that attempts to create market socialism would founder.

In their 1990 book, The Turning Point: Revitalizing the Soviet Economy, Nikolai Shmelev and Vladimir Popov recall what happened when the government in Moscow increased the price it would pay for moleskins, prompting hunters to supply more of them: “State purchases increased, and now all the distribution centers are filled with these pelts. Industry is unable to use them all, and they often rot in warehouses before they can be processed. The Ministry of Light Industry has requested Goskomsten twice to lower purchasing prices, but the ‘question has not been decided’ yet. And this is not surprising. Its members are too busy to decide. They have no time: besides setting prices on these pelts, they have to keep track of another 24 million prices.” None of this would have surprised Hayek. The idea of the free market as a spontaneously generated system for “the utilization of knowledge,” he said to an interviewer later in his life, was “the basis not only of my economic but also much of my political views . . . the amount of information the authorities can use is always very limited, and the market uses an infinitely greater amount of information than the authorities can ever do.”

Back in the 1940s, when Hayek formulated his ideas about information, there was no sign of communism collapsing: to most observers, it looked like laissez-faire was the ideology whose time had passed. In 1942, Joseph Schumpeter, another Austrian admirer of free markets, who taught at Harvard, published Capitalism, Socialism, and Democracy, in which he argued that capitalism itself was doomed and bureaucracy was its replacement. Hayek was equally fearful about the future, and he set out to write a popular text defending the values of free market liberalism. As with his intellectual heroes Smith and Mill, Hayek’s support for laissez-faire extended far beyond a belief in its economic utility: he viewed the free market as the

only effective guarantor of individual freedom, and he reacted viscerally to what he saw happening around him in Great Britain.

During World War II, Sir William Beveridge, a former colleague of Hayek’s at LSE, published two influential papers—“Report on Social Insurance and Allied Services” and “Full Employment in a Free Society”—that laid the intellectual basis for the postwar welfare state. Like Keynes, Beveridge was a member of the Liberal Party rather than a socialist. He agreed with Keynes that capitalism needed adult supervision: left untended, it had produced a worldwide slump and, ultimately, fascism. Hayek never accepted the argument that fascism was a capitalist phenomenon. He saw Stalin and Hitler as two suits in the same closet, and the closet was marked “collectivism.” He dedicated his book The Road to Serfdom “To the Socialists of All Parties,” a clear reference to National Socialism.

Much of the book was devoted to central planning. Hayek repeated the arguments about prices and information that he had made in his academic papers, but his main concern was to develop their political implications. When the government has to decide how many pigs are to be raised or how many buses are to be run, these decisions cannot be deduced purely from economic principles, Hayek said. The allocation of resources inevitably involves disputes between different communities and regions. The central planner has to choose among many competing options, and in this role he acquires enormous power over the economy and over people’s lives. “In the end somebody’s views will have to decide whose interests are more important; and these views must become part of the law of the land, a new distinction of rank which the coercive apparatus of government imposes upon the people,” Hayek wrote. “[P]lanning leads to dictatorship, because dictatorship is the most effective instrument of coercion and the enforcement of ideals and, as such, essential if central planning on a large scale is to be possible.”

As far as the organization of Communist economies goes, Hayek’s argument was a penetrating one: so far, at least, all efforts to build a fully centralized economy have involved one-party rule. But Hayek’s primary target wasn’t the Soviet Union or China. His argument was that Britain, France, and other European social democracies, and even the United States, were only a step away from totalitarianism. “We are rapidly abandoning not the views merely of Cobden and Bright, of Adam Smith and Hume, or even of Locke and Milton, but one of the salient characteristics of Western civilization as it has grown from the foundations laid by Christianity and the Greeks and Romans,” he wrote. “[T]he basic individualism inherited by us from Erasmus and Montaigne, from Cicero and Tacitus, Pericles and Thucydides, is progressively relinquished.” In one passage, he even compared the Britain of Churchill and Attlee to Nazi Germany. While “few people, if anybody, in England would probably be ready to swallow totalitarianism whole,” he said, “there are few single features which have not yet been advised by somebody or other. Indeed, there

is scarcely a leaf out of Hitler’s book which somebody or other in England or America has not recommended us to take and use for our own purposes.”

