So there has been a lot of talk that the economic crisis, specifically the housing crising, was a failure of the free market. The housing crisis was definitely a failure but don’t think that what drove it was the free market. In fact a properly functioning free market would have actually prevented it. Also don’t think this is a new problem requiring new theories. There are hundreds of years of economic theory (recognized by no less than 5 Nobel prizes) that predicted and can explain all of this. Allow me to do that in one web page. (SPOILER ALERT: There will be economic terms used but it will be quick, mostly painless but very informative)
Lets first start with the assertion that for any market to work there is the underlying assumption that complete (if not perfect) information is available and that all participants act rationally. According to this article:
Complete information is a term used in economics and game theory to describe an economic situation or game in which knowledge about other market participants or players is available to all participants. Every player knows the payoffs and strategies available to other players.
Complete information is one of the theoretical pre-conditions of an efficient perfectly competitive market. In a sense it is a requirement of the assumption also made in economic theory that market participants act rationally.
Examples of the LACK of complete information in the housing market included:
- Buyers didn’t understand housing market risk.
- Buyers didn’t understand the true mechanics of the financial commitments they were making.
- Banks for giving out “No-doc” mortgages.
- Rating agencies provided bad information on ratings (either via ignorance or straight up fraud).
Without complete information you wind up with information asymmetry:
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry.
Examples of information asymmetry during the housing bubble include:
- The exotic and esoteric financial contracts that emerged. (asymmetry between the bank and the consumer)
- The questionable package of mortgages (loaded up with “no doc” mortgages) that also emerged. (asymmetry between the bank and the investor)
One of the outcomes of information asymmetry is adverse selection:
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which “bad” results occur when buyers and sellers have asymmetric information (i.e. access to different information): the “bad” products or customers are more likely to be selected.
Examples of “adverse selection” almost go without saying but here goes anyway:
- People bought houses they couldn’t afford.
- Most of those “no doc” customers got loans.
- Most of those questionable packages of mortgages were gobbled up by investors.
In short this was NOT a failure of the free market because the free market wasn’t even involved. If a proper free market was involved then there would have NOT been information asymmetry. Without information asymmetry there would have been no adverse selection and hence no bubble.
So what now? Well this is where another term gets misused and misunderstood and that is regulation. It appears to me that most view the term regulation as the way for the government to restrict certain activities so OF COURSE we should be against that (offering certain financial products, limiting speech, telling us what we can do in our bedrooms ,etc..) . I think, however, there is another form of regulation that is far more beneficial and more universally acceptable and that is requiring disclosure/transparency of information (AKA “complete information”). One successful example of this is warning labels on cigarettes. This did NOT restrict usage of cigarettes but allowed consumers to make more informed decisions (and replaced those ads where doctors told you smoking was good for you).
Regulation that provides greater “transparency of information” (e.g. disclosure of true financial costs of mortgages) is clearly a pre-requisite of the free market (see “Complete Information” above) as it prevents information asymmetry and thus adverse-selection.
So in the end the great irony here is that those that are supposedly the proponents of the free-market (fiscal conservatives) also seemed to be the most opposed to regulation (even of the information-transparency kind).
Well they actually do, inadvertently, have one point. Even if you make information readily available, if the general public is not properly educated to consume it, its a waste of paper to print it. So in the end if information transparency is provided it will still be useless without education. If you want to see a good piece on the importance of education then check this out.
