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.
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