Banana redux

by on December 5, 2008 at 3:16 pm in Economics | Permalink

At Cato Unbound there is a symposium about the roots of the financial crisis, with several notable contributors.  To sum up my view again, I agree that government had many bad policies, many of those policies made the crisis worse, and that such policies should make us despair at the quality of government as regulator, past, present, and future.  But still markets must bear a very considerable share of the blame.  Bryan Caplan reminds me of my banana post, excerpted for your convenience:

Let’s say that the government subsidized the price of bananas, you bought so many bananas, put them on your roof, and then the roof collapsed.  Is that government failure or market failure?  The price was distorted, but I still say this is mostly market failure.  No one made you put so many bananas on your roof.

If Minsky and Hayek are running in a race for interpreting the last two years of the U.S. macroeconomy, Hayek has something to offer but so far Minsky is in the lead.

Ryan December 5, 2008 at 3:27 pm

How is that market failure? Why are markets supposed to protect people from putting too many bananas on their roof? People ask too much from a system which allocates scarce resources. As long as he isn’t putting the bananas on my roof, I think the only costs which are not correctly internalized are the taxes I paid to subsidize this idiot and his bananas.

Neal W. December 5, 2008 at 3:37 pm

Re: the banana example

You’re right, that is a market failure, but it’s not a FREE market failure. It’s an INTERVENTIONIST market failure. The interventionist market steered behavior in a certain direction that had silly consequences. I fail to see how this is a argument against the free market.

Todd December 5, 2008 at 3:45 pm

Buying a more expensive house than you can realistically afford, or speculating on future appreciation in housing by using lots of leverage to buy real estate can probably be fairly described as risky endeavors. We might even agree to call them stupid in hindsight, but to compare them to completely inane activities like putting bananas on your roof or stuffing scorpions down your shorts doesn’t strike me as particularly illuminating. Even though the former bets turned out badly, we all understand what it would have meant if they had turned out well. What, exactly, is the winning outcome of the “putting bananas on your roof” maneuver?

Jody December 5, 2008 at 3:48 pm

The banana example does not make sense as a market failure as the allocation of banannas (e.g., the additional purchase of bananas), given the government subsidy, may well have been efficient and / or optimal.

A market failure is where combined application of self-interest leads to sub-optimal outcomes. A tragedy of the commons (or anti-commons, if you like) is an example of a market failure.

As storing bananas on your own roof to the point of collapse is not individually rational (i.e., the person in interest did not act in their self-interest), it is not a market failure.

Specifically, the roof collapse is neither a market failure nor a government failure. It is a a personal / private failure due to the dumba**ery of improperly storing the bananas.

apostate December 5, 2008 at 4:16 pm

I still fail to see how “the Market” is at fault. It’s just a means of measuring what people are willing to pay for things. Blaming the market would be like blaming the bathroom scale because you’re too fat.

MattYoung December 5, 2008 at 4:31 pm

Talking reality.

Simply because Asians collected dollars for some reason does not mean that they are evaporated. The dollars that Asians collected may have been collected precisely because we would forget about them and crash.

It was up to us to hold production in reserve to cover the dollars.

John December 5, 2008 at 6:01 pm

Several people have noted the obvious ways in which the analogy is mistaken.

However, they didn’t note the obvious facts. If the government had not distorted the price of bananas, then they would have had fewer to store on top of their house. Indeed, it would have taken much longer for him to accumulate bananas and some bananas might have depreciated in value (by going bad) and some might have been consumed. He may never have accumulated enough, so quickly (a key point), so that the roof would have collapsed. If he accumulated them more slowly, he might have been more able to see the roof weakening and switched up the storage or sold some.

There is plenty of data supporting the idea that credit expansion fuels asset price booms. I refer you to “Asset Price Booms & Monetary Policy” by Detken & Smets and “Liquidity Shocks & Asset Price Boom/Bust Cycles” by Adalid & Detken. Not to say that Minsky doesn’t have anything to say about the current crisis, but you shouldn’t be so quick to dismiss the Hayekian point.

