Thursday, August 7, 2008

When Is A Market Not a Market?

I've been hearing and seeing a lot about markets recently. People wonder if I am a "free market" economist, whatever that is. And there's been a lot of discussion about the "subprime mortgage market" and whether that debacle indicates some kind of boundary of the usefulness of markets. This is going to be the first of a couple of posts on this general topic, and I want to start by teasing apart the not-so-obvious question "What is a market?"

In particular, I think it is necessary to distinguish between the concepts of voluntary action and markets. For one thing, both "liberals" and "conservatives" sometimes launch a government vs. markets debate that can be both incomplete and inaccurate. In the 1960s, Richard Cornuelle popularized the term the "independent sector" in his book Reclaiming the American Dream. The important point he made was that a lot goes on in American society that is not summed up by an artificial polarity of government action versus for-profit-enterprises. In this indepedent realm we find religious, charitable, philanthropic, and non-profit activity. Furthermore, this important sector need not be insulated from the concepts of government and/or markets. Doug is really the expert on this area, so I hope he can expand on this in the future.

Instead I'd like to consider the discussion of the sub-prime mortgage market. It's important to remember that this is a particular economic institution with particular economic features. Just because it is a "market" does not mean it should be immune from criticism by economists who recognize that government, also, can fail, nor is our choice simply between this market and some undefined "government" alternative that might or might not have made things better. Consider, for example, how most consumer loans, including many mortgages, used to be made. The customer would approach a bank loan officer, fill out some forms, and have a discussion with the loan officer. The loan officer either could make the decision regarding the loan or had, at the very least, a great deal of input in that decision. Banks kept track of the performance history of loans made by their loan officers. A loan officer could be rated down for a portfolio of loans that was either a ) so cautious that there were few problems but not enough returns, or b) a history of making too many bad loans.

The process I've just described may or may not look like a modern definition of a "market." There is no organized central location, nor a thick shelf of formal bids and offers. The loan officer may or may not have much leeway over some of the loan's terms, but might have some flexibility on others. A good loan officer might be one who relied upon everything from instinct to long-term experiences to refinement of those parts of the loan agreement over which she had some control. Nevertheless, I consider this system a "market" system, or, more specfically, one of private, voluntary exchange. (Of course, the mortgage could have been an FHA mortgage, and thus the entire transaction might have simultaneously been a market transaction in the context of government activity).

As has been widely discussed, the changes in the mortgage "markets" over the last several years include the significant increase in practices such as re-selling and bundling mortgages into mortgage backed securities traded in national and even international markets. ALL OTHER THINGS BEING EQUAL, these advancements had the theoretically advantageous properties of increasing liquidity and diversifying risk. A portfolio of one-ten-thousandth of 10,000 loans diversifies risk more than a full share of a single one of the loans.

But, are ALL OTHER THINGS EQUAL? One obvious change was that loans were typically originated and processed differently. The importance of the local loan officer down at the local branch diminished considerably. I have a colleague in financial economics who, in addition to calling the housing market a bubble long before anyone else I know, has plausibly argued that all other things were not equal. Specifically, he points out that the older practice of individual loan officers having responsibility for the performance for a small group of loans with "their names on them" is very different than when 10,000 people each share in 10,000 loans. Namely, the old system created an evaluation process with a loan officer having a strong incentive to balance all available information in making a decision about the loan and to keep watch on the loan as it was being paid. Much of this may have been lost in a "Here, fill out this form" mentality in which mortgages were quickly resold and then bundled and resold again as diversified securities.

If we have found that there are advantages to moving back to the older system, and if the older system seems less "market-like" in some kind of Bonfire of the Vanities sense, then so be it. Not all forms of private, decentralized, voluntary exchange look like eBay auctions or trade-sports markets. Of course, the real kicker to the sub-prime mortgage mess is that the newer, more sophisticated "markets" had a Big-Government six-ton elephant in the living room anyway: Fannie Mae and Freddie Mac were creatures of the federal government designed to look like private entities with a maybe-we-do-and-maybe-we-don't role for the U.S. taxpayer. Many officials of these firms had resumes that were more political than financial. That doesn't exactly look like a "free market" in any sense that I'm used to talking about.

Let me close with another example. My wife and I many years ago used a heating and air-conditioning contractor I'll call "Company E." Over the years, we have found Company E to perform high quality work and to provide exceptional customer service. When we decided that it was time to replace a unit, we had Company E secure bids across manufacturers, but we did not ourselves structure a formal competition between Company E and other contractors. Company E had won our trust and our loyalty. Our decision to go directly to Company E may not have looked much like a market-based decision. But I think that it is a good example about why economists should talk in terms of the whole scope of voluntary actions. I think our decision is just as much a "free-market" decision as a formal and highly centralized market that is whirring away under some vague assumption that the government will step in if the outcomes get too uncomfortable. Too many people think that notions of trust, commitment, loyalty, reciprocity, discernment of intentions, monitoring and so forth are concepts that exist in opposition to markets. I believe, instead, that they are integral to the notion of markets as voluntary action. Too many people also believe that government intervention somehow is a perfect antidote to bad faith dealings and moral hazard problems, when as we have seen they can actually make things worse. I think it's instructive how much the prophets of the Old Testament disliked the hybrid of economic and political power acting together for unjust purposes.

The universe of voluntary exchange structures is vast, and no economist should confuse that universe with any specific manifestation. Human society is capable of vast feats of physical engineering, but we still have bridges that collapse and door handles that break and computers that overheat. The subprime mortgage market may not have worked well, but we may yet decide that it worked better than the current hysteria suggests that it did. (I can make an argument that a lot of responsible people were able to purchase homes under this system that might have been shut out by our hypothetical local loan officer.) But we can also talk about other market processes that might do things better. We can talk about whether the fact that there was an active role of government influence made things better or made things worse

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