Daily Archives: October 7, 2008

Justification for Public Intervention in light of Market Failure

Bernanke, using history of the Great Depression, opines:

Finally, Mr. Bernanke, who is an authority on the Great Depression, said that the country and its federal officials had learned from history that inaction or delayed reaction to financial calamity could be disastrous.

“This is not the situation we face today,” he said, predicting that official Washington’s fast response “together with the natural recuperative powers of the financial markets” will pave the way toward recovery.

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Mark-to-Market : Public Interest causes Market Failure?

From Congressional testimony excerpted in the NYT:

AIG says the rules forcing information into the market regarding debts caused their downfall:

In his testimony, Mr. Willumstad attributed the company’s failure largely to mark-to-market accounting rules that forced A.I.G. to recognize tens of billions of dollars in accounting losses, as well as a “tsunami” of market instability ignited by the collapse in value of mortgage-backed securities.

Congressman Waxman thinks otherwise:

“A.I.G. is blaming its downfall on accounting rules which require it to disclose losses to its investors,” the specialist, Lynn E. Turner, the former chief accountant at the Securities and Exchange Commission, said. “That’s like blaming the thermometer, folks, for a fever.”

So, basic econ theory says there is an assumption of perfect information which supports an efficient marketplace.  But, AIG (and others) say a rule forcing disclosure of “more” information than the company ordinarily would have disclosed — caused the market to devalue their company.

This argument causes one to question whether the markets were overvalued because of inefficiencies due to imperfect information.

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Market Failure — a teaching moment

Review in the Chronicle discusses whether the current financial crisis causes one to consider whether economics is taught well.  Here are a couple of interesting quotes:

At some point, and this is as good as any, we have to ask ourselves if we have been teaching theory or ideology.

What about a return to the idea that economic theory does not offer settled answers but instead offers only an engine of analysis? Are we fearful that if we allow for too much ambiguity in the use of our theories, we will no longer be perceived as proper scientists? If anything, this episode should remind us to remind our students that there may not always be a unique right answer.

And —

This crisis is built on the foundations of financial illiteracy.

And —

It is very ironic that the end result of the misplaced application of incentives in the Soviet Union led to the increased role of the market system in that country. In the United States, the misplaced application of incentives is bringing about greater government intervention in the economy.

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