I'm not sure you understand what the free market is, or how it works.
The fall of 2008 wasn't a free market. In particular, the government was forcing lenders to accept more risk (viz sub-prime borrowers) than they would otherwise have done. Also, the lenders themselves incorrectly modeled their risk exposures.
None of your objections:
what about information asymmetry? What about borked incentives? What about just plain stupid? "I played golf with the guy so I'll buy it"? "I know these instruments are crap but I'll sell them to my clients to get them off my balance sheet"?
hold any water:
Information asymmetry (also, incorrect information as with lenders in '08): This has nothing to do with the efficiency of markets. The efficient market hypothesis depends on actors behaving rationally to achieve their goals. That does not mean that those actors will always be correct. For example, in The Myth of the Rational Voter[1], Caplan describes how it's actually rational behavior for voters to vote irrationally: the benefit of the degree they can sway the election is far smaller than the cost of acquiring sufficient knowledge to determine what candidate would most benefit them.
Bad incentives: it's the incentives (see "Invisible Hand") that make things work properly! To the extent that the incentives are wrong, these are the regulations, the aberrations that make things deviate from the free market. In your '08 complaint, that was the Congress forcing lenders to take on borrowers that would not normally have qualified. It also comes from externalities, places where our laws prevent the free market from completely accounting for the costs of an action. For example, because air and waterways are held in common by the government, without a real owner, there is nothing capturing the cost of pollution. Thus, incomplete property rights leads to market failures. If the government got out of the way, the market could resolve it (see "Coase Theorem")
Stupidity: as separate from your other points, well, there's no such thing -- at least not that we can perceive. Mises shows that (a) each person acts to maximize his own utility, and (b) it's impossible for outside observers (and frequently even the individual himself) to know what ends he is attempting to achieve. Thus, if your hypothetical golfer places some personal value on the relationship with his golf buddy, it may be perfectly rational for him to spend extra few bucks buying from the guy. And you and I certainly aren't privy to enough information to decide that it's not so.
Fraud: your Yankees example seems to be an example of fraud, and thus can't be considered a free market transaction. Fooling someone into a transaction is no different from forcing them into a transaction.
That said, research in psychology and econometrics has shown that people do systematically misconstrue very large or very small values, leading us to sometimes choose differently from what we really intend. The only solution to this, of course, is to formally model the problem to enable us to act rationally. In this day and age, such models are de rigeur, but -- as I note above -- the investment in the models itself has some risk: we're balancing correctness against cost to develop and feed the model. As with the rational voter, this can lead us to "rationally irrational" behavior, but this is just a meta-behavior of the free market, not an indictment of it.
Moreover, there is no way around any of the issues that you cite. All of these things can be applied equally -- if not more -- to government regulators (see "public choice economics", "regulatory capture", etc.). Why would you want to give power to entities who won't be able to use it any more wisely than the people themselves?
> The fall of 2008 wasn't a free market. In particular, the government was forcing...
To the extent that government regulations are less strong than physical laws, isn't the market still free? For instance, methamphetamines are illegal, but they're still produced, distributed, and retailed; just with a higher cost for all involved than if they didn't have to take precautions against, and accept the probability of, detection and punishment. Given the incentives in place, the supply and demand curves for methamphetamines still meet, and the market clears.
I've always found the belief that markets can withstand any form of interference except government regulation fairly bemusing.
One side-effect that falls out of this more cosmopolitan view of free markets is that the fall of 2008 was the efficient outcome. If market participants had information about what would happen strong enough that they were willing to bet on it in 2005-2007, the catastrophic drop in 2008 would not have happened as it did.
Given the incentives in place, the supply and demand curves for methamphetamines still meet, and the market clears.
Sure it does. But the individual actions that occur in so doing are different than they would otherwise be. So you've got hordes of young black men (yes, stereotyping, but to make a point) killing themselves supplying drugs. This wouldn't be happening in the free market; you'd be buying it legally from your pharmacist, or even the local convenience store. Those young men would still be alive.
the fall of 2008 was the efficient outcome.
