The Financial Meltdown and Market Failure

Many people who weren't terribly fond of the free market to begin with have, predictably, been pointing gleefully to the recent meltdown of the financial sector as incontrovertible evidence that free-market economics has failed and that we need much more government regulation. And some more government spending and higher taxes, while we're at it.

This suggests to me a considerable degree of confusion regarding how markets work, when they don't, and when we can expect government to do better. Hopefully I can shed a bit of light on these issues.

Market failure is a real phenomenon. But it's a phenomenon that's fairly well understood. Markets tend to fail in predictable, well-defined ways. Specifically, they tend to fail in situations where people have an incentive to act in ways that produce large negative externalities, or lack incentive to act in ways that produce large positive externalities.

Pollution is an obvious example of the former; if I can make $1 of profit for every $5 worth of pollution damage I generate, I might as well do it, even though the net social value is negative*. Innovation is an example of the latter. Without patent protection, I have very little incentive to innovate, especially if it requires expensive research.

Another way markets can fail is imperfect information, but this is somewhat overhyped. Because information is valuable, markets tend to provide ways for people to get the information they need to make important decisions (e.g., reviews, third-party auto inspections, etc.).

Now, it's worth noting that market failure does not necessarily imply that government intervention is a good idea**, because government failure is also a real phenomenon. It's also a much more general phenomenon than market failure. For a variety of reasons (uninformed voters, public choice, dispersed costs/concentrated benefits, etc.), democratic governments tend not to do much of anything very well. Yes, I'm sure that you have all kinds of great ideas for improving on market outcomes. Those aren't the policies that will actually get implemented by a democratic government, though.

However, in those rare cases where externalities cause markets to fail spectacularly, democratic governments may actually be able to do better.

Which leads us to the mess we're currently in. Usually a market failure involves a bunch of really smart people totally screwing the rest of us over because they don't have any incentive not to, and laughing all the way to the bank. This is where more regulation could, in principle, come in handy.

But that's not what happened. This time, a bunch of really smart people acted in ways that were—in retrospect, at least—very clearly contrary to their own self-interest. And in the process they ended up screwing themselves over. If you're not confused by this, you're either better informed than I am (and I humbly request that you enlighten me with a comment), or you're not paying attention.

When a bunch of a really smart people fail to look out for their own self-interest, this isn't something that can obviously be fixed by more regulation. Politicians and bureaucrats aren't any smarter than the people on Wall Street. And they clearly don't have nearly as strong an incentive to prevent financial institutions from going broke as do the people whose money is actually on the line.

Is there really any evidence that Democrats would have prevented this if they'd been in power? My guess is that their actions would have been limited to grandstanding about executive pay and demands that banks make even more questionable loans to poor and minority borrowers. With the benefit of hindsight, it's easy to pass regulations to stop what went wrong from going wrong again, but the regulations that actually get passed are likely to be a mix of pointless (because the banks already know better) and harmful (because, again, democratic governments tend not to produce very good policy).

I honestly don't know what went wrong. I've been hearing rumours of what struck me as blatantly irresponsible lending since 2005 at least, and I don't understand why anyone would have purchased mortgage-backed securities in the last few years without thoroughly vetting them. My first suspicion, when I hear of people acting contrary to their own self-interest, is some mix of government regulation, subsidies, and political pressure—and I gather that there was some of that going on with Fannie Mae and Freddy Mac, at least—but I just don't know the whole story. And I doubt very much that those rushing to assert that the problem was too little government know the whole story, either.

*Actually, this isn't necessarily true; we've left consumer surplus out of the equation. If in addition to my $1 profit, I generate $5 in cosumer surplus, then the net social value is positive.

**I refuse to get involved in a discussion of IP here, but I'll grant that positive externalities are not a slam-dunk argument for patent protection.

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Brandon, I suggest reading

Brandon, I suggest reading this analysis of the banking crisis from late 2006 ( http://commentlog.org/bid/4412/An-Analysis-of-the-2008-financial-crisis-written-in-2006 ). It's technical but well worth reading. From the perspective of 2006 he explains why the banks are taking such big risks, and makes some guesses about what the Fed will do when the whole thing blows up. It's perhaps the most brilliant thing I've read about the crisis, and all the more brilliant because it was written before the crisis actually happened.

