September 19, 2008
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.
(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?
Posted by Wade at September 19, 2008 9:04 PM
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The intervention from the government seen over the past few days is unjustifiable. This not a market failure, it's in fact quite the opposite. The market is trying to correct the failed system central banking and government intervention in the market.
In a very concise version lets consider how that intervention contributed to the failure through those(4) "market failure" factors mentioned above.
(1) Lack of competition? - Absolutely
But the lack of competition does not apply to the credit markets - it applies to the fact that the Federal Reserve holds complete monopoly over the supply of money in our economy. This system exists only due to legal protection and privileges the FED holds on creating the money.
With the ability to issue money backed by nothing, the fed can manipulate the prices of borrowing and investing, or the interest rates. Keeping the rates below the market rate will cause excess borrowing, excess investment flow into markets suck as the housing market or equity markets. That excess investment puts in motion free market forces by changing future expected risks and returns and thus the bubble is created. When it becomes clear that those expectations were based on illusion (money created out of thin air) the bubble bursts. The market is just trying to liquidate the bad investments so it can free up capital for new and worthy projects. This is the underlying reason why the banks should fail.
(2) Externalities - YES
The FED neglects the external effect of injecting the money into the economy. Those externalities being: creation of bubbles, loss in value of the dollar, inflation. The central bank cannot calculate the long run harms (or benefits) of it's policy on regular people, harm being inflation tax and damage to dollar. Sure the policy props up the market in the short term (as we saw this week) but the full effects aren't felt till later, and it just so turns out that regular people like you and me and the ones losing the most by paying higher prices (and hoping for a higher wage)
(3) Public Goods - I want to say NO
I don't see it play role here. In general I do see some connections to externalities, govn't internvetion and there are ways the market accomodates this but I don't want to go into it.
(4) Poor infoed buyers/sellers - I say YES
I never bought into the "perfect information" assumption for efficient markets. Seems to me that all information has a cost (ex. time) and a benefit that ties to other choices( making a better informed decision regarding the future).
Surely a problem can arise if someone gets an unnatural monopoly on information. Do countries and governments try to restrict what info should and should not be available, what should and should not be taught? I think so since they have the power to do it. Take away the power and the problem is fixed (I hope).
So to answer your final question, "which one of these factors best explains yesterday’s announcement of a new government plan in the works to “fix” the frozen credit markets?" I will say (4).
It's just another attempt to prolong the inevitable and hide the fundamental problems; to let people think things are fine, the system can continue. But as the market unwinds / liquidates and affects more people, those people will seek answers. Well informed citizens would never allow for the system to exist in the first place so lets hope they will find some answers! If you do have those answers, it's your individual responsibility to inform others.
Thanks professor Rousse!
Have a nice day all!
Posted by: Your challenging student at September 20, 2008 6:24 AM
The market failed because buyers and sellers had private information. As a buyer of credit, I know more about my ability to repay the loan and my motives for obtaining credit. My actions spillover onto others. The market fails anytime there's asymmetrical information.
Posted by: Mike Fladlien at September 20, 2008 5:08 PM
Challenging student, although it appears we fundamentally disagree. I’m excited to see that you are thinking through, and arguing, your economic viewpoints. This makes me very proud.
Posted by: Wade at September 20, 2008 6:06 PM
we must consider the cost of allowing the market to "fail" In other words the cost of the bailout could potentially be less than the cost of banks with very little reserves to loan out. After all the man developing this plan specialized in the Great Depression, we should probably listen to him. There are very complicated and historic things happening.
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