I've no doubt that this is true. Unfortunately, even in that, the perversions of the market have not been allowed to resolve themselves. We've got the "too-big-to-fail" thing that is continuing to incent risky behavior, and we've got the government shoring up housing prices, preventing that bubble from deflating.
We're in the real world here. If the real world held up to a given person's theory, communism would've worked. You just have a different theory.
I'm not claiming markets are terrible, they're usually the best way to do things. But when you pigeonhole yourself into an absolutist position, you've guaranteed that you're going to be flagrantly wrong sometimes.
when you pigeonhole yourself into an absolutist position
That's a fair criticism of my reply. My initial statement almost had a flavor of "free markets are perfect", whereas what I really believe is that "free markets are the best system possible".
So, no true scotsman?
But I don't think that's a fair criticism. There is a clear, well-defined concept of "free market"; it's not like I keep backing off my statement every time someone scores a hit on my argument. If the theory can explain exactly why the various regulations on the market have the observed result -- that is, if it has scientific predictive value as opposed to an irrational belief system -- then I don't think I'm susceptible to this criticism.
In high school physics we did Newtonian mechanics assuming a frictionless surface, etc. It turns out that our experimental results didn't match up with what really happened, because we had friction and other factors. But we learned more physics, so even though we didn't have access to that frictionless surface, we could explain why the results differed, and predict just how those differences would appear (friction is proportional to downward force, etc.).
You're criticizing the market theory because the observed results have those "frictional" differences, even though we can tell you what is causing the friction, and predict (albeit to a limited degree at this point) what the future effects of proposed "friction" (i.e., regulation) would be.
I'm criticizing fundamentalist market theory, and the practice of turning your brain off.
The crash of 2008 was preceded by 20 years of deregulation. And the explanation? Too much regulation! A billion dollars in loans to minorities must explain the 2 trillion dollar problem!
There's nothing wrong with thinking a free market's the way to go for a given problem, provided you got there by engaging your brain rather than taking it on faith. Once you do that, you might find yourself thinking things like "Hm, maybe capital gains should be taxed as ordinary income", or "Hey, turns out it's mathematically impossible to balance the budget by cutting domestic discretionary spending".
In what way is it "turning your brain off" to consider the 2008 crash the result of too much regulation?
The mother of all financial regulatory machinery, the central bank, is considered to be the primary cause of the crash by many. I find the argument reasonable. Correct or not is another story, but how can you dismiss the statement wholesale?
The, uh, the united states doesn't have a central bank.
I don't want to be nitpicky here, but this is a conversation about not turning your brain off. Are you referring to the federal reserve? They don't regulate anything. The SEC? They're in no way similar to a central bank and have been regulating progressively less over the last 70 years. What changed in 2008 that made their regulation more burdensome?
If you're making a statement, it's on you to back it up. Shouting "regulation!" with no insight behind it might work in your social circle but in mine, it's turning your brain off.
The United States does have a central bank; it's the Federal Reserve. They kept interest rates abnormally low for much of the last decade which meant that borrowing was incredibly cheap causing many consumers to overextend themselves. Regulation, government intervention they're the same thing. It is undeniable the government intervened in the housing market and this was discussed earlier in this thread[1].
> They kept interest rates abnormally low for much of the last decade which meant that borrowing was incredibly cheap causing many consumers to overextend themselves
The federal reserve manages the cash rate. The don't directly specify the risk premium spread associated with risky loans.
If someone offers a no-recourse billion dollar loan with no obligation for collateral, the rational financial decision is to take the loan, and invest the money. If the investment appreciates pocket the money. If it goes south return the investment and say "your problem" to the lender.
The federal reserve said they thought self interest would ensure the banks would not invest stupidly.
I don't see how this argument changes if overnight rate is 10% or 1%.
>Again. This subthread is not about turning your brain off.
I'd appreciate it if you quieted your condescension. For someone who didn't even know that the United States had a central bank, you are extremely vocal about the topic of finance. We're all here to learn and exchange.
