A Remarkable Question

Our colleague, Richard Wagner, a leading light in the public choice revolution, wrote the following remarkable question for the 2005-2006 graduate political economy preliminary exam at George Mason.

Joseph Schumpeter claimed that capitalism would give way to socialism largely for ideological reasons. This does not seem to have happened, at least directly. But might it be happening indirectly? Consider, for instance, a significant change that has occurred in the economic organization of debtor-creditor contracts. Not too long ago, lenders held their loans in their portfolios. They would lose if the borrower defaulted, which gave the lender a strong incentive to monitor the borrower, particularly for large loans. Now, lenders split their loans into numerous small pieces and disperse them throughout the economy. (For instance, many people who hold mutual funds and retirement accounts will find that they are holding small pieces of large loans made by commercial banks.) The burden of non-performing loans is thus dispersed throughout the economy rather than residing with the original lender. Does this development weaken the incentive of lenders to monitor borrowers and thereby weaken overall economic performance? That is, can market transactions generate institutional arrangements that impair the market economy? However you address this topic, do so clearly and cogently.

I am sorry to say that none of the students got the answer right.  Of course, very few of their teachers, here or elsewhere, got the answer right, either.  Kudos to Dick for his prescience.

I thank David Levy for the pointer.