Blaming the Market

A theme running throw much commentary on the financial crisis is that the free market has brought us to this pass, so therefore we need to unleash hordes of regulators.

Financial analyst and blogger David Merkel tosses a bucket of reality on this budding meme.

5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.  First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.  Our dear government had many lending programs pre-crisis, and even more post-crisis.  They further encouraged the increase in debt through the tax code.

Why is debt finance tax deductible, and equity finance not?  What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?  Leverage would have been a lot lower, and the system would be a lot more stable.

Market efficiency means many things.  In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.  They reveal problems that need to be solved.  Some might call those market failures but they aren’t.  In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.  The visible hand, the government, says: “Have some more of the hair of the dog that bit you.  We need lower mortgage rates.  We need more consumer lending.  We’re going to borrow more than ever before in an effort to create prosperity.”  Caroline Baum takes a similar view, and as usual, she expresses it well.

Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.  Some things become revealed as truly public goods that the government needs to regulate.  But that is not the majority of human actions.

This was point #5 of 7 -- the others are good, too.