Even if actions of The Fed are not necessarily regulations themselves, the fact that The Fed exists at all and is able to exert influence is certainly the result of law. Understanding this, I don't have a problem with conflating the actions of The Fed and the regulation that enables The Fed-- "regulation".
There is healthy debate regarding the cause of the 2008 crash. Economics is not a science proper, and the data is noisy. You cannot simply write-off the argument wholesale by latching on to the debatable causal link between "de-regulation" and the crash. Unless, of course, you turn off your brain.
The Fed isn't responsible for regulation and isn't a central bank like the bank of france or something. I immediately said, in that thread "if you mean the fed.." and explained why they have nothing to do with the noun regulation.
Thanks for the counter-condescension.
To the original point, they don't write regulation and it's hard to call a fixture of the last 80 years "regulation responsible for a recent incident", due to the fact that at some point there was a law.
"The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States.
Its duties today, according to official Federal Reserve documentation, are to conduct the nation's monetary policy, supervise and regulate banking institutions, maintain the stability of the financial system and provide financial services to depository institutions, the U.S. government, and foreign official institutions."
"Mission...
supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers..."
I think the parent post overstates it a bit. I wouldn't say that the Fed was a primary cause, although they were certainly complicit by keeping interest rates so low, artificially increasing the demand for mortgages.
If you're willing to generalize the comment to say that the crisis was primarily due to the heavy hand of the federal government, then I offer these two links. They're both op-ed pieces, so shouldn't be considered definitive research, but they're pretty solid evidence that some serious people do blame the government's regulation (as opposed to de-regulation).
Ok - I can see that those articles make some good points about the US housing market. However, I am not in the US, and the housing market in the UK suffered from very similar problems and, as far as I am aware, we never had any overt government support for mortgages so our mortage market looked rather more "free market" than the US one and we still ended up with similar problems. Northern Rock being the most obvious example:
Bad incentives: it's the incentives (see "Invisible Hand") that make things work properly! To the extent that the incentives are wrong, these are the regulations, the aberrations that make things deviate from the free market.
It's fairly common for traders managing (or depending how you look at it, gambling) other people's money to be paid a percentage of the total money under management (for the sake of argument, let's say 0.5%) plus a much larger percentage (10%) of the upside.
That this leads to perverse incentives is, I hope, obvious to everyone here - I've literally sat down with traders and run best guess numbers incorporating the risk of getting fired (or losing investors, shutting down the fund, etc.), difficulty finding another gig doing the same thing vs. the potential gains, and the mathematical conclusion is almost always the same: go all-in, take on as much risk as you can possibly manage, and you'll do better personally than if you invested safely. The only real question is a moral one, i.e. do you care enough about doing what's right to actually try to preserve your client's money rather than gamble it away for a shot at a bigger prize? [Interestingly enough, I've found that most do, the problem is that there's a small subset that don't give a shit, and their abuses taint the entire field]
This type of risk-seeking unquestionably played a role in the recent collapse, I don't really see how that can be denied - sure, government incentives triggered the initial housing market buildup and drop, but IIRC that was initially only a 4% correction, it was only because of how massively leveraged the financial sector had become w.r.t. credit that such a drop had any impact on anything at all.
Do you really think the payment incentives in the financial sector are helping the market work properly? Or do you think that those payment schemes (a nibble of the principal and a chomp of the upside) are somehow caused by government meddling?
IMO, the problem is that it's a mistake to assume that the negative effects of "government meddling" end with official government. Any time you put a group of people together and have them agree on rules and regulations, especially ones about how to distribute money amongst themselves, you run the risk of creating incentives where individually self-interested actions actually work against the group. This applies to corporations, clubs, families, teams, etc., just as much as it does to governments.
The stock market merely reflected the balance sheets of large financial institutions. The stock market drop did not cause Bear Stearns to go bankrupt, Bear Stearns being bankrupt caused the market to collapse. That triggered enough insurance policies that AIG went (or would go), and GS had enough insurance with AIG that it would go if AIG went.
> For example, in The Myth of the Rational Voter[1], Caplan describes how it's actually rational behavior for voters to vote irrationally: the benefit of the degree they can sway the election is far smaller than the cost of acquiring sufficient knowledge to determine what candidate would most benefit them.
