Does the credit crisis indicate the failure of the “free market”

Matt McCarten was someone I enjoyed listening to when I was a young Alliance supporter many years ago – however, even in the heyday of teenage communist sympathies I would not have agreed with his conclusion that the recent credit crisis is undeniable evidence that voluntary trade does not work.

Now Kiwiblog and Anti-dismal have already gone to task explaining why they don’t believe this is a fair criticism of free trade, and good on them I think they are on the money (David Farrar focuses on why the criticism doesn’t sit well while Paul Walker paints the case for regulation being the cause of the problem – more here). The Hive also mentions dis-satisfaction with his choice of historical comparison. However, even after reading these posts you may still harbour some confusion surrounding the fact that I said voluntary trade instead of free markets.

Ultimately, his criticism of the “invisible hand” draws out something incredibly naive about the point of view that the free market is bad. Supporters of the free market are not so much saying that corporations should be allowed to manipulate information and “defraud” the public as they are saying that voluntary trade among groups is a good thing.

If two people choose to trade, it must be in their benefit and therefore giving people the freedom to trade is an important part of a society – this is what free trade represents.

Now when you think about it, free trade does not imply the absence of regulation, or the absence of government – it merely implies that people can make choices. As David Farrar aptly states:

Free market capitalism is not the total absence of any regulation at all, just as socialism is not the total absence of any markets at all.

This of course stems from the realisation that a sometimes regulation and government can increase individual freedoms. The true question should be, in what ways can government increase individual freedom and propensity. In my Trotskyist teenage years I had a subjective belief that government action was more useful than the current subjective belief I hold – I blame moving closer to government and seeing how it actually functions 😉

Blah blah – but what about recent events?

Recently we have experienced a problem stemming straight from the economics textbooks – bad information was not provided to the market, and so the wrong decisions were made, and now no-one will trust that information.

This is a standard “market failure”. If the government could improve information, then the market participants could trade again (better regulation of the firms providing information on risk could have helped in this regard – if it had occurred many years ago). As they can’t do that they want to jump in and grab a bunch of assets that people are concerned about (namely from these subprime loans). Doing this will allow the market for other assets to function, then when information is revealed (once the default rate on these loans is more obvious) they can sell them back to on the marketplace.

Far from “socialising Wall Street” the goal is to improve information to allow “the market” an “voluntary trade” to continue. This sounds like the sort of market intervention that free market supporters agree with – so I struggle to see how this provides an example of the failures of voluntary trade.

  • This is absolutely no indication that free markets don’t work. This is only an indication that they have been abused, and have not been protected from abusers…which is the only job the government should undertake. A free market can work- but, it needs protection from greed.

  • While some forget or ignore or don’t believe… “free markets” need regulation. They need regulation to protect against negative externalities like pollution. “Too big to fail” is a similar obvious example of capitalist theory requiring regulation to prohibit organizations that are too big to fail – which is just a specific example of a risk to the economy that private market participants want to market to pay while they take the gains.

    I see the problem is in our failure to have those interested in promoting capitalist solutions. Instead monied interest promote policies that provide benefits to their special interests and harm the economy.

    The current failure can be seen as a failure of those that tried to re-interpret “free market” to mean totally free. Those that believe in Capitalism of Smith et. al. though know that markets must be regulated to make the invisible hand work properly (to prevent market manipulation by large players, to regulate negative externalities…).

  • Steve

    The complaint about the bailout is that the government will pay too much for the assets. Yes, there is not enough info at the mo to decide what “too much” is, but still, by buying these assets etc, they are insuring the bad risks that bankers took (and have largely passed on to unlucky investors). None the less, bankers and investors should pay for the bad risks that were taken (or the poor decisions of the managers/bankers that they employed). If they don’t do this, it will fundamentally change the investment landscape because investors can expect a certain level of government intervention for investments gone wrong.

    What should happen is a fundamental change in regulation of these markets to mean more information is provided to investors about the risks involved, and then “voluntary trade” to continue. But banks must be allowed to collapse, or we face a moral hazard.

  • “This is only an indication that they have been abused, and have not been protected from abusers”

    Indeed.

    “The current failure can be seen as a failure of those that tried to re-interpret “free market” to mean totally free”

    I see that as a function of people acting in their self-interest rather than a failure of the concept of the “invisible hand”. People that support free markets all know the potential for market failures – however, Matt seems to view the idea of market failure as a critique of economic policy, when understanding hope to defeat market failure is truly part of supporting “free trade”.

    Fundamentally, I am not willing to let him define free trade as a straw man (like in the free trade vs fair trade debate) that he can use to beat up to sell his agenda.