Then there is another problem with your point. Let’s say the government had a program giving knives to U.S. soldiers stationed in Japan. One of those soldiers stabs a Japanese girl. Certainly you would say that the soldier is morally culpable for the stabbing, just as you could say that the banana hoarder is at fault for making a poor decision. However, just ias in the case of the hoarder, the problem would have likely never occured if the government didn’t give the soldier the knife, or for that matter keep him in Japan. There’s no way you can say all the fault lays on one or the other, but there is a difference between morals/fault on one hand and economic efficiency on the other. I’d say it’s much easier to get the institutions right than it is to get the individual soldier/entrepreneur right. Therefore, focus on the institution making the problems, the government.

Bill Stepp December 5, 2008 at 6:18 pm

A roof is designed to bear a certain load, just like a bridge is. If someone puts excessive weight on the roof, causing it to collapse, then that is not a market failure. On the contrary, the roof did what it was designed to do.
Markets are often blamed for lots of things, none of which they cause. When prices collapse due to unsustainble booms, markets are simply reallocating resources in accordance with shifting patterns of supply and demand in various markets. That’s what markets do.
Markets are not designed, like roofs or bridges. They evolve spontaneously as a result of human action but not human design. They work by facilitating traders’ trading, whose trading begets prices.
The Krugmans, Minskys and DeLongs of the world don’t begin to understand this, so they can’t possibly really understand economics.
Btw, if Bryan is reading this, I was kicked off your blog by the administrator for a quesion about Krugman. I thought the question was quite reasonable, unlike the action of the administrator.

David Shor December 5, 2008 at 7:57 pm

Nobody is understanding what Tyler is trying to say.

Libertarian types often take a stridently individualistic approach to things, which can make them infuriatingly unable to talk about collective issues in the private sector.

The important key in the analogy is that instead of this person being one idiot, an extremely large segment of the population bought enough bananas to make their roofs collapse.

This suggests that the population, as a whole, is often collectively irrational, with devastating consequences.

More directly: It’s been shown that financial markets, left unchecked, are persistently irrational. And this suggests that market regulation right be a good idea.

the buggy professor December 5, 2008 at 8:25 pm

“Nobody is understanding what Tyler is trying to say… This suggests that the population, as a whole, is often collectively irrational, with devastating consequences More directly: It’s been shown that financial markets, left unchecked, are persistently irrational. And this suggests that market regulation right be a good idea.” — David Shor

…………..

(1) That seems right on target, David. And it leaves you wondering how much do the large majority of the posters here know about Hyman Minsky’s work? Most likely, not much . . . and maybe in many cases not at all. Let’s hope the remarks that follow help a little to remedy this shortcoming.

…..

(2) The crux of Minsky’s views of financial booms-and-busts — based, please note, not just on his academic work but his long experi9ence in banking — is that financial markets in a capitalist economy are prone to crisis for emotionally charged psychological reasons.

In particular, in prosperous times, excessive optimism develops; creates in the process a speculative fever in the stock market and in other financial or real assets — like real estate, as we know now to our regret; and, as speculative euphoria surges, leads lead borrowers to draw on a variety of high-risk loans and margin-purchases and other financial innovations that have created what we would now call “near money† for speculative purposes. And since cash-flow and profits are on the rise in the business world, not to mention the capital gains in financial and other markets, banks and other lends are increasingly anxious to lend out money and take more and more risks in doing so

†¦†¦†¦†¦†¦†¦

(3) Sooner or later, though, an economy begins to move ever quickly toward excessive cumulative debt (or insolvent debt if you want) . . .all aggravated in the run-up to a financial crash by various forms of high-rolling borrowers. Minsky distinguished three or so:

†¢ Hedge borrowers (still not regulated in big hedge funds despite Henry Paulson’s recent warning), who borrow money to invest in a variety of assets that will enable them to pay off the debt with returns from such investments (or capital gains upon a sale);

†¢ Speculative borrowers who borrow in the hope to invest and service interest on the loans, only to roll over the principal into buying more investment;

†¢ Ponzi borrowers, very apropos of mortgage-buyers, sellers, derivative repackagers, credit debt-swappers, and so on, who keep betting that their assets bought with loans will appreciate into the future, but who end up without sufficient resources — once the debt-overload of the economy leads to a financial crash and recession — to repay those loans.