Dime a dozen

Devin,

The problem was already unfolding in the late 1990's. One could see the signs of a monetary inflation back then. The internet bubble was obviously just that and I don't remember how many articles I read that were disparaging of Greenspan's "New Economy", the trade deficit, the price/earning ratios, the Greenspan Put, etc. There were lots of them however.

Also, when the Fed lowered rates to unprecedented levels after 2001 there was plenty of talk about how that was a very bad idea and would only exacerbate the problem, how the housing market was in a bubble, about the inability of rents to support the current levels, about the underreporting of inflation, etc.

I became so concerned I wrote my companies CEO, and CFO, and urged them to allow other options in my 401K. I named exactly the problems that later turned out to be true. We were indeed running the economy in bubble mode.

Such articles were a dime a dozen. Unfortunately the other kind of articles, the one's praising Greenspan, were a penny a gross.

Democrats were in power

The credit crisis/housing bubble has been brewing for decades. Democrats have been in power much of that time. Part of my beef with Republicans is their failure to loudly point out how much government action over the years has laid the groundwork for our current problems. You'd think the party of limited government would have been all over it.

We have a party of limited government?

Well, I'm sure a major party of limited government would have pointed out these problems, but we don't really have one of those. Have you seen the stats on government spending during the Bush/Republican congress years? They don't look like a party of limited government to me!

Or possibly the really, really, smart people who own the

politicians knew exactly what they were doing and did it on purpose.

Not against self interest

"But that's not what happened. This time, a bunch of really smart people acted in ways that were—in retrospect, at least—very clearly contrary to their own self-interest. And in the process they ended up screwing themselves over. If you're not confused by this, you're either better informed than I am (and I humbly request that you enlighten me with a comment), or you're not paying attention."

How is getting bonuses and pay raises in the tens to hundreds of millions of dollars against their interests?

The people responsible for the mess, the Barney Franks, the Herb Moses, The Paulsons, the Greenspans, the Madoffs, the Raines, the Grassos, etc. They all made out quite well on this.

Short term incentives never align with long term ones when you have fractional reserve banking and central banks. It's especially true when you have fiat currency on top of that.

You aren't distinguishing long term interest from short term interest. You say, "clearly contrary to their own self-interest". How's that? If these "really smart people" didn't see the bubble and the end result then it wasn't clearly against their self interest. If on the other hand they saw the writing on the wall, that there were bad incentives in place that would lead to disaster, and they wanted to make a quick buck with other peoples money, then how was that "clearly contrary to their own self interest".

It's been pointed out by Austrians that when there is monetary inflation there is no strategy for business people to isolate themselves from the consequences. They just have to go along for the ride. If they try to act "sensibly" they will be out competed during the boom phase, and potentially put out of business.

How many of the bear investors during the boom phase made the kind of money the bulls did? None. Even though guys like Bill Fleckenstein and Peter Schiff were precisely on the money about the sham economy they aren't the ones rolling in money. It's the guys who got to be heads of companies based on exploding their earnings, and running the companies into the ground that got rich.

Austrians live in a dream world

Austrians refuse to admit that prior to WW2 half of all Americans and Canadians lived in poverty. Half of all Americans didn't have electricity or indoor plumbing - or had to share a bathroom with two dozen other people.

>It's been pointed out by Austrians that when there is monetary inflation there is no strategy for business people to isolate themselves from the consequences.

Yes, there is. Businesses can borrow money to buy machinery or whatever and pay the loan off with cheaper money. The people who are hurt are those who don't work for a living but live off interest payments and clip bond coupons.

Further, moderate money inflation is meaningless to the guy who punches a time clock. All he (should) care about is how many hours does he need to work to pay the bills and buy stuff. Thanks to increased productivity almost every consumer good is MUCH cheaper than it was before WW2 and before we went off the gold standard. The only things that cost more require personal service.

Houses and doctoring would also be be cheaper that in the 1940's if people were satisfied with 1940 or 1950 houses and doctoring. Half the cost of new housing is due to zoning and eco rules.

You Live in a World Ignorant of Austrian Economics

Bill,

"Austrians refuse to admit that prior to WW2 half of all Americans and Canadians lived in poverty."

Really? So you have a quote from Austrian economists where they deny that things were bad during the great depression? If so, I've never heard it, and it's completely contradictory to what I have read them write.

You do realize that Murray Rothbard wrote an entire book on the period of the Great Depression. I'll let you know that it wasn't full of stories about the booming economy.