    “The complaint about the bailout is that the government will pay too much for the assets.”

    Definitely, however I was not aiming to cover the actual bailout in detail here. My one attempt to discuss the bailout was here:

    http://tvhe.wordpress.com/2008/09/24/is-the-us-taxpayer-being-forced-to-surrender-to-wall-street/

    I will try more another time 🙂

    “What should happen is a fundamental change in regulation of these markets to mean more information is provided to investors about the risks involved, and then “voluntary trade” to continue. But banks must be allowed to collapse, or we face a moral hazard.”

    Indeed me do need institutional change, agreed. I also agree about the moral hazard – however, we have to remember that there is a cost to short-term economic volatility, and this cost has to be traded off against the cost of moral hazard for different possible bailout schemes. In sum, there may still be a scheme that increases social welfare – even if it does lead to a small degree of moral hazard.

  • A little nonsense now and then is relished by the wisest men.RoaldDahlRoald Dahl

  • Matt, I have added a short update to the posting A must read for Matt McCarten … and others. In it I say, “The visible hand in economics asks Does the credit crisis indicate the failure of the “free market”. Matt sees the issue as one of asymmetric information, which must be to a degree true. But I’m not sure it is one of the primary causes of the current mess. I think a lot of people knew what they are trading and traded anyway due to the incentives provided by the government or its agencies. So I see the causes as more to do with incentives than information.”

  • Thanks for the link Paul.

    If the primary issue is one of moral hazard (which would be of the factors providing these peverse incentives) then I see no reason for government intervention – given that the cost stems from messed up expectations that have to adjust and optimal market action (although there could be a role for “smoothing” the economic cycle – given that there is a cost from volatility).

    If there was no problem with asymmetric information, we wouldn’t need a bailout – as the loan market would still be functioning (providing loans to good quality clients). The asymmetric information problem is the one that prevents the loans to these clients and thereby indicates that we may “need” a bailout (or else firms may not be able to keep cashflow going and may be forced out of business even though they are profitable).

    The asymmetric information is the primary driver of the current market failure – even if it isn’t the main driver of the collapse of the finance industry. At least, that’s how it works in my head 😛

  • “If there was no problem with asymmetric information, we wouldn’t need a bailout – as the loan market would still be functioning (providing loans to good quality clients). The asymmetric information problem is the one that prevents the loans to these clients and thereby indicates that we may “need” a bailout (or else firms may not be able to keep cashflow going and may be forced out of business even though they are profitable).”

    I would argue that the reason we have gotten into the mess we have isn’t because the loan market failed to operate, the problem was it operated under a set of incentives that resulted in loans being given in situations where they shouldn’t have been. But people knew about the loans they were making but made them anyway. As Jeff Miron put it

    “Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.”

    The current the current credit freeze is likely due to Wall Street’s strategic actions. They hope for a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

    I guess I see this as more of a government failure than a market failure.

  • “I would argue that the reason we have gotten into the mess we have isn’t because the loan market failed to operate, the problem was it operated under a set of incentives that resulted in loans being given in situations where they shouldn’t have been”

    I am definitely not disagreeing with that. However, when I am talking about the “socialising of Wall Street” the issue of what caused the problem is not what I have in mind – the issue of what could be a welfare optimising solution in the face of this crisis is what I am trying to cover.

    The current seizing up of credit markets is partially the result of asymmetric information regarding the quality of assets, and partially the result of, as you say, firm behaviour in the face of expected government action. Both of these factors prevent private firms from achieving what the bailout could. Optimal government action differs in both cases, however in both cases it would involve less government (and taxpayer exposure) than we will actually get 😛

    Ultimately, I completely agree that we want prices to adjust and the real value of assets to be found out, and firms that are not able to function in a market with credit that is “too loose” should be allowed to go bankrupt.

    However, another welfare consideration is the variability of economic conditions. Even if there is a long-run efficiency cost associated with some type of bailout it may be welfare optimising if it smooths the transition in the US economy. I get the feeling that the optimal level of government involvement would be lower in the optimal case than it is going to be sure, but even if it was the governments fault that we ended up in this crisis does not mean there is no role for them in improving outcomes given the crisis has occurred.

  • Kimble

    The US is a messed up place. I didnt realise until recently that the idea of charging different people different rates of interest depending on their credit worthiness is controversial!

  • That government is best which governs the least, because its people discipline themselves.ThomasJeffersonThomas Jefferson

  • “The US is a messed up place. I didnt realise until recently that the idea of charging different people different rates of interest depending on their credit worthiness is controversial!”

    Indeed. You would think that the country with the most illustrious economics schools in the world would have a good level of economic advice and education – however, it seems not 😛

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