A Breathtaking Failure of the Market

The $700 billion bailout of the debt markets now being debated in Congress is stark evidence of the fact that markets can fail, not just in little ways around the edges of the economy, but in a massive way that threatens the very foundations of the whole American economy.

This failure is important to understand because one would have thought that financial markets are among the least prone to failure. There have been active markets in loans for hundreds -- even thousands -- of years. The issues are well understood. Even for exotic mortgages, it was pretty clear what the terms were -- what the borrower must repay, what the lender can expect, and what the risks to both were.

The fact that both borrowers and lenders acted irrationally -- or at best irresponsibly -- is incontrovertible evidence that markets can fail.

In the case of mortgages, there are many reasons for failure. One is ignoring the costs of energy and location, as I discussed in a previous blog.

Another cause of the mortgage default problem is the creation of a market failure that went unrecognized by the lending industry and by the financial companies that financed mortgages. It is the trend since the 1990s of separating the business of originating of loans from the business of investing in income-generating financial assets. While lenders used to make their money from the interest payments on the loan, now most lenders make their money on points and fees, and sell the actual mortgages to financial corporations that create mortgage/securities from them. With different parties responsible for different parts of the transaction, there is no one who can act to work out potential problems of non-payment with the borrower.

In the area of energy efficiency in buildings, one of the major failures of the market is called diffuse decisionmaking. An energy efficiency measure with a 100% return on investment accomplished through upgrading the cooling system in an office building may not be undertaken because no one has both the authority and the responsibility for the cost and authorization of the investment.

Today this problem characterizes the mortgage mess as well: because no one has both the authority and the responsibility for negotiating a solution better than foreclosure.

Market failures are at the heart of the discussions about energy efficiency and its potential to protect the climate at a profit. Those skeptical of the ability of efficiency to deliver the solution argue that markets cannot fail: that if you think that there are trillions of dollars of profit from efficiency that could be reaped with the right policies, you are mistaken. Markets could not allow such an unexploited opportunity to exist.

But the mortgage crisis provides irrefutable evidence that markets can fail on a large scale.

Further discussion of the mortgage crisis and its causes will appear in my new book, tentatively titled, Invisible Energy: How Efficiency Can Stabilize Global Climate and Fix the Economy, forthcoming from Bay Tree Publishing. More detail on failures of the market can be found in my current book Saving Energy, Growing Jobs.

Economic fundamentalists might counter that the problem is due to government interference in the market through the creation of Fannie Mae and Freddy Mac. But if this were true, the problem would have focused on these corporations: they would have been the first to fall, and federalizing them would have solved the problem. But other institutions were hit even worse, and as we are seeing, solving the problems of these two did not stop the panic.

The problems are consequences of known failures of the market. The government could have corrected these failures in advance and avoided most of the crisis. And unless it tries to correct them now, it will not succeed in stopping the bleeding without immense cost to the taxpayer.