hhttp://www.spectator.co.uk/the-magazine/politics/552986/budget-2008a-mortgage-market-for-lemons.thtml

During class, we discussed George Akerlof’s economic theory of “the market for lemons.” This Nobel Prize winning idea shed light on a major economic problem based on the asymmetry of information. This theory revolves around the fact that many transactions that involve the interaction of buyers and sellers have an imbalance of information–one side of the market, has more information about the goods or services being sold than the other side does. Akerlof applied this to the used-car, or “lemon,” market. In this market, sellers know more about the quality of the cars being sold than the potential buyers do. With no way of knowing whether he is purchasing a defective car, the buyer can only expect to get a car of average quality, which correspondingly makes him unwilling to pay more than the average price. In response, the used-car dealers remove the good quality automobiles from the market since this puts them at a loss–they are receiving an average price for a good that they know is worth more. This leads to a gradual removal of good quality used-cars from the market, leaving only the lemons behind. The average quality of the remaining cars thus declines, resulting in a cessation of buyers’ purchases since they are increasingly receiving bad products. The ultimate result is a collapse of this “market for lemons” in which both parties are clearly at a loss.  (Chapter 15 of Econ204 textbook)

Recent events have led to a seemingly parallel situation in the mortgage market. The article “Budget 2008: A Mortgage Market for Lemons?” by Ian Mulheirn introduces the ways in which the circumstances surrounding the purchase of homes in the UK are coming to resemble the purchase of second-hand automobiles.

The British housing market is under threat of collapse, which, according to the UK Treasury, is due to the problem of asymmetric information. Mortgage markets are frozen because risky debt is driving safe debt from the market by raising the price for all debt. To apply this to the Akerlof’s used-car analogy, the risky debts are the poor-quality goods while the safe debts are the good-quality goods. The balance of information in this case, however, is tipped towards the side of the buyers, since they hold more knowledge concerning their ability to repay than do the creditors. With questionable debt rising in numbers, interest rates are steadily climbing and lender confidence declining, putting the mortgage market in a precarious position.

The British government has therefore proposed several methods to solve this “lemon” problem and revive the housing market. Some suggestions are to reserve credit for home-buyers who borrow no more than 90% of the value of the house, or those who borrow only a low multiple of their annual income. This filtering of the mortgage “lemons” would finally allow for a return of cheap credit for safe borrowers, and save the housing market from the current slump.

The article states, however, that the government has failed to notice that this market for lemons is “yesterday’s problem.” Firstly, although Akerlof’s situation exists, in some cases, nothing can be done about it since many dealers consider their reputation with customers, which will affect future business. Should creditors consistently refuse potential “bad borrowers,” their public image and trust may suffer. Furthermore, businesses have found several ways around the “market for lemons” problem. Warranties, agencies such as Standard & Poor’s and Moody’s that help punters understand how risk their investments are, and increasing amounts of available information on the potential borrowers have all aided in this process.

If the asymmetry of information has been made somewhat balanced, what, then, is the problem? Why is the deterioration of credit continuing to persist despite the solution businesses have found for the mortgage market for lemons? The answer lies in investors’ behavior as they respond to the possibility of potential loss. Businesses are becoming increasingly concerned about complex processes involved in the relationship with the mortgager characterized by “impenetrable legalese and arcane financial vehicles.”

The article ends with the conclusion that the government’s solution to the mortgage market for lemons has come too late. Not only have businesses found their own methods of solving this economic issue, but another, more labyrinthine issue has emerged. To apply this to our discussions in class, it is clear that solutions to Akerlof’s market for lemons do indeed exist-it is possible to devise methods to avoid this situation. However, as the article illustrates, these solutions must be applied in a timely manner. While it might have been helpful for the British government to identify the “lemon” borrowers during years of reckless lending, current times call for more effective measures. As Mulheirn states, the British government’s proposals “might make [it] feel better to look like they’re doing something, but pointing and shouting isn’t going to help anyone now.”