A Free Market Solution to Further Market Crises
by Tom at Radio Free NJ
http://freenj.blogspot.com/2008/04/free-market-solution-to-further-market.html

This article is a lot like others that have been written and posted about in regards to the credit market crisis but (at least from all the posts that I’ve read) this article takes a simplistic and economic angle but actually provides an interesting solution to the problem, that may prevent future crises like the one we’re currently in from happening again. What is interesting is that some of the discussion of this crisis and why it’s happening ties into both information cascades and auctions.

According to Tom, the problem that caused the crisis that we’re experiencing now is that there was an asset bubble due to too much buying that eventually burst and threw the economy for a loop. The reason for the asset bubble (this is where it ties into auctions, sort of) was that people kept buying at a price higher than their value because they were confident that they could sell it for even higher (thereby still making a profit). Try to picture a succession of auctions where the buyer of one auction becomes the seller of another, and so on. The reason why everyone is buying at a price higher than their value is because of an information cascade, which can only happen as long as the buyers outnumber the sellers overall by a certain percentage where their outlook (sum of incentives) is made into a “self-fulfilling prophecy” (they predict it will happen, and by doing so actually cause it to happen). However, the players in this market had no idea when the boom would be over (when the buyers/seller ratio would sink below the magic level), so when the boom did end and people stopped buying, there was such a big asset bubble that when it exploded it was a big deal. We know that when players in an auction buy at a level about their value, it’s inefficient, even though in this situation it makes sense for an individual to do it if they think that someone will buy the product at an even higher value. And this is an information cascade in that as soon as a few people do this, everyone’s incentive based on their private information plus what they observe everyone else is doing (buying) is also to buy.

The FED and the government are trying a lot of things to remedy this problem and prevent it from happening in the future. For example, the FED offered to buy JPMorgan and deal with it’s portfolio’s issues in order to give people confidence in the value in transactions. The government wants to increase its control of financial markets through regulation and oversight. Tom argues that because there’s no way to predict how all of the players in a market will act and that government regulations always get circumvented somehow, these measures won’t work to prevent future crises like this one. In order to find the solution we need to only look at how information cascades work. How do you stop cascades? By providing the players with more information to give them an incentive to not continue to go along with the cascade. That’s why Tom’s recommendation of publishing leverage statistics to give people more information would work, because then the natural workings of the market would cause excess buying to stop before it got out of hand.