Can markets calculate their own failure?
Anybody reading Business Journals or Economist has heard about subprimes. Subprimes are loans given to people with higher risk of credit failure. Subprimes are mortgages or credits sold at prices higher than normal credit loans.
Because of increasing prices for property in the US, houses became higher assets and even subprime credit taker could bargain for lower interest rates, which resulted in two things: it increased the number of credit takers and increase the prices of property in the US (because more people would improve their property). If increasing demand would have been met by a more rigid supply, interest rates would have gone again, but with the capital market expanding into even riskier zones, the demand for subprime mortgages were easily met by the capital market.
This all constituted a wonderful bubble – as long as everybody was on the road of upward prices, nothing happened. However, as soon as some doubt arose, the whole bubble bursted – in theory at least. There are some very good accounts why the subprime crisis was not necessarily a bubble and why the overall economic impact has been rather diminishing and far from being a real economic crisis.
But another question is important to think about: Can a market predict a market failure? I would define “market failure” as a situation in which demand and supply go two different ways, either demand goes through the sky and supply crashes, resulting in shortages (famines), or demand crashes and supply goes through the sky, resulting in sharp price drops.
But market failures are very rare and often have no long-term effects. Take for instance the tulip crash in the 17th century: no doubt bitter at that time but the market recovered eventually.
Has there ever been a complete market failure – after which demand and supply never came back? I don’t think so. Markets can fail if too many ‘lemons’ enter the market – lemons are objects that appear to have a better price than they actually are worth. New Economy Start Ups as well as used cars are potential candidates for lemons (see Akerlofs famous Market of the Lemons for more details.) But what if you can bet on the percentage of lemons in the market? If you can bet on market failure? If enough people bet on market failure, then an emerging bubble shrinks or explodes – but the market as such is not destroyed. This creates an interesting paradox: people who will bet on market failure are doing their best to prevent it.
