One percent, the margin, and recovery


There are reasons why the free market works and government doesn't
There was a great piece in yesterday's Wall Street Journal that's worth your time. Emphasis added.

The Panic of 2008 is a crisis of trust. Investors don't trust the value of bad debts enough to offer market-clearing prices. Banks don't trust one another to stay in business long enough to do business together. And there's definitely no trust that Washington can avoid creating costly new moral hazards as it attempts to bail out the system.

But the most paralyzing loss of trust may be in Wall Street's system itself: How did the smartest people at the best banks running the most sophisticated financial models fail to forecast the collapse of mortgage-related securities? How did this unpredicted collapse devastate the system? And most of all, can we ever again trust the financial models on which value is supposed to be determined?

These questions matter because despite the current crisis, modern finance has delivered enormous benefits, from explaining to investors why they should diversify their investments to the creation of mutual and index funds. Related innovations helped financial institutions speed capital to its best use, fund new businesses and accelerate global prosperity. In other words, financial engineering worked beautifully -- until suddenly it didn't.

So what happened? Financial models take logic and historical data into account, but it's now clear that these elegant models have a serious weakness: They can't cope with illogical and uneconomic factors. Washington's insistence for years on artificial subsidies for mortgages through Freddie Mac, Fannie Mae and other programs led to a loud "Does not compute!" that is still rocking the financial system.

The article makes the point that 99% of the time, the system works. Unfortunately, that 1% failure rate can be catastrophic, especially if the system isn't fault tolerant. What's more, increasing the complexity of the system and removing transparency increases both risk and raises the cost of failure.

The real question is not if government can fix it, but what the costs will be.

Government action most directly influences marginal behavior. It's an economic truth. Lower the cost of flood insurance by government decree and more people build in a flood plain. Tell banks that they don't have to cover bad subprime loans and of course there will be more loans. Pay unwed mothers and a majority will stay unwed.

It's these marginal behaviors that can lead to cascade reactions because it's at the margins.

If the income tax rate jumps three percent between 50 grand a year and 51 grand per year, that whole zone between 50 grand and 52 grand becomes a "no man's land" that everyone avoids because it costs less. People will resist moving above 50 grand until they can keep more of their money. That means that there is less movement up the income scale, and when income does change (if it changes), it's going to spike over the gray area.

Watch those marginal behaviors.

Government also doesn't respond fast to a crisis. Well, not without threatening martial law anyway. Government action in a hurry IS NEVER a good idea.

On the other hand, free market and competition delivers FAST AND IMPROVING products and services almost as quickly as the demand. If someone isn't doing it fast enough or cheap enough or safe enough or sturdy enough, then someone else will.

If you don't want to take my word for it, check your history. Look at the what the American economy was in January of 1930 and January of 1940. Check stock prices. Check unemployment. Check the amount of abandoned property. And remember, government had been "fixing" that for ten years.

Neither government nor the free market can totally protect you from disaster. The free market can do it better, recover from catastrophe faster, and adapt.

The government solution will always threaten force.

Choose for yourself.

— NeoWayland

Posted: Tue - October 14, 2008 at 07:17 AM  Tag


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