Market Failure

Gary S. Becker wrote a great piece on The Great Recession and Government Failure. In it he makes the point that while market failures are inevitable, it’s a mistake to assume that government intervention will improve the situation. I certainly agree, but I have a hard time accepting the term market failure. It’s not that markets are incapable of failing, they are. Monopolies are one example, public goods (in some instances) can provide other examples.

However, what most people point to as a market failure—say, the housing crisis, or the cost of health care—is usually something entirely different. Monopolies are already illegal in the U.S.,¹ and there are also laws regulating most public goods. We figured out true market failures pretty early on in this country and made laws accordingly.

After a market bubble bursts—say, the dot-com bubble or the housing bubble—people call it a market failure. That’s not accurate. A market failure is an occurrence in the market which results in a persistent state of brokenness (inefficiency) in that market. That doesn’t happen often. Normally what happens are market corrections. It’s a lot like your son steals a candy bar and you discipline him. Your son is not a failure, he behaved badly and was corrected. This is a distinct occurrence from your son growing up and choosing a career of thieving. In that scenario, categorizing him as a failure is accurate (from a moral point of view).

Did lots of people lose money when the dot-com bubble burst? Yep. Are a lot of people going through foreclosure right now? Absolutely. That doesn’t mean the market is a failure. It is correcting itself, though. It’s painful for a lot of people, but it’s a serious mistake to think the government can step in and make it better. You don’t neglect disciplining your kid when he steals, doing that is exactly how kids end up making a career out of stealing. The market needs painful correction in order to learn.

What’s unfortunate is that the current administration doesn’t believe in the free market, and any time it starts to falter, it steps in fast and heavy. When the dot-com bubble burst, Bill Clinton was in office—a decidedly liberal president—but he didn’t really mess with the market. Part of the reason for this is probably because most of the people affected were what the liberals like to call “rich”, so there was little incentive to help them.

The market learned from this bubble bursting. It’s pretty tough to get funded in the tech industry today compared to 1997. You not only have to present a great idea, but you also need a comprehensive plan to make it profitable, and soon. Even then you’ve got to have investors that believe in your ability to execute your plan. The reason for this is because a lot of investors watched their money evaporate into thin air as the dot-com bubble burst.

Are banks are going to continue issuing copious mortgages to people who can’t really afford them? I don’t see why not. They got away with it once already. The government just stepped in and took away the financial pain (i.e. the consequences). Also, many home buyers who made terrible decisions by purchasing homes they could not afford are also getting bailed out through mortgage restructuring.

So, what many people are referring to as a market failure is not actually an event that results in a persistent state of brokenness. Instead it’s an event where the market acted badly. This normally fixes itself, but instead we have Uncle Sam stepping in to stop the normal course of discipline and consequences.

It’s also worth mentioning that in the case of the housing bubble, the market isn’t even the sole party to blame. Did banks irresponsibly issue mortgages? Yes. But the government did encourage them to issue these mortgages through faux private institutions like Fannie Mae and Freddie Mac. They took all of the risk out of risky mortgages by guaranteeing to buy them through these faux private companies. Don’t like your collection of toxic mortgages? No worries, Fannie Mae will buy them.

Liberals pushed to institute these policies in the name of helping lower income families afford homes. Their supposed intentions were great, but they messed with the free market and the consequences are that many people obtained mortgages who had no business buying a home to begin with, because they weren’t financially capable of making a mortgage payment in the long run. The result was actually the opposite of the policy’s stated intention. Instead of lower income families owning homes, many of them are now going bankrupt (or should be).

It’s important to note this, because Liberals are notorious for implementing policies that have great intentions behind them and disastrous consequences. Then, when their policies fail, they make the situation even worse by eliminating the consequences. Market failure may be a convenient term to push new legislation and regulation, but let’s make sure it’s a true market failure first. If not, call it what it is—a correction—and let it run its course and allow the market learn from its mistakes.

After all, you know what happens when you don’t discipline your kid, right? They become a spoiled brat.