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 😛

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.

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.

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 😛