Business Insight Zone

Two articles on quite different subjects have me thinking about economic feedback loops and what governments can (or should) do to influence them. First, here’s a blog entry from economics Nobelist Gary Becker:

Should Central Banks Intervene During This Financial Crisis?

[...] some [...] economists have argued that trying to stem the [credit] crisis by making loans cheaper and more available is an unwarranted bailout of financial institutions. This could create a risk-called “moral hazard” – which means in this situation that hedge funds and other financial companies might lend recklessly in the future in the expectation that they would be helped again by Central Banks if they get into trouble. Others have argued that the financial system has to go through a crisis to eliminate all the reckless investments that have been made during the past few years.

I have been a strong opponent of bailouts of individual companies since I do not believe in the “too big to fail” justification when applied even to large manufacturers, financial intermediaries, or service companies. [...] It would be a further mistake for the Fed or other Central banks to come to the assistance of hedge funds or other lenders that may be in financial difficulties because they excessively invested in assets of dubious value. They should bear the consequences of their mistakes. [...]

I believe [central banks] should continue to be guided by the criteria that have served them very well during the past couple of decades. That is, their policies should be determined by rules dependent on broad developments in the economy: unemployment, the growth in GDP, and the inflation rate. Central banks should intervene by lowering interest rates only when these broad economic indicators begin to slip badly.

I’m going to go waaaay out on a limb and agree with the Nobel laureate in this case. He’s hardly the first in recent weeks to raise the issue of “moral hazard” in connection with the Fed, but his summary of the risks here seems particularly apt. Hedge funds and private equity houses and mortgage companies and others placed themselves at more or less risk over the past few years because of the bets they laid on things like long-term interest rates, the ready availability of credit in the world lending markets, and the state of the US housing market. We can hope that they laid these bets on sound principles and with a prudent judgment of both upsides and downsides. Surely the passive investors in these firms share that hope with particular ardor.

But economic history suggests that, in any overheated market environment — whether or not we choose to call it a bubble — there are virtually always market players who aren’t prudent. If the basic principles of economic feedback (reward for shrewdness, penalties for foolishness) are to apply, these imprudent actors must lose money. If they go bankrupt, so be it. In this case, all of the folks at the hedge funds and private equity shops are at least relatively rich, anyway, so there’s no need to shed a tear for them. True, lowly mortgage adjustors and the like will go out of numbers in droves — as when American Home Mortgage collapsed — and it stinks that the folks down the ladder suffer that way for the mistakes of their superiors. But the government can’t put intself in the business of stopping failures like that, no matter if we’re talking about a third-tier mortgage company or one of the titans of Wall Street. The only risks the government should act to avert are the risks of broader impacts across sectors, across borders, and so on.

Now for the second piece, written by Erica Barnett of WorldChanging, a prominent environmental blog. This one shows how well properly-informed market actors (in this case, Seattle commuters) can respond to changed baseline conditions in a market (the supply of highway lanes in central Seattle) when they’re given adequate visibility into the market’s operation (in the form of advanced warning about construction and the threat of gridlock).

Congestion as Incentive

A few days ago, two lanes of the main freeway arterial through Seattle, Interstate 5, were shut down for construction. They will remain closed at least another two weeks. For weeks preceding the lane closure, local newspapers, blogs, and television have predicted utter traffic chaos and disaster. But despite predictions of “nightmare” traffic, “survival tips” for dealing with the commute, and even an entire blog called “The Clog” dedicated to the closure, Traffic Jam 2007 failed to materialize. (Actual headline on day two of “The Clog”: “No Clog Just Yet.”) Not only that, but many commuters described the drive as smoother than ever.

What happened? Media and government efforts to sow collective panic can’t, on their own, explain the startling reduction in traffic on I-5. According to the state Department of Transportation, of 120,000 cars that normally use northbound I-5 daily, about half simply disappeared. The explanation: Drivers are adaptable. When faced with the prospect of gridlock — and given ample warning and time to prepare — people found alternate routes, rode transit, worked from home, and avoided unnecessary trips.

Which is as it should be. I’m picking a non-financial example with this second article on purpose. Sometimes we act as though one set of rules applies for the financial world, and something else applies outside of it. But in fact, there are far more parallels than differences, at least from where I sit. A government’s job, in each case, should be to ensure that information flows smoothly and that the system as a whole is protected for major shocks. Whether we’re talking about Seattle’s traffic or the fate of hedge funds, much of the rest of it will work itself out in time.

Category: Economics, Finance & Real Estate, Transportation