by Mario Rizzo
In an under-appreciated book, The Foundations of Morality (1964), the Wall Street Journal and New York Times economic journalist, Henry Hazlitt, wrote that the price system does not send accurate signals in the absence of private property rights.
“It is important to insist that private property and free markets are not separable institutions… If I am a government commissar selling something I don’t really own, and you are another commissar buying it with money that really isn’t yours, then neither of us really cares what the price is” (p. 304).
The so-called Geithner (U.S. Treasury) plan to purchase toxic assets from banks disregards the relationship between an adequately functioning price system and property rights. The purchasers will not be playing with money that is really theirs. In the first place, up to 85% of the value of a portfolio of assets can be borrowed from the Federal Deposit Insurance Corporation (FDIC). These loans will be “nonrecourse loans,” that is, they are secured only by the value of the assets being bought. So if the assets turn out to be worthless (an extreme case) the FDIC is out the 85% and not the purchaser. In the second place, the Treasury itself will put up the money for as much as 80% of the remaining 15%.
Under these circumstances, when the private investors bid for these assets, what price will they pay? The provisions of the Treasury’s plan largely insure them against downside risk so they are not risking their own money. Therefore, their bids will not reflect an unbiased estimate of the value of these assets. The bids will be biased upward since the potential owners’ private payoffs will differ systematically from the social payoff. The quality of the prices that come out of this process will be poor.
There is a general lesson here. The market is a complex system in which both property rights (responsibilities) and the price system play inextricably linked parts. The failure to recognize this is responsible for much mischief. This is only the latest.
When the prerequisites for a well-functioning market are not in place, it is wrong to say that there is (or will be) market failure.
UPDATE: Jeffrey Sachs has an excellent article presenting an arithmetic illustration of my point. He also tells us why the government would advocate such a flawed bidding scheme — and it is not because they don’t know better!