This was a strange way to portray the European welfare state and Roosevelt’s New Deal. From a purist perspective, health insurance, Social Security, state- financed education, and regional development programs were violations of laissez- faire, but none of them impinged on the industrial and financial core of the free enterprise system. Alvin Hansen, the dean of American Keynesians, had a point when he wrote in The New Republic, “This kind of writing is not scholarship. It is seeing hobgoblins under every bed.” In The Road to Serfdom and in his other works, Hayek neglected to account for some serious failures of the market system. In the 1930s and 1940s, it was already glaringly obvious that ordinary people needed decent medical care, breathable air, and money to retire on, and that the market had failed to provide these things. Why was that? Hayek didn’t offer an answer; he didn’t even seem particularly interested in the question.

The alarmist thesis of The Road to Serfdom didn’t get much purchase in Britain, where there was widespread public support for the welfare state, but in the United States, where suspicion of government ran deep, Hayek was hailed as a visionary. In The New York Times Book Review, Henry Hazlitt, a conservative economic commentator, wrote a rave. Reader’s Digest, then the voice of God-fearing conservatism, rushed out a condensed version of Hayek’s tome, which the Book-of- the-Month Club published, selling six hundred thousand copies. By the time Hayek arrived in New York in early 1945, he was something of a celebrity. “The hall holds three thousand, but there’s overflow,” his publishing representative told him on the way to Town Hall, a theater in midtown Manhattan.

“My God. I have never done such a thing,” Hayek replied. “What am I supposed to lecture on?”

“Oh, we have called the tune ‘Law and International Affairs.’ ” “My God, I have never thought about it. I can’t do this.” “Everything is announced; they are waiting for you.” To his surprise, Hayek liked public speaking, and he traveled the country for five

weeks. The book and book tour made his reputation in the United States, and in 1950 the University of Chicago’s Committee on Social Thought, a newly formed interdisciplinary department, offered him a job. Feeling unappreciated in London, and having been recently divorced, Hayek accepted the invitation and moved to Chicago. Largely freed from the burden of teaching, he retreated from economics, devoting himself mainly to political and philosophical questions. His weekly seminar “The Liberal Tradition”—Hayek always used the word “liberal” in its nineteenth-century laissez-faire sense—covered a panoply of thinkers, from Locke, through Smith and Mill, to von Mises. One of the seminar’s regular attendees was Milton Friedman.

In 1960, Hayek published what many consider his finest book, The Constitution of Liberty, a wide-ranging defense of individualism and the free market. He found the intellectual atmosphere at the University of Chicago congenial, but he missed Europe. In 1962, he accepted a post at the Albert-Ludwigs-Universität, in Freiburg, a small college associated with Ludwig Erhard, the founder of the West German “social market” economy. One reason for the relocation was financial: the Freiburg professorship offered a pension, something his job in Chicago didn’t. Hayek loved the Black Forest scenery, but his return to Europe wasn’t completely successful. During the late 1960s, he began to suffer from deep and paralyzing depression. “We used to talk on the telephone, and I could tell that he was depressed,” Hayek’s son, Dr. Laurence Hayek, told me in 2000, when I was researching an article about Hayek. “He couldn’t summon up any energy to do anything.” Hayek himself later attributed his mental problems to low blood sugar, which went undiagnosed by his doctors, but others thought differently. “He was depressed, I think, mostly because he saw the condition of the world as depressing, and he felt he wasn’t receiving the kind of recognition he hoped for,” Milton Friedman told me in 1999. After Hayek retired in 1968, he moved to the University of Salzburg, which didn’t even have a proper economics department, but which was closer to his native Vienna.