†¦†¦†¦†¦†¦

(4) Enter crash-time on the one hand and real-economy recession on the other.

At some point, as debt piles up and up, borrowers begin to realize they can’t service the loans, let alone pay them back, with current levels of income. Excessive leveraging is everywhere. Soon afterwards, the speculative bubble will burst. In its wake, the economy will be marked by loan- defaults and business bankruptcies; financial and many real assets of all sort will plunge in value — not least, in the stock and bond markets, but as we also know now in real estate markets too.

All this on the one hand. On the other, the financial crash quickly spreads into the real economy occurs.

,,

Why? Because — in Keynesian logic of the sort Minksy himself wrote about (but was downplayed by IS-LM interpretations of Keynes work, not to mention later New Keynesian versions) — a crackling swerve in prevailing psychology occurs . . . first and foremost among bankers and lenders. It’s then credit-crunch time. Lots of uncertainties prevail, aggravated by inter-temporal concerns on the part of not just bankers and other capital-holders but by businesses and households about the future of the economy’s growth and income-streams and profitability.

†¦†¦†¦……

5) In the upshot, as we now know, bankers start sitting on their excess reserves. They might not even trust one another’s balance sheets and lend to banks themselves.

Nowadays, thanks to FDIC and further extensions, the public hasn’t experienced the sort of bank-failures and isn’t engaged in panic-buying as in the 1930s. Even so, wealth-holders may begin — in Keynesian terms — to seek refuge in even miniscule-paying Treasury bills rather than invest in long-term bonds or a volatile stock market out of precautionary and speculative reasons: fearful of capital gains losses, among other things, if interest rates rise in the future or, in equity-markets, if short-term profits by their issuing firms don’t materialize as expected or hoped for.

And so even businesses and households with good credit-ratings and what would seem solid prospects for income or profit find it hard to get loans. At some point, they might not even lend much or most or all of their excess reserves or cumulative savings to business and household borrowers with good credit-ratings and solid income prospects to service and pay off loans.

……

6) Minsky’s policy conclusions?

More or less, David, what you said at the end of your thoughtful comments about Taylor’s banana analogy and his reference at the end of his post to Minsky (left up in the air though).

If I recall correctly — I might be wrong — Minsky didn’t believe that the fragility of financial markets could be cured. Such fragility, after all, is psychologically grounded in the emotionally charged mood-swings that occur between the poles of speculative euphoria in prosperous times and excessive pessimism in the down-phases of the business cycles and recessions. Note though. If such psychological swerving can’t be eliminated, its worst excesses in his view could be walled-in by effective regulations that substitute for the asymmetrical information, agent-principal problems, and irrational boom-and-bust behavior of creditors and borrowers over the business cycle.

Come to that, isn’t this is the conclusions reached belatedly by the Federal Reserve, SEC, the current Secretary of the Treasury (and his predecessor John Snow), and President George W. Bush . . . not to mention most Congressmen?

…..

Michael Gordon, AKA, the buggy professor

P.S. I’m also left wondering how much many of the posters here know about Hayek’s views — which changed in his older age to self-criticism about his failure to speak up in the Great Depression and urge an increase by the Fed and other Central Banks to stop self-feeding deflation and huge unemployment in the 1929-1933 years. He said this in a talk he gave in 1975

“I am the last to deny – or rather, I am today the last to deny – that, in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.

“I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed. †¦ I would no longer maintain, as I did in the early ‘30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognizable function whatever, and that there is no justification for supporting or permitting a process of deflation.†

Lionel Robbins, another Austrian theorist, also said more or less the same thing very late in his life. Neither Hayek nor Robbins disavowed their views about excessive credit-creation; they did at least acknowledge their own role — as well as that of Mises and others I suppose — in failing to urge the Federal Reserve to start expanding noticeably the money supply to halt the worst excesses of the liquidationist-campaign.