Where do you get off spouting nonsense like this?

Furthermore, Keynesian policies are what they are regardless of who is practicing them, even before Keynes. History is replete with attempts to fix fractional reserve monetary deflation via debasing the currency. Even back when everyone was poorer (due to the fact that technology hadn't advanced to current levels, and/or the US was not in the position after WWII where all other industrial nations were bombed to hell).

You are confusing causes and their proper effects, causes with other causes, and effects with other effects, because economies are not controlled experiments.

"Yes, there is. Businesses can borrow money to buy machinery or whatever and pay the loan off with cheaper money. The people who are hurt are those who don't work for a living but live off interest payments and clip bond coupons."

Your response just shows that you have no idea what the Austrians have to say on the subject. Their theories are much more sophisticated than you imagine.

During the boom phase, as fractional reserve banks lower reserves and interest rates drop, businessmen are forced to go with the flow because the price signals drive them that way. Businessmen must follow the price signals because that's how they gain profit to continue in business.

As an example, if the government sets a price ceiling on gasoline, and a price floor under oranges then businessmen will have to over produce oranges, and under produce gasoline to make a profit. The producers, and consumers both cannot coordinate any longer. With price ceilings the consumers over-consume, and producers under-produce.

Interest rates are just another kind of price. When the government sets the interest rate below market it is in fact setting a price ceiling. This will cause dis-coordination in the market. In this case, over-consumption = over-borrowing and under-production = low savings.

Not only that, but interest rates are a special kind of price. Interest rates reflect the "time cost of money", the willingness to spend now vs. save for future spending. A ceiling on interest rates causes producers to plan too much future consumption, and consumers to plan too much current consumption. It distorts everyone’s plans regarding now vs. the future.

Low interest rates tell consumers not to save, and thus they consume more than they otherwise would while producers see increased future profits in long term building plans. Some goods, like houses are both consumed now and in the future. In a sense a house buyer is both a current consumer and a future speculator in housing. Low interest rates cause such people to over purchase. Likewise pure producers of houses also get a signal to over build.

If the expansion in money supply was due to a lowering of reserves, then well that has to tail off. As it does, the interest rates can no longer drop (or in the case of the Fed it cannot lower below 0 percent). When you hit that wall then the error becomes exposed by a termination in the rise in asset prices. Then things are no longer profitable.

So as I said there are no strategies for business people to shelter themselves from these problems. You claim: “Yes, there is. Businesses can borrow money to buy machinery or whatever and pay the loan off with cheaper money.”, but that, as Constant says, is a half baked theory. Machinery is not consumed in one lump. It’s durable and is used over a long period of time. The loan is paid off by using the machinery. Tell me how a carpenter is going to pay off the loans for that new band saw, chop saw, etc. when the housing market collapses? How is that extra bulldozer the excavator bought to meet the excess demand for excavating basements going to pay it off with no housing going up?

The problem with fractional reserve banking, and central banking, and government set interest rates, is that they all can cause interest rates to fall below true market rates. This causes, not over production in general, but overproduction in goods that are far away from consumption. The businessmen are tricked into investing in the wrong areas. What Austrians call, malinvestment.

You perhaps are thinking about fiat currency, and the idea that future money will be cheaper because of that. However, in a non-fiat environment the fractional reserve deflation makes the money dearer, not cheaper. Furthermore it is an extremely rapid phenomenon. Something that fiat inflation is hard pressed to keep up with. There are two different factors here. The recent rise in commodity prices was mostly due to leveraging up via fractional reserve and other methods. That’s why they dropped so fast as people de-leveraged.

Sure you could make it so that the businessmen doesn’t have to pay as much back via cheaper money, but that is a different mechanism. It’s not correcting the actual problem but substituting a different one. This will not help in correcting the malinvestments at all. In fact, what it does is push the market in the same direction. It again requires pushing the interest rates below market.

Do you think that the correct response to a price ceiling on gas, causing a gas shortage, is to lower the price ceiling?

The end result of an attempt to make up for the rapid fractional reserve deflation caused by de-leveraging can only be rapid fiat inflation. What non-Austrians fail to recognize is that that money has to be injected somewhere first. You claim the businessmen will somehow become whole by this new money, but that’s true only to the extent they get any, and to the extent they are first to get it rather than last. They may be out of business before prices rise enough, in general, for it to affect their market.