Given the intellectual climate of the time, the 1974 Nobel Prize came as a complete surprise to Hayek, and it inspired him to start writing again. (“Some years ago, I tried old age but discovered I didn’t like it,” he later joked.) With belated academic recognition came political influence, especially in Great Britain, where Hayek’s admirers included Margaret Thatcher, who, in 1975, became leader of the Conservative Party. During a visit to the party’s Research Department, Mrs. Thatcher slammed a copy of The Constitution of Liberty on the table and declared, “This is what we believe.” In 1988, at the age of eighty-nine, Hayek published The Fatal Conceit, an erudite book that stressed the evolutionary nature of capitalism. By gradually learning to follow a few rules, such as how to exchange goods for money, maintain respect for private property, and act honestly, man had “stumbled upon” a uniquely effective method of coordinating human activity, Hayek argued; socialism was a futile attempt to overturn the evolutionary process. A year later, the Berlin Wall came down and communism entered its death throes. Hayek didn’t issue any public statements, but he greatly enjoyed watching the television pictures from Berlin, Prague, and Bucharest. “He would beam benignly,” his son Laurence told me, “and the comment was, ‘I told you so.’ ”

4. THE PERFECT MARKETS OF LAUSANNE

Hayek’s vision of the free market as an information-processing system was one of the great insights of the twentieth century, but it also raised a tricky question: How can we be sure that the price signals the market sends are the right ones? Just because central planning failed, it doesn’t necessarily follow that markets always get things right. The sheer scale of the pricing problem is breathtaking. A single Wal- Mart store contains tens of thousands of different items. In the economy as a whole, there are innumerable markets, many of them interconnected. When OPEC cuts its production quotas, and the price of heating oil rises, some moderate-income households will be forced to cut back on purchases of food and clothing; the demand for gas boilers, electric radiators, and window insulation will increase. Is there any reason to suppose that a set of market prices exists at which all of these goods will be supplied in exactly the quantities that people demand?

Yes, there is. As long as each industry contains many competing suppliers, and firms aren’t able to lower their unit costs merely by raising output, it can be mathematically demonstrated that a market-clearing set of prices exists. Once these prices are posted, supply will equal demand in every industry, and no resources will be idle. There are two more bits of good news. At this “equilibrium” set of prices, labor, land, and other inputs will be directed to their most productive uses. It won’t be possible, by rearranging production, to produce more output. Moreover—and this is the real kicker—it won’t be possible to make anybody better off without making somebody else worse off. All such unequivocal gains from trade will already have been exploited.

A shorthand way to summarize these findings is to say that competitive markets are efficient. They ensure that businesses supply the products people want, in the

right amounts, at the least cost. Consumers get to buy the goods they value most highly. They can’t purchase everything they want—that really would be a utopia— but given their budgets, the market enables them to do the best they can. The only way to improve upon the market outcome is to provide the economy with more inputs, or to take resources from one person and give them to another who needs them more. But the latter type of transfer involves compulsion, which a market system based on voluntary exchange avoids.

The branch of economics that generated these findings is known as general equilibrium theory, and it is often interpreted as providing strong support for laissez- faire. Take the following passage from Microeconomics, a popular and generally first-rate college textbook by Robert S. Pindyck, of MIT, and Daniel L. Rubinfeld, of the University of California, Berkeley: General equilibrium theory, Pindyck and Rubinfeld write, “is the most direct way of illustrating the working of Adam Smith’s famous invisible hand, because it tells us that the economy will automatically allocate resources efficiently without the need for governmental regulatory control.”

A defining feature of equilibrium theory, and the source of its appeal to many economists, is its mathematical elegance. For a hundred years or so, following the publication of The Wealth of Nations, economics remained an informal discipline: most of its major figures expressed their arguments in prose. As the nineteenth century progressed, this began to change. In 1826, in Mecklenburg, in part of what would become Germany, Johann Heinrich von Thünen, a prominent landowner, devised an equation for the rent that land yielded. Twelve years later, the Frenchman Antoine Augustin Cournot invented a mathematical theory of monopoly and duopoly. These were isolated individual efforts. In Britain, in the second half of the century, scholars such as William Stanley Jevons, Francis Ysidro Edgeworth, and Alfred Marshall began to apply the methods of calculus in a more systematic fashion, developing formal theories—or “models”—of how consumers and firms behave, many of which are still taught today.