Source: click here

Michael December 5, 2008 at 8:40 pm

Which specific works by Minsky would MR recommend for this subject?

David Shor December 5, 2008 at 10:33 pm

Unit,

Sure. That is a valid point. But the financial markets have caused trillions of dollars in damage in the last year. Barring an invasion of France, it’s hard to imagine government failure in a mature democracy being so catastrophic.

John,

The main purpose of interest rate manipulation is economic stabilization. Removing it creates it’s own problems.

Doug December 6, 2008 at 12:20 am

“More directly: It’s been shown that financial markets, left unchecked, are persistently irrational. And this suggests that market regulation right be a good idea.”

You’re making a logical leap between “unchecked financial markets (whatever that means) have problems” to “regulation might be a good idea.” For that leap to be valid, you need some evidence that the regulators are something more than 50% likely to do things that help the problem, rather than make it worse.

The banana example itself is a example of government regulation making things WORSE, not better. So how does that support the notion that “regulation might be a good idea”? Doesn’t support the notion that “regulation might be a bad idea that makes things worse, rather than better”?

Turning to real life, I do not have anywhere near 50% confidence in the government. The BEST of the guys in government now are the same types (or even the same GUYS) who screwed up so badly on the market side. I think they have a MUCH greater chance of making things worse than they do of making things better. They also have a long, well established history of doing things to screw things up, so why believe they will do differently now?

Moreover, the things they are actually doing do not inspire confidence. They are doing the EXACT things that will create and reinforce perverse incentives that will ensure that the next down cycle will be even worse than this one. At the same time, the whole attitude that the government can fix things so that this type of stuff doesn’t happen is just instilling the same false confidence that plagued the housing bubble and the internet bubble before it. This plays into and INCREASES the irrational emotions that lead to so-called market failures.

Alan Brown December 6, 2008 at 2:33 am

This disaster is a failure of government. The mistakes are many and well documented:

http://www.factcheck.org/elections-2008/who_caused_the_economic_crisis.html

You could call the actions taken by business in response to all of the distortions created as some sort of market failure, but you’d be missing the causes and the solutions (rolling back the distorting policies).

But don’t expect the current crop of politicians to take the appropriate actions. They got us into this and its unlikely they’ll suddenly get smart or less greedy.

Franklin Carroll December 6, 2008 at 5:05 am

No offense, but your argument seems profoundly misguided. What do you even mean by blame? This is not a moral dilemma warranting punishment. Blame can only be meaningful if we use it to mean “what must be changed to correct the problem.” Perhaps consumers could have been wiser, but that does not make their lack of wisdom the principle cause of the calamity any more than a person’s failure to wear a seatbelt should be considered coequal with the actions of the drunk driver who kills him. The earliest cause, tied directly and predictably to the result, in the chain must be considered the principle cause: And here that earliest cause is government interference in the market.

Perhaps we saw “market failure”—I have seen that term defined so variously that I have concluded that it is nearly meaningless. However, the question is whether we have seen “free market failure” and—beyond that—whether a government could possibly correct it if we had. They answer to both is a resounding No!

At best, goverments are going to be prone to all the troubles that plague markets (assuming these exist) in addition to all the troubles unique to goverment since goverment activity is little more than a market where votes are bought and sold (without any ties to production, however).

I am sorry to say this, because I admire Bryan Caplan greatly and hope to be studying under him soon, but all these discussions of market failure ignore the practical problem of information gathering and distribution. Of course, if I posit an omniscient economist God who can create enlightened policy and see into every man’s mind and judge his worth and productivity, it may be possible to allocate resources more efficiently than the free market does. However, this line of reasoning is as pointless as the quibbling of Trekies over the plausibility of warp drives. It simply does not matter, and—beyond that—it misleads the public.

The public concludes from your talk of “market failure” that we need to eliminate the free market—after all, if something has failed we ought to eliminate it, they think. It is socially irresponsible to engage in economic jargon that can so clearly mislead.

