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September 26, 2008

Did the market fail? Or did the response fail?

Sure, investment-worthy organizations can’t raise funds in the market today and that indicates a failure. But let’s think of the market as a patient and consider what the patient has been saying in the months leading up to the crises.

An example of the patient showing a symptom is the “TED spread” (the difference between the rate banks use to lend to one another and a risk-free rate). From August 2007, it has been growing dramatically – sending a clear message that financiers weren’t very comfortable lending to one another. Banks also became less willing to offer alternative mortgages, as they were having a hard time finding interested investors. They began to assess risk differently on all types of mortgages.

So, perhaps the market did not fail. But rather the regulatory system failed to react appropriately to the rational conclusion the market came to at the end of last year: it was a problem of valuation. The pricing of mortgage risk became difficult as housing prices kept slipping. As an investor it was hard, if not impossible, to price some of the bundled mortgage products in an environment in which there was no housing price stability.

If you buy my theory that the patient’s illness was a valuation problem, what should have been the role, if any, for the government at that time? The Fed slashed the fed funds rate a whopping 325 basis points from September 2007 to January 2008. But it didn’t seem to stem the tide of bad economic news.

In 2007, former Governor Mishkin wrote a very interesting paper on the topic of Monetary Transmission (the process by which monetary policy affects the real economy) and the Housing Sector. He wrote:

Uncertainty about housing-related monetary transmission argues for humility on the part of monetary policy makers regarding our understanding of the monetary transmission mechanism generally and the appropriate settings of monetary policy instruments.
You can link to the entire paper here. What are your thoughts on our patient?

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Posted by Cindy at 11:40 PM | Comments (6) | TrackBack

September 19, 2008

Markets Fail

By Wade Rousse

It was announced yesterday that the government is working on an intervention plan to unfreeze the credit markets. Is it justified? Most economists believe that if markets are left to themselves (no government intervention) the invisible hand of market forces will result in efficient outcomes. Therefore, value will be created. However, is this always the case? Even the most conservative free market economist would agree that in theory a free market can fail.

There are four major factors that can lead to a market failure:
(1) Lack of competition.
(2) Externalities.
(3) Public goods.
(4) Poorly informed buyers and sellers.

(1) Competition prohibits buyers or sellers from rigging the market in their favor.
(2) Externalities exist when property rights are unclear or unenforceable. An individual or a group’s action may “spill-over” onto others and affect them without their consent.
(3) Public goods are those that are automatically and simultaneously available to all consumers as soon as they are provided to one. Public goods typically benefit all consumers, even those who can’t pay for them. A good example of such a public good is national defense.
(4) If information about a product is costly to obtain or difficult to evaluate, people often make poor choices.

Any of these four can lead to a market failure and subsequent government intervention, which, theoretically, could bring about a more efficient outcome. So I’m just curious, which one of these factors best explains yesterday’s announcement of a new government plan in the works to “fix” the frozen credit markets?

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Posted by Wade at 9:04 PM | Comments (7) | TrackBack

September 12, 2008

Moral Hazard

By Wade Rousse

I’m hearing the TV pundits use the term moral hazard a lot recently in discussions about the government intervention with Freddie and Fannie.

In economics class, moral hazard is usually introduced during discussions about insurance. Hal Varian offers a good example in his textbook. It involves bicycle-theft insurance. If a person buys an insurance policy that completely reimburses him or her if the bicycle is stolen, that person might start leaving the bike unlocked. The lack of incentive to protect the bike is called moral hazard. The point is that people with some form of insurance might take greater risks because they know they are protected. This can result in more claims for the insurance companies. Too much of that and the companies could go bankrupt.

The TV pundits are screaming that the government intervention to rescue Freddie and Fannie is creating an enormous moral hazard problem. They argue that the managers of these institutions, realizing they do not carry the full burden of potential losses because of the government intervention, might continue to engage in risky lending practices that could offer higher returns (or again, result in tremendous loses) . The managers might be especially motivated by the hefty bonuses that can accompany these potential higher returns.

What do you think?

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Posted by Wade at 8:00 PM | Comments (6) | TrackBack

September 5, 2008

Economic Indicators as Proxy for Election Polls?

One of the first things you learn in an economics class is that it’s all about the distribution of scarce resources.

On the first day of class, I always ask students to think about a scenario in which the owners of the Chicago Cubs gave tickets away instead of selling them (for $45 to $100+)? How would those tickets be distributed? Would this be more fair? For example, if the Cubs announced a “Give-Away-Day” in the middle of a workweek, would that be fair to those with school-age children, people who work during the day or to those who don’t live in the area? In addition, what would prevent a ticket re-seller from hiring hundreds of people to stand in line, so that s/he could reap the profits on re-sale?

You get the point. There is no perfect way to distribute scarce resources. Economics teaches about the role of competition and how market mechanisms work to efficiently distribute resources.

So, what does this have to do with the upcoming presidential election? Well, think of government as a major player in the distribution of scarce resources, especially as it relates to public goods. The two candidates have different ideas about how the government should distribute scarce resources and voters across the country are likely to cast their ballots based on the degree to which the ideas appeal to them.

From www.Economy.com (Dismal Scientist), the map below illustrates the different economic situations of each state. Looking at the map, it is interesting to think about how the citizens of each state may take their economic situation into account as they evaluate the candidates’ proposed distribution of resources. What do you think – should we follow-up this posting after November with a comparison? Look up specific stats by zip-code or metro region at Dismal Scientist’s www.economy.com/dismal/pro/data/geo_profiles_new.asp


By: Cindy

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Posted by Cindy at 11:31 PM | Comments (0) | TrackBack