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The world according to economics: a market problem

July 25th, 2008 · No Comments

Have we hit bottom last week. We are fairly sure we haven’t, but the SEC move against naked shorting in some of the financials was a clever move (that should be extended). We still think the housing market is key though, and it doesn’t look like an improvement is on the way any time soon.  There is a fundamental problem at work.

We argued for the oil market that the prices had increased enough to start having serious impact on demand, changing behaviour (trains have been a good investment, Detroit carmakers a terrible one, this gives you an idea).

That housing market. Foreclosures are still growing, they’re now up 121% on last years. Funny enough, this might very well positively influence home sales and so give a false positive on the housing market. This is because foreclosed houses are auctioned off and are likely to be sold way below current prices.

Which, in fact, does show that there would be a price at which buyers will start to reappear. But it also shows that such prices are quite a bit lower than those in the market today. The price mechanims does work, but it works slowly.

Apart from foreclosures, it’s not the instant price adjustment one reads about in those economic textbooks. It’s one more example of real markets, versus the imaginary abstract ones of the neo-liberals, and it’s the latter’s complete contempt for the need for regulation of markets that got us in this mess in the first place.

Modern life has become so complex, knowledge so specialist, that a problem called asymmetrical information is becoming ever more rife. This means that in many more transactions, one party is likely to know much more than the other, and that knowledge advantage becomes liable to being exploited.

This is what largely happened in the sub-prime market, on more than one front. People were suckered into mortgages which they couldn’t really afford, which consequences they did not fully understand, under the ideology of the ‘ownership society‘, which argues that you only become a full citizen if you are the master of your own house.

Another piece of ideology wrong-footing people was the idea that house prices could only go up. Banks were selling these mortgages because everybody else was doing it and if it would go wrong, they wouldn’t have to face all the consequences as the risk was, as we put it before, put in a blender and the resulting confetti spread over almost the entire financial system (including quite a few abroad).

That’s asymmetrical information wrecking havoc twice. And there are people who won Nobel prizes for pointing this out, it’s not that it’s an unknown problem. It’s pervasive. If you go to a doctor, he’s likely to know a lot more about disease than you. If this would be a free market, that information disadvantage could be very, very detrimental to your health (and in parts were it is free, there are plenty of examples of that).

So, you need officially vetted doctors with officially vetted diploma’s (that’s regulation, by the way. Any neo-liberals objecting to this?). How else would you be able to distinguish a real one from just someone calling himself doctor?

And even then, how are you going to distinguish a good doctor from a bad one, a good lawyer from a clown, etc. etc.. When you start thinking about it, the asymmetric information problem is rife.

In the 19th century, food poisoning was rife (in many poorer countries it still is, notwithstanding the fact that the more unsanitary conditions also have a tendency to increase resistance to bacteria).Until the state set sanitary standards, the problem was not really contained.

The market has ways of dealing with these problems, but they do not always work well. Reputation is one way. Good lawyers establish a reputation. In cases where repeat business is important, this often helps to weed out the bad guys from the good, as people would care about their reputation.

Now that the consequences have been there for all to see, the ‘reputation’ of sub-prime mortgages has been destroyed (as well as those other, more ideological lynchpins of the present excesses, the ideas of the ownership society and that house prices had only one way to go, up).

Transparency also helps. If hospitals would publish success rates on all their individual interventions, per ward, or even per doctor, that would also tell quite a bit, for instance. It levels the field a little.

But this is not always enough. How do you know when you buy a second-hand car that it will not show some serious problem that the seller (who is much more likely to be aware of it) might not share with you, as he does not have an incentive to do so, that is, he’s liable to exploit the information asymmetry.

Answering that question (actually, just pointing it out and then pointing out how rife this problem is) is what got George Akerlof the Nobel prize in economics (“The market for lemmons” as his article was titled, appearing in the early 1970s). That problem is still with us today, and markets cannot always deal with it.

Professional ethics codes also work, but there is some research suggesting that the neo-liberals obsession with markets, introducing markets in healthcare, for instance, has a tendency to subvert these, replacing them with efficiency codes and/or profit motives.

In education, introduction of market-like instruments like performance based pay or promotion, has a tendency to lower educational standards. After all, if your salary and career are positively influenced by how many students pass your class, why not make the exam just a little bit more easy. (One solution: national exams set by independent commissions, a form of regulation).

As we can see from the sub-prime mortgage market, the problem of asymmetrical information has a habit of popping up at awkward places, causing serious damage. It actually spread to the mortgage backed securities markets, as many of the derivatives products cutting up the risk were so complicated that few really understood them.

Regulation really is not always the bad that the neo-liberals seem to think and markets do not always take care of themselves. Funny that the US, that supposed bastion of free market thinking, did have a problem with regulation which could have prevented these problems in the first place, but doesn’t seem to have a problem with the enormous state interventions, socializing risk to deal with the massive fallout.

Tags: The World according to Economics