Beyond this, your point is clearly wrong. The dynamics of imputation clearly make distorted prices lead to other distorted prices—there was real demand for houses and it is unreasonable to expect entrepreneurs to be able to anticipate “true demand” apart from it.

But beyond this, on a less technical level, how does it remotely make sense to trust a government that can’t even properly regulate itself—any Fed chairman should have predicted this when the interest rate got to one percent—to regulate the economy in such a way as to increase efficiency. It is absurd.

Steve in Philly December 6, 2008 at 10:51 am

There’s no such thing as “collective irrationality”. Rationality is an attribute of the individual. No matter how irrationally one’s neighbors are acting, it is still up to you to decide how you are going to act.

dj superflat December 6, 2008 at 12:17 pm

you don’t need to know any economics to know that much of this discussion is lunacy. economists can’t agree about what happened 70 years ago in the great depression. economists can’t agree on how to fix whatever’s wrong currently. but we’re somehow supposed to trust that there’s some magic regulation that we know will help next time? if so, why have we gotten this wrong so many times? the answer pretty obviously seems to be that one of the results of human imperfection is that we’ll have boom and busts in the market, and regulators can’t really do much about it. it’s a policy question that’s pretty much inamenable (if that were a word) to correct resolution, probably both before and after busts (and econ just is not close to a hard science with, you know, actual answers to much). believing that there’s some solution that the wise men can come up with is likely to do more harm than just letting things play out. hayek likely should have stuck to his guns (as people get older, they often waiver, probably just biology).

Xmas December 6, 2008 at 7:13 pm

Isn’t the Banana Example also what Greenspan said about the results of his tactic of keeping interest rates really low?

To paraphrase Greenspan from 22-Oct-2008, “I never thought banks and mortgage lenders would be so effin’ stupid.”

Philo December 6, 2008 at 10:19 pm

In interpreting Tyler’s remarks, we must remember that in his world every failure is either a *government failure* or a *market failure*. If I married the wrong person and ended up divorced, that was a *market failure*. If I insulted a guy in a bar and got myself beat up, that was a *market failure*. If I drove too fast for conditions, lost control of my car, and slammed into an abutment, that was a *market failure*.

You might wonder about that last one. The road was owned and operated by the government; maybe if it had been better designed, or better posted, or better policed, I wouldn’t have had the accident. But *ex post* we can *always* point to something the government didn’t do but *might have done* to prevent me from messing up; that shouldn’t make my failure a *government failure*.

More troubling is the fact that *if the road had never been built at all* I wouldn’t have had the accident. Here we are pointing to something the government *did*, rather than something it *didn’t do*, as a contributing factor. So maybe my auto accident *was* a *government failure* after all, at least in part.

But perhaps at this point I need a bit of clarification. How about it, Tyler?

Philo December 6, 2008 at 10:39 pm

How, exactly, are we to distinguish between *government failure* and *market failure*, and what other kinds of failure are there? There must, at least, be *personal failure* that has nothing much to do with either government or the market, and collapsing your roof by overloading it with bananas is surely of this kind. Besides this individual case there are various collective cases–as when a group of students studying together fail to come up with the right answer to a homework problem–that are neither *government* nor *market* failures. But really, all these terms are too loosely defined for serious use. The market almost always plays some role in “government failures,” and the government in “market failures.” Trying to distinguish between these is not worth the trouble.

Andrew December 7, 2008 at 5:18 am

To be more direct, what usually causes these manias is herd instinct.

Yes, in markets it is a herd instinct around the idea that everyone else is getting rich doing it, so why shouldn’t I, but still, the problem is the herd instinct.

I can’t think of anyone less able to distinguish right from popular than politicians and bureaucrats. This is a huge theoretical hurdle in my mind that requires more than the assumption that any regulation whatsoever is an appropriate response to the occassional bubble.

batage May 14, 2009 at 4:18 am

Is it realistic?

sky May 14, 2009 at 4:19 am

Every success is based on continuous efforts. It is not possible be done over nigh.

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