Writers don't understand how markets work

March 29, 2010

The March 29 article, "When consumers lack information, free market system falters" by Charles Scott, Fred Derrick, and Andrew Samuel displays a fundamental misunderstanding of how markets work by these authors. They claim that because sellers have more information about their products and services than buyers, most sellers will cheat or defraud their customers. Nonsense. Baltimore Sun reporters have more information about daily news than their readers, and economics professors have more information about the field of economics than their readers do, but that does not guarantee that they are frauds and cheats and that the markets for newspapers and higher education "fail."

The division of labor in society means that ALL sellers have more information about their products than do buyers. Assymetric information is what makes markets work, not the other way around. Who needs the Baltimore Sun if we all have "symetric information" about daily news?

The writers claim that an auto mechanic has "no" incentive to reveal the truth. They apparently are unaware of the concept of competition, whereby less truthful and reliable businesses lose market share or go bankrupt. A plagiarism scandal at The Sun would be devastating to the paper's market share, for example. Brand loyalty is an important means of competing. They also claim that the used car market is plagued by an "assymetric information" problem but are oblivious to the fact that the market solved this problem decades ago with product warranties.

The authors totally misunderstand the mortgage meltdown as well. They repeat the myth that all purchasers of adjustable rate mortages "were not told the true risks." Anyone who has ever attended a real estate closing knows this is false. It is all spelled out very clearly in the HUD documents. These borrowers were gamblers, and they lost.

These authors are also apparently unaware of the fact that it was the U.S Congress that instructed Fannie Mae and Freddie Mac to "bundle" trillions of dollars of dubious loans, not investors in the free market. The Greeenspan Fed's easy money/low interest rate policy caused the real estate bubble, not the imaginary "problem" of "assymetric information." And the government's implicit promise of a Fannie Mae bailout is what led so many investors to bundle dubious loans and sell them to Fannie, thereby creating a massive moral hazard problem.

Government regulation also contributed to the "sub-prime" crisis in the form of Community Reinvestment Act and other regulations that forced mortgage lenders to make bad loans to unqualified borrowers as part of the federal government's overall policy of trying to increase home ownership. Financial markets in general are awash in dozens of layers of regulation, but these authors seem unaware of this fact. The same is true of health care markets, which the writers falsely portray as some kind of free-market mecca.

Finally, for at least the past 40 years it has been unacceptable for economists to simply assume that perceived "imperfections" in markets will be perfectly corrected by politicians and bureacrats, as the authors assume when they make their pollyanish plea for more and more government regulation. There is a large literature in economics about how government regulation often makes things worse, not better. James M. Buchanan, Gary Becker, and George Stigler were all awarded Nobel prizes in economics for such research. It is dishonest auto mechanic-style behavior to simply ignore it.

Thomas DiLorenzo, Baltimore

The writer is a professor of economics at Loyola University Maryland.

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