This is a minor detail, given that that was just an example you were giving; but in case it piqued anyone's interest, I'll correct it. That's not actually the explanation Caplan gives for voters acting irrationally (indeed, there's nothing that even appears irrational about that; that's obviously rational behavior). What Caplan argues is that voters rationally vote irrationally because they have preferences over beliefs, giving voting in accordance with false but preferred beliefs psychological benefits, and that if these psychological benefits outweigh the negative effects of the irrational voting, discounted by the low probability of deciding the election, it is rational to vote irrationally.
In particular, the government was forcing lenders to accept more risk (viz sub-prime borrowers) than they would otherwise have done.
As I pointed out above, the number of loans made because the government said-so is not enough to account for the problems they encountered. Because of the mortgage-backed securities industry, there was incentive for banks to make sub-prime loans and offload the loans (and the risk) elsewhere. In other words, the government's requirements did not lead to the glut of sub-prime loans.
I also find your comment about lenders incorrectly modeling risk strange - it's a true statement, but I don't see how that means the market wasn't "free."
The fall of 2008 wasn't a free market. In particular, the government was forcing lenders to accept more risk (viz sub-prime borrowers) than they would otherwise have done. Also, the lenders themselves incorrectly modeled their risk exposures.
None of your objections:
what about information asymmetry? What about borked incentives? What about just plain stupid? "I played golf with the guy so I'll buy it"? "I know these instruments are crap but I'll sell them to my clients to get them off my balance sheet"?
hold any water:
Information asymmetry (also, incorrect information as with lenders in '08): This has nothing to do with the efficiency of markets. The efficient market hypothesis depends on actors behaving rationally to achieve their goals. That does not mean that those actors will always be correct. For example, in The Myth of the Rational Voter[1], Caplan describes how it's actually rational behavior for voters to vote irrationally: the benefit of the degree they can sway the election is far smaller than the cost of acquiring sufficient knowledge to determine what candidate would most benefit them.
Bad incentives: it's the incentives (see "Invisible Hand") that make things work properly! To the extent that the incentives are wrong, these are the regulations, the aberrations that make things deviate from the free market. In your '08 complaint, that was the Congress forcing lenders to take on borrowers that would not normally have qualified. It also comes from externalities, places where our laws prevent the free market from completely accounting for the costs of an action. For example, because air and waterways are held in common by the government, without a real owner, there is nothing capturing the cost of pollution. Thus, incomplete property rights leads to market failures. If the government got out of the way, the market could resolve it (see "Coase Theorem")
Stupidity: as separate from your other points, well, there's no such thing -- at least not that we can perceive. Mises shows that (a) each person acts to maximize his own utility, and (b) it's impossible for outside observers (and frequently even the individual himself) to know what ends he is attempting to achieve. Thus, if your hypothetical golfer places some personal value on the relationship with his golf buddy, it may be perfectly rational for him to spend extra few bucks buying from the guy. And you and I certainly aren't privy to enough information to decide that it's not so.
Fraud: your Yankees example seems to be an example of fraud, and thus can't be considered a free market transaction. Fooling someone into a transaction is no different from forcing them into a transaction.
That said, research in psychology and econometrics has shown that people do systematically misconstrue very large or very small values, leading us to sometimes choose differently from what we really intend. The only solution to this, of course, is to formally model the problem to enable us to act rationally. In this day and age, such models are de rigeur, but -- as I note above -- the investment in the models itself has some risk: we're balancing correctness against cost to develop and feed the model. As with the rational voter, this can lead us to "rationally irrational" behavior, but this is just a meta-behavior of the free market, not an indictment of it.
Moreover, there is no way around any of the issues that you cite. All of these things can be applied equally -- if not more -- to government regulators (see "public choice economics", "regulatory capture", etc.). Why would you want to give power to entities who won't be able to use it any more wisely than the people themselves?
[1] http://en.wikipedia.org/wiki/The_Myth_of_the_Rational_Voter
[2] http://en.wikipedia.org/wiki/Human_Action