In the comments section from my post dealing with the policies of the Bush administration there is one comment raises interesting economics and political economy issues that I hope could be discussed on this blog. One reader writes:
As for the foreclosure rate freeze -- Roubini has a cogent defense of it. I think it raises terrible moral hazard issues for the future, but it is clear that investors and borrowers are both better off with this than with a cascade of foreclosures that collapses the real estate markets and leaves everyone with nothing.
Roubini's argument can be found here.
The bailout and rate freeze, in my mind, is a price control plain and simple; the subprime mortgage crisis is the consequences of distortions caused by credit expansion; and the demand for, and search for government solutions to the crisis in the housing market and mortgage industry rather than relying on market processes of adjustment signals an abandoning of the principles of market-oriented public policies in the US in rhetoric as well as reality.
What are the best economic arguments you have see concerning the causes and consequences of the subprime mortgage crisis? What argument or evidence would persuade you to the opposite of your opinion on this issue of 'current history' and public policy relevance?
Douglass North raises some interesting questions that attack directly the emphasis many economists place on the ability of the market to self-correct. Most important, perhaps, is the stability of an institutional framework that enables the market economy to perform well. Institutions, and their relative stability, depend upon the complicated structure and union of formal rules (regulatory codes, statutes) and informal constraints (norms of behavior, social conventions) that are responsible for (and determine) the way in which markets operate and function.
As Israel Kirzner would say: All this may sound trivial. But, in a social context in which rules are ambiguous, conventions spontaneously evolve (and have "tenacious survival ability") and enforcement remains unpredictable, such considerations are from trivial.
The market, if it is to be taken seriously, cannot be studied in isolation. Individual perceptions influence the outcomes of institutional matrices. Such informational feedack mechanisms, however, are imperfect and some rules may give rise to higher transaction costs and consequently contribute to a less efficient (unstable) institutional framework. It is the acme of naivete to presume that the market will correct errors committed by policy makers precisely because the market is determined by the rules and constraints that endogenously factor into the performance of economies.
Two months ago I thought the Austrians had the answer to government failure. But an accidental reading of Douglass North changed all this in a single instant. I think his work is tremendously important and believe Austrians have much to gain by incorporating most of his insights into the development of their own tradition.
I hate to feel like I am preaching. But all this came to mind from reading your post. Markets are not the sum of economic theory, or to the extent that economic theory is based on considerations that abstract from political and social institutions, markets can no longer serve as the sole engine of economic progress.
Posted by: matthew mueller | December 08, 2007 at 05:31 PM
Matthew,
You haven't read Kirzner correctly. He emphasizes the "institutional framework" throughout his work. Also, I should point out that my first professional publications in the 1980s were on the issue of institutions and economics, including an essay from the early 1990s entitled "The Institutional Infrastructure of development" and another entitled "Why Culture Matters."
I would argue that you are misunderstanding the Austrian position as related to institutions and the self-correcting properties of the market. Invisible hand theories rely on "filters" and "equilibrium" processes (see Nozick's discussion of 'invisible hand' theories). The filters are the institutional framework (both formal and informal rules). I think you would be hard pressed to not see this emphasis on the institutional framework within the Austrian school analysis of the market. There are no "isolated markets" in the Austrian tradition.
North's critique of self-correcting is a critique of neoclassical economics.
I would also recommend R. Rajan's IMF little note entitled "Assume Anarchy?" --- which also addresses this issue of the institutionally contingent nature of market processes.
Posted by: Peter Boettke | December 08, 2007 at 07:01 PM
"There are no "isolated markets" in the Austrian tradition." So no Austrian version of tight-prior? Really?
You neoclassical-austrians (boettke, kirzner, hayek, mises, rothbard) only get equilibrium by totally ignoring Lachmann's challenge.
Posted by: Lachmannian | December 08, 2007 at 07:19 PM
I'm doing my M.A. thesis on this with a couple of other guys. We've got some pretty solid statistical evidence that the percent of ARMs and IO ARMs increases after anti-predatory lending laws were passed back by states from 98-03. FRM decrease. Similarly, we found that interest rates on more exotic mortgages like ARMs, Balloons, subprime, etc decrease and the reverse is true for the more conventional mortgages like FRMs and NonIO. I haven't found any corresponding increase in delinquencies, but our study is from 98-2006 so we miss some of the increase in delinquencies that happens in 2007. I also think it's no coincidence that delinquencies began to increase after the BAPCA laws were passed. We control for HPI and interest rates which controls for monetary policy, but those are usually significant as well. That's my short argument about why it happened.
Anyone who thinks the freeze will stop anything is a fool. The APL laws were supposed to stop obviously anti-predatory lending, but they resulted in riskier mortgages getting cheaper and people were encouraged to write them. Moral hazard is real.
Posted by: John | December 08, 2007 at 07:55 PM
Lachmanian said:
"You neoclassical-austrians (boettke, kirzner, hayek, mises, rothbard) only get equilibrium by totally ignoring Lachmann's challenge."
