From Project Syndicate:
Adam Smith famously wrote of the “invisible hand,” by which individuals’ pursuit of self-interest in free, competitive markets advances the interest of society as a whole. And Smith was right: Free markets have generated unprecedented prosperity for individuals and societies alike. But, because we can be manipulated or deceived or even just passively tempted, free markets also persuade us to buy things that are good neither for us nor for society.
This observation represents an important codicil to Smith’s vision. And it is one that George Akerlof and I explore in our new book, Phishing for Phools: The Economics of Manipulation and Deception.
Most of us have suffered “phishing”: unwanted emails and phone calls designed to defraud us. A “phool” is anyone who does not fully comprehend the ubiquity of phishing. A phool sees isolated examples of phishing, but does not appreciate the extent of professionalism devoted to it, nor how deeply this professionalism affects lives. Sadly, a lot of us have been phools – including Akerlof and me, which is why we wrote this book.
Routine phishing can affect any market, but our most important observations concern financial markets – timely enough, given the massive boom in the equity and real-estate markets since 2009, and the turmoil in global asset markets since last month.
As too many optimists have learned to their detriment, asset prices are highly volatile, and a whole ocean of phishes is involved. Borrowers are lured into unsuitable mortgages; firms are stripped of their assets; accountants mislead investors; financial advisers spin narratives of riches from nowhere; and the media promote extravagant claims.
But the losers in the downturns are not just those who have been duped. A chain of additional losses occurs when the inflated assets have been purchased with borrowed money. In that case, bankruptcies and fear of bankruptcy spawn an epidemic of further bankruptcies, reinforcing fear. Then credit dries up and the economy collapses. This vicious downward spiral for business confidence typically features phishes – for example, the victims of Bernard Madoff’s Ponzi scheme – discovered only after the period of irrational exuberance has ended.
Epidemics, in economics as much as in medicine, call for an immediate and drastic response. The response by the authorities to the Great Crash of 1929 was small and slow, and the world economy entered a “Dark Age” that lasted through the Great Depression of the 1930s and the Second World War. The 2007-2009 financial crisis portended a similar outcome, but this time the world’s governments and central banks intervened promptly, in a coordinated fashion, and with an appropriately high volume of stimulus. The recovery has been weak; but we are nowhere near a new Dark Age.