This ignores the fact that the fractional reserve run-up has already inflated the long term goods prices that were over-invested in by businessmen. Those are exactly the last prices that will tend to raise more if we open the gates to fiat monetary inflation. Who is going to want to build more houses in this environment?

In fact, the artificially low interest rates increased the total housing stock above the original levels from before, so actually prices should be lower than before the fractional reserve inflation. Suppose that the businessmen had not been building based on the false signal of low rates and artificial demand. Suppose instead they had just built all the extra houses on a whim. Then the extra housing stock, given no increase in the money supply would housing prices to DROP. That is why when the fractional reserve inflation reverses from boom to bust, with no increase in base money supply we expect housing to drop even below the starting prices.

If before the fractional reserve inflation your house was worth $250,000, and at it then peaked out say at $500,000, then when the bank reserves are brought back into balance by raising them, and the quantity of money falls back the level they were at when your house used to be $250,000 then the new price will be lower, like $150,000. How far it goes down, depends on how long it was raised and therefore how many extra houses were built.

The amount of fiat monetary inflation needed to make up for this is impossibly large unless you want to go the way of Zimbabwe. Did you see how fast commodity prices dropped? Do you see the way housing prices are dropping, despite the enormous quantity of cash, base money, being injected into the system?

The extra fiat money injected is going to drive other prices up first, short term consumer good prices. Also since long term goods are spread over longer periods than short term goods there is a multiplier factor. My housing consumption is spread over 30 years when I take out that loan. Short term consumption by definition is over shorter time periods. Thus to maintain my long term goods price I need to increase the quantity of money in a way that is going to effect short term goods by a higher factor.

The way this plays out is that inflation is a factor in interest rates (along with the time cost of money, and risk payments). As prices rise and inflation becomes apparent the lenders will ask for a higher interest premium to make up for inflation. This will mean that the fraction of money from a loan repayment going to businessmen who build houses will go down. People won’t be able to even afford the houses they did before with the same payments.

It’s going to be impossible to make the businessmen who were deceived by government interference in the economy whole again. Impossible. Cheap money, or not. This is because the cheap money isn’t going to even go to the businessmen that over-invested in the areas where the government distorted price signals.

Where the money is going to go, because Keynesians are in charge, is to government friends, their employees, people who bribe [a.k.a. contribute to] politicians, etc.

”Further, moderate money inflation is meaningless to the guy who punches a time clock.

Austrians aren’t complaining about moderate monetary inflation. Which is shown by the fact that they are not against mining gold in a gold based system. The Keynesians on the other hand are against moderate deflation caused by productivity increases, which are also meaningless to everyone, and not just the guy who punches a time clock.

What the Austrians are concerned about is many different issues: 1) Fractional reserve monetary inflation. 2) The potential for fiat monetary inflation. 3) The political forces that inevitably come into play to drive number 1) and number 2) up. Forces applied by businessmen as well as the average Joe.

All he (should) care about is how many hours does he need to work to pay the bills and buy stuff.

Exactly, and even without moderate monetary inflation, even with a fixed amount of money, increased productivity means that prices fall faster than wage rates.

Thanks to increased productivity almost every consumer good is MUCH cheaper than it was before WW2 and before we went off the gold standard.

No thanks to going off the “gold standard” [not that we were on a true gold standard]. I’d prefer to call this, going fiat. Richard Nixon put us on full fiat, not FDR. We were on a partial gold standard prior to Nixon. The same trend of productivity increases was already happening long before FDR. The cause is NOT fiat money.

The only things that cost more require personal service.”

Why, mention this? You though it was my only counterpoint? You so failed to comprehend Austrian position that you didn’t see that this is moot.

Houses and doctoring would also be be cheaper that in the 1940's if people were satisfied with 1940 or 1950 houses and doctoring. Half the cost of new housing is due to zoning and eco rules.

Now you are living in fantasy land if you are trying to argue that fiat monetary increased since the 1940’s haven’t caused price rises. What’s better an old house or a new? There are people who bought entire houses for a few thousand back in the 1940's, that can’t be had now, the same exact house but older, for less than hundreds of thousands.

When I was a kid you could get a candy bar for 5 cents. Believe me chocolate hasn't gotten any better.

This post

Brandon,

You may be interested in reading some of my many posts regarding subprime lending. This post will provide access to most of the links on this subject from my perspective (I was employed in the mortgage industry for over 15 years).