Lachmann missed the point. Since the market tends toward a final state of rest, it must tend toward equilibrium, for it could not rest at disequilibrium.
Posted by: dglesvic | December 09, 2007 at 12:22 AM
And what pray tell have you read by Lachmann Mr Lesvic?
Posted by: Lachmannian | December 09, 2007 at 09:53 AM
Though it's been a long time since I read it, I happen to have a copy of Capitalism and Its Structure before me, but what difference does it make?
Suppose I had never heard of the man.
Two and two would still be four, and the market still could not rest at disequilibrium.
Posted by: dglesvic | December 09, 2007 at 12:08 PM
I rather doubt you have a copy of Lachmann's capital and its structure in front of you given you do not even know the title and you clearly no even less about Lachmann's theory of the market process
Posted by: Lachmannian | December 09, 2007 at 12:14 PM
Wy don't you test me.
Posted by: dglesvic | December 09, 2007 at 12:55 PM
You're right. I did get the title wrong. It was not Capitalism but Capital And Its Structure.
Sorry about that. Nonetheless I certainly have it right before, and, nonetheless, it still doesn't make a bit of difference.
Posted by: dglesvic | December 09, 2007 at 04:04 PM
On a point of detail, a cascade of foreclosures does not leave "everyone with nothing", it just might teach some people a lesson, which they will not learn if they are bailed out.
Posted by: Rafe Champion | December 09, 2007 at 06:05 PM
Sure Mr L - what is Lachmann's basic argument againhst coming up with an aggregate measure for the capital stock?
You have nothing right but you are right that what you think makes no difference to serious scholars (the good people who run this blog) or real-world politics (including your God Bush and your Satan Clinton).
Posted by: Lachmannian | December 09, 2007 at 07:30 PM
Lachmannian says:
Sure Mr L - what is Lachmann's basic argument againhst coming up with an aggregate measure for the capital stock?
Whatever it was, would it lead to the conclusion that the market rested at disequilibrium?
Posted by: dglesvic | December 09, 2007 at 08:16 PM
My 15 minutes of fame have begun! Thanks for quoting me.
My take: The root cause is the federal budget deficits, which had to be covered by foreign lending since Americans don't save. Foreign willingness to buy U.S. debt kept interest rates low, facilitating the housing boom. Couple this with creative financial engineering that helped fuel the boom, aided and abetted by Greenspan's fed... and a partially regulated banking system in which highly regulated, FDIC-insured banks also were allowed to have SIVs etc, makes for a scenario vaguely reminiscent of the S&L crisis, only bigger I think.
As the U.S. financial position has looked increasingly doubtful, foreign lenders have become increasingly reticent, hence falling dollar and interest rate pressures, triggering ARMs and threatening the whole house of cards.
John is quite right about moral hazard, it's all over this thing. And while I'm often critical of Austrians, when its stripped of all its complexities and confusions, the story sounds quite like the credit boom-bust Mises outlined in 1912.
I don't think the freeze is really an abandonment of free market principles, though. It's the absence of free market principles that led to the whole mess in the first place.
I think Roubini's freeze argument holds that it would be prohibitively costly to restructure contracts on a case by case bassis, and hence the crude en masse approach is warranted. Makes sense, but it raises all sorts of bad precedents, moral hazard issues, Constitutional questions and won't work anyway, in my admittedly unhumble opinion.
The financial debacle will be much worse than most are saying, also IMAUO.
Posted by: Arrow.Debreu | December 09, 2007 at 11:41 PM
Wow, quoted on the Austrian blog...my 15 minutes of fame have begun, right? I'd better use them wisely.
My take: The root cause is the federal deficits; since Americans don't save, these were financed with foreign loans. Foreign loans kept interest rates low, which allowed the housing bubble to inflate... aided and abetted by Greenspan's Fed, and creative financial engineering that generated a host of new financial products of doubtful value and found ways to put mortgages in reach of every man and woman, and most cats and dogs. Highly regulated banks, FDIC-insured, were allowed to have SIVs and similar junk, a scenario vaguely reminiscent of the S&L crisis.
Now foreigners have become increasingly reticent about unabated lending to the U.S., putting downward pressure on dollar and upward on interest rates, triggering ARMs and starting the bubble a-popping.
John is right about the moral hazard; there's MH in many different dimensions at work here. This isn't the free market but a regulated system that many have tried gaming in myriad ways.
I'm sometimes critical of Austrians, but stripped of numerous complexities and confusions, this is quite like the credit boom-bust Mises laid out in 1912.
But I disagree that the freeze is an abandonment of free market principles. It was a highly interventionist system that led to the boom-bust.
I gather Roubini believes it would be prohibitively costly to restructure 1 million contracts individually, hence the en masse approach. Makes sense. But it also raises numerous bad precedents, future MH issues, and Consititutional questions, and won't work anyway, in my admittedly unhumble opinion.
I also think the financial trainwreck will be worse than most are currently predicting, again IMAUO.
Posted by: Arrow.Debreu | December 10, 2007 at 12:16 AM