Are economists allowing us to wander towards the Great Depression II

This was the feeling I got from Justin Wolfers at the Freakonomics blog and Dani Rodrik on his blog.

Both of these authors seemed to imply that our profession has:

failed to explain in clear language just what it is that credit markets do, and hence why it is so important that we fix them

However, I’m not sure I actually agree with this.

The above statement states that there is something “broken” in the credit markets – something that can be fixed.

Now when I hear the term broken and fixable in terms of a market, it tells me that there is some type of market failure – a market failure that can be solved through government intervention.

What is the failure here? I have prattled on about asymmetric information in the past and if this is the failure lets accept it and figure out how best to solve it.

But I am uncertain whether this is the failure that Dr Wolfers discusses. His failure stems from a more “institutional” standpoint. Fundamentally he seems to state that credit markets are a “good thing”, they are now frozen, and so government must do something to unfreeze them. In his language:

Today’s problem is that the bridge between borrowers and lenders has been washed away. Think of the bailout as infrastructure investment. We need to rebuild that bridge.

So the credit market is like infrastructure? In the case of infrastructure we require government intervention only because we suffer from a “free-rider” problem, which leads to suboptimal investment in infrastructure by private agents. I don’t see a free rider problem in the credit market – so I can’t see why a government could “re-build these bridge” any more quickly or efficiently than the private sector.

Another way of reading the comment is that the market has stopped functioning – so the government must come in and restart the market. However, would we do this in any other market? I’m afraid I can’t support government intervention on the premise that the market stopped – markets are supposed to stop if they are not worthwhile.

But externalities

I have also heard about “externalities” from the credit market no longer functioning. I’m sorry but this is not an externality. If the market for tuna stopped functioning, the fact that people no longer have tuna in their choice set is a pain – but in the absense of a real market failure (like asymmetric information) this cost stems from the fact that the value people place on the product in the market is below the cost associated with making the product. As a result, when we take into account the “opportunity cost” this externality is optimally solved for.

If there was symmetric information, sellers and buyers of goods would reach a price that is mutually beneficial – or else trade would not occur.

Some institutions may suffer from the fact that have to sell at a low (fire sale) price given the timing of sales – however, this is just a transfer to other institutions who buy the assets.

But you were saying something about economists

Oh yea I was.

My impression is that economists don’t actually agree on what is the best course of action here – because fundamentally many economists disagree on what the problem is, and what is going wrong.

For example, I am not in the camp that believes no government intervention is needed and that the market will simply clear.

But I am also not in the camp that believes that government intervention is needed to repair some “mythical externality” that exists.

However, I am in the camp that believes the primary issue here is one of asymmetric information (a problem that I admit is made worse by an “information externality” – whereby lower levels of transactions reduce the information signal and increase the information asymmetry).

However, many far more intelligent economists than myself are in other camps, arguing with each other about whether government intervention is necessary at all!

If the economics profession agreed that this bailout must occur then I think that our profession has been a bit useless in explaining to people why. However, instead of putting this down to our terrible ability to communicate with other people, I would conjecture that this has more to do with the fact that many economists can’t completely explain why we must have the bailout.

In this sense I respect the fact Dr Wolfers gave it a go – even if I don’t agree with the way he framed it for the public.