How Would the Market Deal with the Mortgage Mess?

I have been on the road much lately and unable to blog. However, some weeks ago we received this excellent question in our comments section.

"We have just discarded two government subsidy solutions to the housing market/bad loan mess we now have. Is there a politically viable alternative that conforms to free market principles? So far, free market ideas on how to deal with these toxic assets has been seriously lacking."

First of all, I will point out that markets are not perfect; they are—after all—made up of people, which can cause them to swerve too far up or too far down in much the same way a mob may stampeded this way or that (for an excellent analysis of this phenomenon I would recommend Charles MacKay’s Extraordinary Popular Delusions and the Madness of Crowds). Despite these sometimes dramatic swings, market price trends are still the best way to collect widely dispersed information about supply and demand to effectively allocate society’s scarce resources. The problem with the current mess was that government institutions were effectively cheering and prodding the mob on, which made it swerve entirely too far in the wrong direction, when it might have otherwise turned back to sanity earlier.

Sadly, I muss confess that there is unlikely to be a politically viable alternative to this happening again. Both parties cheered the expansion of home ownership and were even joined by strong free-marketeers (the latter felt the creation of an “ownership” society would advance the cause of markets and that too much housing was a relatively minor evil when compared to most other subsidies)). In a broad sense, the crisis has not shifted the government’s paradigm—the government is still pressing banks to loan money to the un-creditworthy (indeed, the threat of legal action or community pressure caused many a bank to lend to those with both poor incomes, poor prospects, and little collateral). Having been badly burned by doing just this, the banks are decidedly reluctant. Like with our wandering mob, the pressing momentum of the human beings making up the market are now carrying the mob far in the opposite direction. The free market approach to this mess would have been to first not create the conditions that caused it, and, second hold accountable those foolish enough to lend and borrow. Markets are fantastic at punishing those who make bad decisions, but this involves letting those who made bad loans fail. When economic resources have been misallocated by market manipulation, the only way to ultimately fix the problem is to pull these resources apart (companies, capital, and people) and allow them to find where they can create the most value for society. Unfortunately, this is often a very painful process and must be endured for the restoration of long-term prosperity. If the government had allowed the banks and other large firms to fail, then the short-term pain would have been significant, but it would have been just that—short-term—and emerging from the mess would have been a stronger economy built on a solid foundation for a renewed march forward. This is why free market proposals to toxic assets has been lacking, because the free market approach to such assets would be to do nothing and treat these assets as the worthless scraps of paper that they actually are.

Comments

[Kevin Cassidy]

Alastair,

Like so many, I've been watching this issue closely. I accept and agree with what you say about letting those who made bad loans fail, but I wonder if there is a "true zero" with the economy - a state from which markets are unable to recover in terms acceptable to the people therein.

What would have been a level too far? The collapse of Wall Street? Of these United States? We were told several institutions were "too big to fail"...is there a point of pain beyond which the free markets would have us go that we would find unacceptable? What is the answer in such a situation?

Just trying to think that, if political means are going to exist and influence free market thinking, how do we account for it when it does lead to situations like this.

[Kevin Cassidy]

One place I am still having trouble finding where Decision Rights fit in the global economy is the environment. This NYT article captures that sentiment:

http://www.nytimes.com/2009/07/30/us/30iht-letter.html?_r=1&emc=tnt&tntemail1=y

What would correct assignment of environmental decision rights look like?

[Ben]

Kevin - Market-Based Management attempts to understand the models, institutions, etc., that make free societies so prosperous and appropriately apply them in a beneficial way within the firm. To apply an MBM dimenion like Decision Rights to some issue in the broader society might not be the most appropriate approach.

I would think we'd want to look at how Property Rights and other concepts that work so powerfully well in free societies could be better applied in the face of environmental issues.

For example... in society, those who OWN things tend to take better care of them - we like that beneficial aspect of ownership... but you can't just bring private property into the firm - employees don't OWN assets inside the firm. We want to find ways to apply the benefical aspects of ownership without literally bringing private property mechanisms into the firm.

However, we very well might recommend paying closer attention to those concepts in the various areas of society where we are struggling. I'm certainly no expert there and others could more intelligently comment (see for example, http://www.perc.org) - but I do want to avoid the mistake of applying MBM to societal issues - there are more appropriate models and tools for that.

Cheers.

[Ben]

As a follow on to my comments - the analysis of societal isses and their potential "solutions" is better addressed in our Science of Liberty framework, from which MBM derives (if that's the word).