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Faith-Based Markets

posted by Adam Levitin

Paul Krugman has a column today about the blind, fundamentalist faith in efficient markets.  This is a phenomenon that Stephen Lubben and I have been discussing recently (did Krugman just preempt our paper idea?), as we've both encountered it in the financial regulatory policy debate: 

  • The Chapter 14 proposal that would resolve large financial institutions in bankruptcy takes it as a matter of faith that there would be sufficient private DIP financing available to resolve, say, JPMorgan Chase. I don't know how much would be needed, but it would be a multiple of the largest private DIP loans to date:  $10B for Energy Future Holding and $8B for Lyondell Chemical.  Where would the, perhaps $100B needed for a megabank come from?  Well, not from that megabank...  But don't worry, the market will provide.
  • Housing finance reform proposals that would either total privatize the housing market (the House Republican solution) or privatize 10% of the market (the Johnson-Crapo bill in the Senate).  We could have a completely private housing finance system.  But don't be surprised when home prices drop precipitously.  There just isn't enough private risk-capital willing to assume credit risk on housing to finance the whole market. It's not clear to me that there's enough private risk-capital willing to assume the credit risk on 10% of the market, and if there isn't it is going to result in at least a 50 basis point increase across the board, and much higher price increases for riskier borrower.  But don't worry about these details.  The market will provide. 

So here's the inconvenient paradox of market fundamentalism:  the idea that the free market can be directed. Either the market is free or it will follow direction, but it's not going to do both. Markets do what markets want.  

Markets can't be willed into working the way we want them to work.  Just because there's an invitation extended doesn't mean that the market will take it up.  That's the nature of the free market.  

This is a lesson we ought to have learned in the 1930s:  In 1934, Congress created a Federal National Mortgage Association charter that was available to any qualified applicant.  The idea was that we'd have a whole bunch of privately capitalized FNMAs providing a secondary mortgage market. Guess what?  No one applied for the charter. So in 1938, the Reconstruction Finance Corporation (a government corporation) created a subsidiary called Federal National Mortgage Association of Washington, DC.  Why the "of Washington DC"? Becuase the hope remained that someone else would still apply for the charter.  When that didn't happen the "of Washington DC" was dropped and Fannie Mae was born.  Private capital didn't step up in the 1930s, despite the Congressional invitation. 

We see this same phenomenon time and time again.  Remember the various homeowner refinancing programs Congress and FHA came up with in 2007 and 2008, like Hope for Homeowners and FHA Secure?  They refinanced a few hundred loans.  Just because an offer is made, it's foolish to assume that the market will take it up.  The economics have to work for that to happen. But market fundamentalists ignore that little detail. 

Finally, Stephen had the very keen observation that this market fundamentalism has a parallel in conservative Constitutional jurisprudence.  Many conservatives are enamoured with the idea of following the original meaning of the Constitution.  Let's put aside the problems of whether there was one single original meaning, much less whether we can accurately divine it.  Originalism can produce some uncomfortable results:  could the Supreme Court have arrived at Brown v. Board of Education or Bolling v. Sharpe (DC school desegregation)?  Unlikely, although some scholars do go to great lengths to try and square the circle.  Instead, where do we end up?  Faith that originalism would produce the results we want, even if we don't know how.

I'm not quite sure what to make of this phenomenon in American political life, but it is on some level deeply anti-rational. It latches on to a patina of quasi-scientific theory that lends it some respectibility (from those who don't probe it very deeply), but then ignores inconvenient facts and makes fanciful assumptions. I don't know if conservatives currently have a monopoly on this type of thinking--I suspect not--but it does seem to be a hallmark of contemporary conservative policy positions. 


Same logic applies to faith in freedom of expression. Hence, PC. It is deeply irrational not to believe in PC.

Every developed economy for generations has been a mixture of open markets, more regulated markets and government provision of services. Despite immense variety, experimentation and analysis, no society has ever found it beneficial to move toward unregulated markets for everything. Solemnly "refuting" the argument that the latter course would be a good idea is about as necessary and sensible as refuting the idea that bloodletting is a panacea for illness.

Most pundits, and Krugman and this post are no exceptions, simply attack an opposing argument, leaving their own position unexamined and implicitly standing victorious at the end of the column.

The real and difficult issue is that both market and government mechanisms fail to achieve all of their goals, and also generates externalities, in large doses and frequently. The housing finance crisis was caused to a substantial extent by government policies - housing specific, but also the imperative politically imposed on the Fed to keep intereset rates low to stimulate the jobless recovery of the early 2000s.

The real issue is the selection between imperfect mechanisms. Market pricing tends to produce better information and resource allocation than political pricing (compare Venezuela, Argentina, Egypt, etc.). The housing market was clearly a combination of both, as are the securities markets (the prices of most capital assets being obviously influenced by Fed policy). In both, the government wants prices to go up and not down so the market bakes that into its calculations.

What you call "faith" in what I suspect is an effort to connote some kind of ideological inflexiblity and zealotry, is equally found on the left ,which if anything tends to be more dogmatic than the right, given that a libertarian approach allows for some measure of diversity and freedom and change over time while the statist approach imposes the opposite. Some people prefer the market not out of faith, but out of skepticism. A market can eliminate bad and outdated products over time, a government does so much less successfully.

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